market value” but very few recognize it.[1] Unfortunately, this is also true of some business valuators.

            This article is intended to assist in the identification of fair market value, which I refer to as the “four-faced monster.”  Learning to recognize the key elements (faces) of fair market value will assist valuators and users of valuations, in identifying the fair market value of most equity/investment interests when an actual sale of the interest in not anticipated.

For simplicity, I have organized the “four faces” of fair market value into two categories.  Each category contains two elements. The first category is the Standards Category, while the second category is the Participants Category.  The following discussions examine the four “faces” of fair market value.  Also, I am providing some actual examples of arguments that have been made by valuators on different sides of the fair market value question.

Standards Category

            Two separate definitions can generally apply to the standard of fair market value.  Some states and jurisdictions may also have statutory definitions of “fair market value.”  However, for purposes of this article, I am assuming a lack of jurisdictional statutory definition.  In the absence of such statutory definition, the two general standard definitions are provided by:

While the definitions provided by each of these authoritative sources are similar, the strict literal adherence to either definition can cause different results under each definition.  Let’s take a closer look at each definition.

Revenue Ruling 59-60 Definition

            This is probably the most common definition of fair market value, and the one discussed most often.  Revenue Ruling 59-60 defines fair market value as:

. . . the amount at which the property would change hands between a willing buyer and a willing seller when the former is not under compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.

This definition is commonly used by the IRS, the courts, and valuation consultants. It assumes a hypothetical arm’s length sale without regard to a specific buyer or seller.  This definition is what I consider as “the first face of fair market value.”

International Glossary of Business Valuation Terms Definition

            Jointly approved by the AICPA, ASA, Canadian Institute of Chartered Business Valuators (CICBV), NACVA, and IBA, this Glossary of Business Valuation Terms provides some slight variations to the old definition of fair market value as set forth by Revenue Ruling 59-60.  The International Glossary defines Fair Market Value as

…The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. (Note: In Canada, the term price should be replaced with the term highest price.)

I consider this definition as “the second face of fair market value.”

            So, what is the difference between the two definitions that can cause valuators to arrive at different results under each definition?

A practical observation is that the primary difference is the phrase “expressed in terms of cash equivalents” that can be found in the definition provided by the International Glossary of Business Valuation Terms. While this appears to be only a slight variation, it can often be the cause of heated debates between litigants, their attorneys and business valuators.

Here is an example that I recently encountered.

The business valuator engaged by the out-spouse, prepared a valuation of the subject accounting firm using the Fair Market Value standard established by Revenue Ruling 59-60:

. . . the amount at which the property would change hands between a willing buyer and a willing seller when the former is not under compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.

The valuator acknowledged within the report that accounting firms are quite often sold on an “earn-out” basis.  That is, the gross sales price paid for the firm will be paid over a set period of time (generally from three to five years) based upon some percentage of fee revenues generated by the firm.  However, in his valuation, the valuator opined the fair market value as being an amount based upon a multiple of anticipated firm revenues.  The valuator did not consider or discuss the prospect that the actual sales price (based upon his calculations using multiples) may be paid over a number of years.  In essence, the valuator did not consider or discuss the present value of the transaction. 

What was his defense to the approach of not recognizing the present value?  He said, “I relied upon the literal definition of Fair Market Value as established by the Internal Revenue Service in Revenue Ruling 59-60: . . . the amount at which the property would change hands between a willing buyer and a willing seller when….  My conclusion represents that amount for which the property would change hands.  The standard’s definition imposed no further requirement.”

The out-spouse’s valuator did not mention it, but many business brokers also think of value in terms of transaction values, where the total of all consideration passed at any time between the buyer and seller for an ownership interest in a business enterprise represents the value.[2]

My engagement was with the attorney for the in-spouse and I also used the Fair Market Value standard.  However, the standard on which I relied was the definition of Fair Market Value as provided in The International Glossary of Business Valuation Terms:

…The price, expressed in terms of cash equivalents, etc.

In addition to other methods, my valuation analysis also considered price to revenue multiples for accounting firms. In fact, the other valuator and I used the same data and price multiples in our calculations.  However, citing the “earn-out” method that is frequently used in the sale of CPA practices, I set forth an assumption of a 25% down payment with the balance to be paid over 5 years based upon assumed even collections (no indication that gross collections would decrease).  I converted the expected stream of collections into a present value using the mid-term Applicable Federal Rate (a published rate) that had been in effect for the valuation date.

Of course, my indication of value based on this market approach was lower than the indication of value calculated by the other valuator.  We both contended that the definition of Fair Market Value on which we each relied, supported our findings!     

In the foregoing situation, the parties’ attorneys argued back and forth about the valuation issues, filed motions, and went through the standard legal procedures that stall cases and drive clients to insanity! Finally, the attorneys convinced their respective clients that compromise was the best answer, and the issue was settled by the parties using a simple average. 

How might business valuators assist attorneys and their clients in avoiding some of the pitfalls in issues concerning fair market value?  The answer may sound too simple.  First, seek the exact legal definition of fair market value in the jurisdiction.  If there is no established statutory authority or case law that specifically defines fair market value, then why not suggest the parties consider “stipulating” to the exact definition of the valuation standard to be used?  Do the parties agree to adhere to the older Revenue Rule 59-60 definition, or the newer International Glossary of Business Valuation Terms definition?  This takes some additional effort on the part of the business valuator; educating attorneys as to the subtle differences between the two definitions of Fair Market Value may be time well spent.

The following table allows us to compare the basic defined requirements of fair market value:

Comparison of Requirements

Participants Category

The next two faces of fair market value concern the seller and the buyer.  I refer to the seller and buyer as having the third and forth “face” of fair market value, respectively.

In the definition of hypothetical fair market value, a valuator must consider the positions of EACH the seller and the buyer.  I don’t know how many times I have reviewed business valuation reports (claiming to render an opinion of value based upon the “Fair Market Value Standard”) that devote page after page of discussion, analysis, and calculations dealing with the hypothetical buyer.  In some reports I have seen nothing at all mentioned about the considerations of the hypothetical seller!  In my opinion, such reports may be opining an investment value rather than a fair market value.  Why?  Because the valuator was concerned only with the value to the purchaser!  Yet, the valuator will swear up and down that the value represents fair market value!

So, what is hypothetical fair market value, and how is it recognized?  Both of the previously mentioned standards give us a definition of fair market value.  But the trick seems to be in implementing the analysis leading up to the conclusion of fair market value. This is where I refer to “recognizing the third and fourth faces of Fair Market Value.”

To assist the reader of my reports to follow my logic, I have added a paragraph right below the definition of the standard being used (I have been using the FMV definition prescribed by the International Glossary of Business Valuation Terms).  This additional paragraph further explains the basic characteristics of each, the seller and the buyer:

            Then, in the Valuation Methods section of the report, further discussions can also address those methods that may be considered by each, the seller and the purchaser, and the reasons why each may consider a particular approach or method.  We must remember that the hypothetical seller is not being forced to sell, and the hypothetical buyer will only enter into the transaction up to the point where the price no longer makes sense to that buyer. Failure to examine the “faces” of both parties may indicate the valuator’s failure to meet the requirements imposed by the Fair Market Value Standards. 

            The following table is intended to assist users of valuation reports in identifying the “faces” of the hypothetical seller and buyer, respectively.  The items listed within the table may not be “all-inclusive” and are intended to give the reader an idea of the general considerations that attach to the seller and also to the buyer. 

Attributes of Hypothetical Sellers and Hypothetical Buyers

In Conclusion, valuators and users of valuation reports will find that identifying hypothetical Fair Market Values may be much easier when each of the four faces can be identified:

                                    Summary of the “Four Faces” of Fair Market Value

            Just be thankful that I did not title or model this dissertation on the famous TV star that            allegedly has sixteen personalities!