Fair Market Value of the Family Business

Fair Market Value is by far the most often used and most relevant standard for the valuation of closely-held business in divorce. It is logical, ascertainable, and bolstered by precedent.

Black Letter Law

The technical standard for determining Fair Market Value has remained unchanged for more than 35 years. I.R.S. Revenue Ruling 59-60 provides that Fair Market Value is the price that would be demanded and paid in a sale involving a willing buyer under no compulsion to buy and a willing seller under no compulsion to sell, assuming both buyer and seller have reasonable knowledge of the relevant facts about the asset.

Concepts of Fair Market Value

There are several ways of looking at Fair Market Value. The first is to look at the actual prices at which similar companies have sold recently. The difficulty with this approach is twofold. First, the nature of closely held businesses is that it’s difficult to find similar companies that have sold recently. Second, the price for a transaction involving closely held businesses is often secret, and even if known, the real “price” may be a combination of cash, personal service contracts, and covenants not to compete — difficult to compare with that of another company.

One market-related technique that may indeed be useful is examination of a buy-out provision. Presumably, the principals know better than anyone else the true value of the enterprise. If they have executed a buy-out agreement with each other, and if it was truly negotiated at arms’ length, it may provide the best measure available of the value of the business.

By the same token, a shareholder’s agreement may have a great deal to do with the value of an interest, because it may govern how the enterprise may repurchase its own stock, whether it pays dividends and on what schedule, and the extent to which the enterprise will reconfigure itself on the death or withdrawal of one or more of its owners.

The second way of looking at Fair Market Value for a closely held business is to look at what the enterprise cost. The main problem with this approach is not only that the price may be years or even decades old but also that the price may be illusive. That is, the purchase price may have been a combination of various benefits as described above.

The most typically used and accurate way of looking at Fair Market Value for a closely held business is to evaluate the present value of all the future benefits of owning the enterprise. This includes the income from the enterprise, the eventual value of the enterprise when it is eventually sold, and the noncash benefits of ownership (perks, etc.). The most typical approach is to discount these expected future benefits to their present value using an appropriate discount rate. The discount rate will vary from company to company, and may even vary from benefit to benefit, depending on a host of factors. This method of calculating Fair Market Value based on a discount rate is sometimes called the “Discounted Cash Flow” or “DCF” method.

I usually see valuators arrive at the discount rate by combining two rates. They speak in terms of a so-called “investment” rate — the rate a prudent investor would demand from investing his money — and a “risk premium” — the additional return an investor would demand from a business like this because it’s small, because its income varies from year to year, because it’s closely held, and for many other reasons. So, for example, the investment rate for an enterprise might be 10 percent, and the risk premium for that same enterprise might be an additional 18 percent, yielding a total discount rate of 28 percent.

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