Chapter 2 The Fair Market Value Standard of Value

• Jurisdiction: United States

Chapter 2: The Fair Market Value Standard of Value

A. FMv and Going-Concern value Compared: An Expert's Perspective

In business and security valuations, confusion exists between the concept of fair market value (FMV) and that of going concern. Various parties to a bankruptcy proceeding often make the mistake that in order to arrive at an FMV conclusion, the valuation analysis must be performed under the assumption that the subject company is a going-concern business enterprise. However, this is not always the case.

The FMV is the price that a property would sell for on the open market. Solvency may be tested by examining the FMV of a debtor company's assets in relation to the amount of its liabilities (known as "balance sheet solvency"). When testing balance sheet solvency, the analyst estimates the FMV of the company's assets and compares it to the amount of its liabilities. If a debtor company's liabilities are greater than the value of its assets on an FMV basis, then it is considered to be insolvent.

In most fair market valuations, the subject company is presumed to be a "going concern." As a going concern, the company's value might be determined by applying several different generally accepted valuation approaches and methods, including quantifying the future cash flow or earnings produced by its assets for an indefinite period stretching into the future; comparing the subject company to guideline publicly traded companies; or comparing the subject company to transactions in which guideline companies were acquired.

One of the important presumptions of a going-concern premise is that the business is a viable entity that is expected to operate into the foreseeable future. Analysts frequently encounter troubled companies that are not viable operating entities and will not be able to continue to operate in the foreseeable future. Yet, analysts are still able to arrive at a fair market valuation for these troubled entities based on assumptions that a willing, reasonably informed buyer who is not under compulsion to act would have applied.

Many bankruptcy-related decisions are based on the value of the debtor company assets. For example, the court would like to know whether a company's stakeholders are better off if the debtor company is dead or alive. Similarly, in cases where fraudulent conveyance and preference claims are involved, the issue is based on the solvency of the debtor company at a particular date. Independent of the specific issues involved, as long as the decision-making process relies on valuing the entity (or its assets) very early in the process, analysts need to decide on the premise of value. From many analysts' experience in the courtroom, there is a great tendency to debate the detailed issues, such as the appropriate discount rate, valuation pricing multiple, expected growth rates and projected earnings. However, an important issue that is often ignored prior to all of the assumptions that have to be made is the determination of the premise of value. This determination affects the nature of the assumptions that have to be made. Moreover, it is our experience that many bankruptcy practitioners do not distinguish between the determination of the premise of value and the assumption of whether the company is a going-concern entity. A starting point for the process is understanding the concept of FMV, which is defined as "the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts."⁴

Company Is a Going Concern, Yet the Transaction Price Does Not Represent FMv

By definition, when either of the parties is under compulsion to act, the fundamental definition of FMV is violated. However, this does not imply that the subject company is no longer a going concern. For example, we were retained to value a sporting goods company. The company's founder, who ran the business for several decades and fully controlled its financial and operational aspects, passed away. The founder's widow was never involved in the business, and thus did not possess the managerial skills or know-how to successfully take over the business, so she had no other option but to sell the company soon after her husband's death. The widow was "advised" by an acquaintance as to the value of the company, and ultimately sold it for that price. She did not retain an investment banker to assist with the sale. Moreover, she also projected a sense of urgency to complete the sale.

This transaction was a topic of a related court case, where we were required to value the company. The transaction price is often stated to be the best indicator of value of a company. In this case, one of the parties claimed that because of the widow's compulsion to act and her lack of reasonable knowledge of the company, the transaction price did not represent the company's FMV. Indeed, the jury decided that the company's FMV was significantly higher than the transaction price. This scenario is a classic case of a company where the valuation analysts should have based their valuations on the assumption that the company was a going concern; however, the price at which the company ownership changed hands did not reflect the...