Fair Is Fair

Fair market value sounds pretty -- well, fair -- doesn't it? Unfortunately, the ideal buyer and seller, as defined in the concept of fair market value, don't necessarily coincide with actual buyers and sellers. Fair market value assumes a hypothetical and idealized transaction, but actual buyers and sellers are real people with unpredictable motivations. This can cause conflict between a business's fair market value and its transaction value.

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Fair market value sounds pretty — well, fair — doesn’t it? Unfortunately, the ideal buyer and seller, as defined in the concept of fair market value, don’t necessarily coincide with actual buyers and sellers. Fair market value assumes a hypothetical and idealized transaction. But actual buyers and sellers are real people, with unpredictable desires, emotions, motivations and decisions relating to transactions. This can cause conflict between a business’s fair market value and its transaction value. The common definition of fair market value comes from Revenue Ruling 59-60: The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts. In addition, court decisions frequently state the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and the market for such property. Let’s take a closer look at some of the definition’s terms and concepts to better understand their meanings and implications. THE ELEMENTS OF FAIR MARKET VALUE Several concepts within the definition raise interesting issues that need clarification. For instance: The price at which the property would change hands. Several qualifying characteristics define “the price at which the property would change hands.” Note the definition refers to the price — not the proceeds of a property sale. Many experts have said the fair market value price is paid in terms of money or money’s worth, so the fair market value price is a cash — equivalent concept. The buyer pays it in terms of dollars today, or the present value of consideration to be received in the future. Note also that property changes hands. The definition of fair market value presumes that a transaction occurs. Willing buyer and seller. The hypothetical buyer of the fair market value definition is a willing buyer interested in engaging in a transaction to acquire the interest. He or she is inclined to do so “if the price is right.” This evaluation of the “right price” is based on a rational review of financial and economic principles as well as the inherent risks associated with the interest to be acquired. The hypothetical seller of the fair market value definition is a willing seller. A seller will typically sell an asset “if the price is right” to obtain liquidity or to invest in higher yielding alternative investments. The hypothetical seller is evaluating the same principle and risks the buyer is considering. No compulsion and reasonable knowledge. Neither party is assumed to be under any compulsion to engage in a transaction, nor to be under any duress. Both parties are assumed to have reasonable knowledge about the relevant facts. This is an important assumption, because knowledge about some companies, business interests or other investments may not be readily available. The focus is on what is reasonably known, knowable or foreseeable on the valuation date. Able and willing to trade. The hypothetical willing buyer and seller are assumed to be able to engage in a transaction. The implication is that each of the parties must have the financial capacity to engage in the subject transaction. The valuator must consider this factor in determining fair market value. Both parties must be willing to consummate the transaction. As discussed previously, the buyers and sellers are expected to be rational investors. A buyer or seller’s propensity to enter into a given transaction is based on a rational analysis of the financial and economic factors and risks. The property and its market. Both parties are assumed to be well informed about the subject property. In other words, the parties must have the knowledge and ability to investigate the potential investment. This aspect of the definition pushes beyond being reasonably informed in a general sense to being well informed in a specific sense. The last element of the fair market value definition carries the reasonably informed concept one step further. Both parties are assumed to be knowledgeable, not only about the specific property, but also about the relevant property’s market. Knowledge about the market for a property assumes an understanding of industry conditions as well as local, regional and national economic conditions. ACTUALLY, IT’S FAIR Fair market value is not actual value. Appraisers, attorneys and other users of valuation reports who operate every day in the actual transaction arena need to continue to develop a better understanding of the hypothetical market in which fair market value transactions occur. Kenneth A. Arlein, CPA, ABV/CVA, is a partner in the business investigation services group of J.H. Cohn of Edison, N.J. If you are interested in submitting an article to law.com, please click here for our submission guidelines.

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