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Do Prior Purchases of the Subject Equal Market Value or Fair Market Value?

I recently became involved in a very interesting case – the valuation of an independent insurance agency for a divorce. I was asked to review this appraisal and subsequently to testify in court. The business appraiser asked to appraise the agency used the same formula that was used when the agency was purchased from its prior owner in 2014. No other market transactions in the industry were used to support this value and the value conclusion using this method was considerably higher than the indications of value derived from the income and asset approaches.

The agency was acquired in 2014 using a two times annual commission (revenue) multiplier. However, in 2014 when the agency was purchased, the motivations of the two employees that purchased the company from their retiring employer and the motivations of the seller were not considered. When I searched the various market databases available for multiples, I found that a two times multiple was higher than normal for similar purchases.

It should be noted that the fair market value of a business interest is not dependent on the price actually paid for it – i.e. by definition, fair market value is based on a hypothetical willing seller and a hypothetical willing buyer; not an actual previous transaction that may be based on other than “normal” motivations.

According to Shannon Pratt, a widely recognized business valuation authority, “one of the most useful but often overlooked market approach methods is analysis of past transactions involving the subject company.” In looking at past transactions, it is important to determine if the transactions were made on an arm’s-length basis. If the transactions were made on an arm’s-length basis, then they may be useful in determining an indication of value.

Further, according to Pratt, the following are definitions of Arm’s-Length transactions:

Black’s Law Dictionary

Arm’s length transaction. Said of a transaction negotiated by unrelated parties, each acting in his or her own self interest; the basis for a fair market value determination. A transaction in good faith in the ordinary course of business by parties with independent interests. … For example, if a corporation sells property to its sole shareholder for $10,000, in testing whether $10,000 is an “arm’s length” price it must be ascertained for how much the corporation could have sold the property to a disinterested third party in a bargained transaction.

Barron’s Dictionary of Finance and Investment Terms

Arm’s Length Transaction. Transaction that is conducted as though the parties were unrelated, thus avoiding any semblance of conflict of interest. For example, under current law parents may rent real estate to their children and still claim business deductions such as depreciation as long as the parents charge their children what they would charge if someone who is not a relative were to rent the same property.

After interviewing the parties involved, it was discovered that one of the buyers already owned 25% of the agency and had worked in the agency for many years. He was highly motivated to purchase the selling shareholder’s interest as he did not want to start over somewhere else and he had restrictions that would have made taking clients with him in a move to another agency difficult. The other buyer, was the son-in-law of the selling shareholder. He stated that he knew that they were paying “too much” for the agency, but he was willing to do so due to family considerations. Both of the buyers had special motivations to pay more than fair market value for the business interests purchased.

The same principal applies when examining prior sales of virtually anything being appraised and when searching for comparable transactions for an appraisal assignment. When it is possible, buyers and sellers or others involved in a transaction are interviewed and asked about special motivations. When “normal” motivations to buy and sell are not found, either adjustments must be made or the sale disregarded.

Since it is often impossible to find out the motivations of a buyer or seller, multiple transactions are typically used to value any type of property or interest. The use of only one comparable, particularly a prior sale of a Subject is highly problematic and not likely to yield a reasonable indication of either market value or fair market value.

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.

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