Pop quiz…fair market value implies:
(1) A sale of equity
(2) A sale of (some) assets
(3) A sale of (some) assets and (some) liabilities
(4) None of the above
The correct answer is (4): none of the above. Fair market value is a standard of value. It only controls HOW value is measured, not WHAT is valued. WHAT is valued is determined by other engagement parameters.
When we are asked to appraise fair market value for tax purposes, WHAT is valued is almost always very clear. An individual, estate, or entity wishes to transfer something to a related party, and that something is the WHAT. It could be anything – equity in a company, a partnership or limited liability company interest, debt, real estate, etc.
When we are asked to appraise fair market value for a TRANSACTION, however, confusion can arise. I have been working with four brothers – A, B, C and D- who each own 25% equity interests in two businesses. Brother A wants to buy out B, C and D from one business so that he will own all of it. Brother B wants to buy out A, C and D from the other one so that he will own all of it. They agreed on a fair market value standard (and to ignore valuation discounts), and asked me to appraise the fair market value of each business. This was not complicated.
The confusion arose because the brothers did not understand the difference between a stock sale and an asset sale. Both businesses have fair amounts of debt, and the brothers were unclear as to who would end up responsible for it. They asked me whether “a fair market value purchase includes the debt.”
When I clarified that fair market value is just a standard of value, and that it does not dictate the structure (the WHAT) of the transaction, things were quickly resolved. They realized that Brothers A and B would be responsible for the debts of the businesses they each fully acquired (as well as for any debt extended to them by their brothers).
This was another example of how important it is to make sure that clients understand the fundamentals of an engagement. Things that are obvious to appraisers, because we work with them all of the time, are not always clear to our clients, who encounter them infrequently or not at all. It never hurts to over explain!