What's Fair About Fair Market Price?
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By Laura Markee, CFA, ASA, Markee Valuations September 2020 Bar Bulletin September 1, 2020

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

In a divorce in Washington State, lawyers ought to be conscious of when and how Washington's "reasonable worth" requirement may come into play in figuring out the worth of an independently held service. In certain scenarios, fair market price (FMV) and reasonable value analyses will result in considerably different conclusions and lawyers who are uninformed of the application of fair value might recommend their clients to accept a worth for their organization interest far listed below what could be granted.

Definition of Value

In organization evaluation, appraisers are usually engaged to figure out worth under the fair market price requirement. Fair market value (FMV) is specified by the American Society of Appraisers as:

"The price, expressed in regards to money equivalents, at which residential or commercial property would alter hands in between a hypothetical ready and able purchaser and a theoretical willing and able seller, acting at arm's length in an open and unlimited market, when neither is under compulsion to purchase or offer and when both have reasonable knowledge of the appropriate truths."

Although FMV is the standard of value in a marital dissolution context in many states, in Washington, the reasonable worth standard is utilized. Unlike FMV, there is no frequently accepted definition for reasonable value. In the AICPA's published SSVS,1 it is noted that, "for state legal matters only, some states have laws that utilize the term fair worth in investor and partner matters. For state legal matters just, therefore, 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 "fair worth" of the shareholder's interest, as opposed to the "reasonable market value."2 In Washington, for the function of an investor oppression suit, it is agreed that "reasonable value" does not consist of a discount for minority status.3

"Fair worth" is not synonymous with "fair market value."4 While FMV relates to determining reasonable value, the scenarios of a particular case are necessary to figuring out reasonable worth.

If the parties are getting divorced and they own 100 percent of a rewarding business, the application of fair worth versus FMV will frequently not come into play due to the fact that the FMV of a 100 percent ownership interest in a successful organization is frequently equal to reasonable value.

However, in particular cases, identification and recognition of the reasonable value standard is critical to getting to the right value conclusion for the client.

Example # 1: The Professional Practice

Let's go back to the example of a partner's thriving psychology practice. Fair market price (FMV) and fair worth analyses will result in significantly different conclusions in this case.

In identifying FMV, the majority of would concur that the "property approach" to evaluation must be applied, which appoints value to the tangible properties minus liabilities. In this engagement, tangible properties would include money, accounts receivable, and likely computers, desks, and furnishings, web of liabilities. However, the value would not consist of any intangible worth, or "goodwill," for the easy fact that her clients and files are confidential. It would break HIPAA5 and her ethical standards to disclose this info; therefore, there is no open and unlimited market for selling it to a third celebration. The existence 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 designate value to the practice in the hands of its existing owners.6 A common approach for valuing expert goodwill is to establish market level settlement (replacement payment) and to the level that the owner/operator earns more than market level compensation, the difference is capitalized to get here at a value conclusion.

The first 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 property that occurs as an outcome of name, reputation, consumer loyalty, location, and comparable factors not independently determined."

The analysis needs to develop that the owner of the professional practice is creating profits at a level above his/her market level settlement consistently with expectation that such profits level is reasonably anticipated to continue in the future. Without the facility of expert goodwill, the value of the expert practice is the exact same under the FMV and the reasonable value requirement, utilizing the possession approach (tangible assets minus liabilities).

Attorneys who are uninformed that value can be appointed to a non-saleable practice might possibly damage their client by the expenses associated with debating the concern amongst valuation specialists and possibly taking an unsupportable position all the way to trial.

Example # 2: The Minority Interest

As talked about, in a typical fair worth assignment, consideration is provided to the value of a minority shareholder's ownership interest due to unfair or overbearing acts dedicated by the bulk investor or investors. In this context, the concept of reasonable value is that the minority investor has actually currently been wronged and is seeking remedy from the court. It would be "unfair" to even more lower the worth of this oppressed investor's shares for discount rates for lack of control and absence of marketability, having already suffered at the hands of the bulk investor.

In a marital dissolution in Washington, think of carrying out an appraisal of a one-third interest in a moving company where the other 2 owners are unassociated business partners. The determination of FMV of this one-third interest would require to consist of discounts for lack of control and lack of marketability, as it is typically accepted that the market sees the value of a minority interest as less than the pro rata value of the entire. If this one-third interest was not discounted, it would not represent the true worth to the marital estate. So, in this case, FMV and fair value would be the exact same.

Now consider that the subject one-third interest was slated to transform to a 52 percent interest in six months. Further, picture that the husband and his service partners had signed sale contracts 10 years earlier that described that on this particular future date, the subject interest was going to transform to a bulk interest. In this scenario, the worth conclusion from a fair worth analysis will diverge from that of FMV.

The subject interest would nearly assuredly be incumbered by restrictions on transfer, preventing transfer to a 3rd party. Such constraints would safeguard the owners from having an unapproved celebration as a third owner. With these restrictions on transfer, the FMV analysis would require to consist of the application of the discount rates for absence of control and absence of marketability as is generally used to minority interests.

However, the fair worth analysis would consider this future conversion to a bulk interest. The one-third interest, in the hands of the existing parties, will transform to a majority interest in a relatively brief amount of time and for that reason, discount rates for lack of control/marketability would not be applied.

In this case, the worst-case situation would be that the other half hired a lawyer and a service appraiser from out of state, both of whom were uninformed of how to use fair worth. The outcome would be that the attorney would have advised the client to accept the FMV determination of the business interest, a quantity far listed below reasonable value. It is regularly the case that lawyers who do not have a grasp of the fair value concept will require to end up being educated on this concern, ultimately harming the client by the increased billings associated to researching and comprehending its application.

Conclusion

In specific scenarios, fair worth, as used in marital dissolution cases in Washington, can diverge considerably from FMV. In order to finest serve their clients, it is imperative that attorneys engage service evaluation professionals who recognize with the proper methodologies and considerations utilized by the courts in Washington.

Laura Markee, CFA, ASA is the owner of Markee Valuations LLC (markeevaluations.com). Over the previous 20 years, Ms. Markee has completed over 2,000 appraisals and has actually affirmed as an expert more than 35 times. Her firm of four full-time employees performs organization appraisals for a range of factors, including marital dissolution, shareholder disagreements, present and estate tax reporting, sale, and bank financing.

Laura can be gotten in touch with at 360 601 0713 or laura@markeevaluations.com.

1 Statement on Standards for Valuation Services: Valuation of a business, 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 Medical Insurance Portability and Accountability Act

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

This information is not intended nor ought to it be construed as legal or tax advice. You might wish to consult with other professional advisors concerning how this details relates to your individual situations.