What's Fair About Fair Market Value?

By Laura Markee, CFA, ASA, Markee Valuations
September 2020 Bar Bulletin
September 1, 2020

Imagine a circumstance in which your clients are divorcing, and the other half is an effective psychologist. For the sake of the example, assume further that her practice is so successful that she earns over $500,000 yearly in her practice, much higher than the market benchmark of $250,000 for solo practitioner psychologists with her level of education.

In a divorce in Washington State, attorneys must understand when and how Washington's "reasonable value" standard might come into play in determining the worth of an independently held organization. In specific scenarios, reasonable market price (FMV) and fair worth analyses will result in significantly various conclusions and attorneys who are unaware of the application of reasonable value may advise their clients to accept a value for their organization interest far below what could be awarded.

Definition of Value

In service valuation, appraisers are frequently engaged to determine worth under the fair market price standard. Fair market worth (FMV) is defined by the American Society of Appraisers as:

"The cost, expressed in regards to cash equivalents, at which residential or commercial property would change hands in between a hypothetical ready and able purchaser and a hypothetical prepared and able seller, acting at arm's length in an open and unrestricted market, when neither is under obsession to buy or sell and when both have affordable understanding of the pertinent truths."

Although FMV is the standard of value in a marital dissolution context in many states, in Washington, the fair worth requirement is utilized. Unlike FMV, there is no commonly accepted definition for reasonable worth. In the AICPA's released SSVS,1 it is kept in mind that, "for state legal matters just, some states have laws that utilize the term fair value in investor and partner matters. For state legal matters just, for that reason, the term may be defined by statute or case law in the particular jurisdiction."

In dissenter's rights actions in Washington State, courts figure out the "reasonable worth" of the investor's interest, instead of the "reasonable market value."2 In Washington, for the purpose of an investor injustice suit, it is agreed that "reasonable value" does not include a discount for minority status.3

"Fair value" is not associated with "fair market price."4 While FMV relates to figuring out fair value, the scenarios of a specific case are vital to identifying reasonable worth.

If the celebrations are getting divorced and they own one hundred percent of a profitable enterprise, the application of fair value versus FMV will most frequently not enter play since the FMV of an one hundred percent ownership interest in a lucrative company is often equal to fair worth.

However, in specific cases, recognition and acknowledgment of the reasonable worth requirement is important to getting to the correct worth conclusion for the client.

Example # 1: The Professional Practice

Let's return to the example of a better half's flourishing psychology practice. Fair market worth (FMV) and reasonable worth analyses will lead to significantly different conclusions in this case.

In figuring out FMV, the majority of would concur that the "asset technique" to assessment ought to be applied, which appoints worth to the tangible assets minus liabilities. In this engagement, concrete assets would consist of cash, balance due, and likely computers, desks, and furnishings, web of liabilities. However, the worth would not consist of any intangible worth, or "goodwill," for the basic fact that her clients and files are personal. It would breach HIPAA5 and her ethical requirements to disclose this info; for that reason, there is no open and unlimited market for selling it to a third party. The presence of her above-benchmark level of payment establishes that there is goodwill value, however under the FMV requirement, there is no market for selling this goodwill.

In contrast, using fair worth in the State of Washington, the court would likely assign worth to the practice in the hands of its existing owners.6 A typical method for valuing expert goodwill is to establish market level compensation (replacement settlement) and to the degree that the owner/operator makes more than market level payment, the difference is capitalized to come to a worth conclusion.

The primary step in this type of analysis is to establish the presence of goodwill. Goodwill is specified in the International Glossary of Business Valuation Terms as: "The intangible asset that develops as an outcome of name, reputation, client loyalty, location, and comparable elements not individually determined."

The analysis ought to develop that the owner of the expert practice is producing incomes at a level above his or her market level payment regularly with expectation that such profits level is reasonably expected to continue in the future. Without the facility of expert goodwill, the value of the expert practice is the very same under the FMV and the fair worth requirement, using the asset approach (tangible assets minus liabilities).

Attorneys who are uninformed that worth can be designated to a non-saleable practice might possibly damage their customer by the additional legal costs connected with debating the concern amongst valuation specialists and potentially taking an unsupportable position all the method to trial.

Example # 2: The Minority Interest

As discussed, in a common fair worth project, consideration is offered to the worth of a minority shareholder's ownership interest due to unfair or overbearing acts dedicated by the majority investor or shareholders. In this context, the principle of fair value is that the minority investor has already been mistreated and is looking for solution from the court. It would be "unreasonable" to further reduce the value of this oppressed shareholder's shares for discount rates for lack of control and absence of marketability, having actually already suffered at the hands of the majority investor.

In a marital dissolution in Washington, picture performing an appraisal of a one-third interest in a moving business where the other two owners are unrelated organization partners. The determination of FMV of this one-third interest would require to include discounts for absence of control and lack of marketability, as it is frequently accepted that the market sees the value of a minority interest as less than the pro rata worth of the whole. If this one-third interest was not marked down, it would not represent the true worth to the marital estate. So, in this case, FMV and fair worth would be the very same.

Now consider that the subject one-third interest was slated to transform to a 52 percent interest in six months. Further, envision that the spouse and his service partners had signed sale agreements 10 years previously that detailed that on this particular future date, the subject interest was going to transform to a bulk interest. In this circumstance, the value conclusion from a fair value analysis will diverge from that of FMV.

The subject interest would nearly surely be incumbered by constraints on transfer, preventing transfer to a third celebration. Such constraints would secure the owners from having an unapproved celebration as a third owner. With these limitations on transfer, the FMV analysis would need to include the application of the discounts for absence of control and absence of marketability as is normally applied to minority interests.

However, the reasonable value analysis would consider this future conversion to a bulk interest. The one-third interest, in the hands of the existing celebrations, will convert to a majority interest in a relatively brief amount of time and for that reason, discounts for lack of control/marketability would not be used.

In this case, the worst-case scenario would be that the spouse worked with an attorney and an organization appraiser from out of state, both of whom were uninformed of how to apply fair value. The result would be that the attorney would have recommended the customer to accept the FMV decision of business interest, a quantity far listed below reasonable value. It is regularly the case that lawyers who do not have a grasp of the reasonable worth concept will need to become informed on this issue, ultimately harming the customer by the increased billings related to looking into and comprehending its application.

Conclusion

In certain circumstances, fair worth, as used in marital dissolution cases in Washington, can diverge significantly from FMV. In order to finest serve their customers, it is essential that lawyers engage organization evaluation professionals who recognize with the suitable approaches and factors to consider used by the courts in Washington.

Laura Markee, CFA, ASA is the owner of Markee Valuations LLC (markeevaluations.com). Over the past 20 years, Ms. Markee has actually completed over 2,000 appraisals and has affirmed as an expert more than 35 times. Her firm of 4 full-time employees conducts service appraisals for a variety of factors, consisting of marital dissolution, investor conflicts, gift and estate tax reporting, sale, and bank funding.

Laura can be contacted at 360 601 0713 or laura@markeevaluations.com.

1 Statement on Standards for Valuation Services: Valuation of an organization, organization ownership Interest, Security, or intangible Asset (2007 )

2 Matthew G. Norton Co. v. Smyth, 112 Wn. App. 865, 873,51 P. 3d 159 (2002 ).

3 Robblee v. Robblee, 68 Wn. App. 69, 78-80, 81 P. 2d 1289 (1992 ).

4 Columbia Management Co. v. Wyss, 94 Or App 195, 202, 765 P2d 207 (1989 ), rev den 307 Or 571, 771 P2d 1021 (1989 ).

5 Health Insurance Portability and Accountability Act

6 Matter of Marriage of Fleege, 91 Wash. 2d 324, 588 P. 2d 1136 (1979 ).

This information is not meant nor needs to it be construed as legal or tax advice. You may wish to seek advice from other professional consultants regarding how this information associates with your personal situations.