The Meaning of Fair Market Value for Buy-Sell Agreements (Video and Text)

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The standard of value of fair market value is very familiar to attorneys and appraisers and often the subject of apparent disagreement. This post looks at the standard definition of fair market value and then breaks it down into its component parts as they relate to hypothetical willing buyers and sellers. Fair market value occurs at the intersection of negotiations between these two sets of hypothetical parties.  First, we must understand the meaning of fair market value.  Next, we must ask the follow-up question: the fair market value of what?  We investigate the relationship of the definition of fair market value and the asset(s) to which the definition pertains.



Hello, Chris Mercer here at ChrisMercer.net and MercerCapital.com.

Today’s video post will address the subject of fair market value.

Fair market value is a concept that’s used in all gift and estate tax appraisals. It’s used in buy-sell agreements. It’s used in many other aspects of business valuation. And so it’s an important standard of value for us to understand.

For years, when I was asked to talk about fair market value, I would read or recite a definition from the ASA Business Valuation Standards.

Let’s see how that goes:

Fair market value is the price, expressed in terms of cash equivalents, in which property would change hands between a hypothetical willing and able buyer, and a hypothetical and willing and able seller, acting at arm’s length in an open and unrestricted market when neither is under any compulsion to buy or sell, and when both have reasonable knowledge of the relevant facts.

So all is crystal clear. Right? Well, I got a lot of MEGOs or My Eyes Glaze Over, when I read something like that. Over the years, I’ve talked to a number of people about fair market value and have evolved into a better way of talking about it.

What is fair market value? Fair market value is a hypothetical transaction. First, it involves a hypothetical and willing buyer and seller. So we have hypothetical sellers who want as much money as they can get and hypothetical buyers who want as low a price as they can get.

Fair market value occurs at the intersection of the negotiations between those hypothetical buyers and sellers.

Well, what about those negotiations? They’re under no compulsion. There are no motivated buyers or motivated sellers in the world of fair market value. They act at arms-length, negotiating in their respective best interest in an open and free market. They have reasonable knowledge of the asset — and we’ll touch on that again, the asset that is being valued. And they have the financial capacity to engage in a transaction.

I would love to buy an Apple Computer. I don’t have the capacity. I can buy lots and lots of apples but not Apple Computer. I’m not in the in the group of hypothetical buyers for an Apple Computer. They have the capacity to engage in it. They engage in what – a hypothetical transaction. So in a business appraisal a hypothetical transaction occurs on the valuation date and for cash or cash equivalent value.

So that’s the meaning of fair market value.  It involves sellers acting in their best interests and buyers acting in their best interests and it involves the intersection of those negotiations between buyers and sellers. In fact, that’s the job of the business appraiser, to simulate the hypothetical negotiations between buyers and sellers and to get the strong points for the buyer and the strong points for the seller and to reflect those in the appraisal. Fair market value itself, as you can see here (FMV), is not a point figure. It’s a range concept and different appraisers can have a different opinion of fair market value within that range, and there’s nothing wrong with that. Did you ever see one home sell at one price and another similar home sell at a much greater price? Something was going on that we didn’t necessarily understand. But fair market value is the intersection of the hypothetical buyers and sellers.

What are the hypothetical buyers and sellers negotiating over? Well, they’re negotiating over an asset and that asset is a business interest. It makes a big difference in your buy-sell agreement if the buy-sell agreement says “the fair market value of the interest,” which would, in my levels of value chart, be a non-marketable minority level of value — versus a pro-rata share of the value of the business enterprise as a going concern, not giving effect for any strategic control premium or discount for lack of marketability. That would be this asset in the middle or sometimes it’s interpreted as a strategic kind of value. Well, it makes a big difference as you can see, whether the asset is a non-marketable minority value, a financial control value, or something strategic in nature. Fair market value is the standard of value used in most buy-sell agreements, but fair market value is not enough.

Please give me a call if you want to talk about fair market value or talk about your buy-sell agreements.

I look forward to talking about this very important concept of fair market value.

Thank you and good day.

 

Please note: I reserve the right to delete comments that are offensive or off-topic.

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