Understanding FMV in Bankruptcy
Fair market value is often defined as the amount at which assets would change hands between a willing buyer and a willing seller, each having reasonable knowledge of the relevant facts and neither being under any compulsion to act. The exchange of assets is considered to be an arm's-length transaction between a hypothetical buyer and a hypothetical seller. Before dissecting the components of fair market value, it is important to discuss these components in the context of the valuation approach being applied.
Valuation Methodologies: Discounted Cash Flow
The discounted cash flow (DCF) method of valuation estimates a stream of cash flow into the future and then discounts the stream back to the valuation date (e.g., date of alleged preference payment) by the discount rate. A terminal value, which accounts for the periods extending beyond the time horizon that was actually projected, is also discounted back to the relevant valuation date. The projected cash flows can either be projected as debt-free (unlevered) cash flows or cash flows to equity-holders. In either instance, it is important that the discount rate used to determine the present value of the projected cash flows is calculated on the same basis as the projected cash flows. For example, projected debt-free cash flows correspond to a discount rate that is a weighted average cost of capital (WACC). WACC takes into consideration the firm's reliance on both equity-holders and lenders. In contrast, cash flows to equity-holders are discounted at the required rate of return by equity-holders.
The total present value of debt-free cash flows represents the fair market value of the firm's assets. Subtracting debt from the fair market value of assets arrives at the fair market value of the firm's equity. Another means of determining the fair market value of equity is to determine the total present value of projected cash flows to equity-holders.
Differences in opinion exist among valuation professionals as to whether the total present value of the projected cash flows results in a valuation on a control basis or minority basis. That debate is beyond the scope of this article, but suffice it to say that one must make that determination as it generally has a significant impact on the results of the valuation. In any event, the results of a DCF produce a value expressed on either a controlling interest or minority interest basis.
Comparable M&A Transactions
The comparable mergers and acquisitions transactions approached evaluation, sometimes referred to as the precedent transactions (comp M&A) approach to valuation, examines the multiples paid for similar target companies in M&A transactions or examines the premiums paid for target companies. Since ultimately the objective for most bankruptcy attorneys is to determine the value of an entire business, typically the search criteria include M&A transactions involving the purchase of a controlling interest (i.e., 51 percent or greater). To value the subject company, one might apply, for example, the median multiple, average multiple or another value based on the range of the comparables' multiples. An example for the numerator of the multiple is the comparables' earnings before interest, taxes, depreciation and amortization (EBITDA). The comp M&A approach typically results in a control-basis valuation, as the premiums or multiples applied reflect the prices paid for a controlling interest in the target company. Given that more M&A information tends to exist for publicly traded target companies vs. private target companies, the comp M&A method tends to produce a fair market value on a marketable, control basis. From this value, adjustments may be made pertaining to the specific situation being considered.
Similar to the comp M&A approach is the comparable company (comp co.) approach to valuation. Using this method, the valuation professional determines the median average, (or other appropriate measure, e.g., lower or upper quartile) trading multiples (e.g., EBITDA multiple) for a peer group, or comparable set of companies. The comp co. approach results in a minority interest basis valuation as the multiples derived are based in part on the market prices paid for one share of the peer group of companies as observed in the market. Stock quotations do not reflect control, as the quotes are for single shares or small blocks of shares. In addition, since public market prices are used to determine the fair market value, that value also represents a marketable interest. Thus, before applying any adjustments, the comp co. method produces the fair market value on a marketable, minority-interest basis.
Quite often, the bankruptcy attorney needs to know the fair market value of all of the estate's assets to determine solvency. Adjustments are then made to each of the three traditional valuation methods in order to arrive at a controlling interest based either on the fair market value of marketable assets or the fair market value based on a lack of marketability of those assets.
For the DCF, if one determines that indeed the projected cash flows result in a controlling interest value, then an adjustment to account for whether the assets are marketable is most likely the only adjustment that may have to be made. Specifically, if the company is closely held, then a lack of marketability discount is applied to the total present value, arriving at the fair market value of the estate's non-marketable assets. On the other hand, if one determines that the projected cash flows do not reflect control, then a control premium must be added to arrive at 100 percent of the firm's assets. As previously discussed, if the estate is closely held, a marketability discount should also be applied.
Assuming the comp M&A approach results in a control value, if the estate is closely held, then a lack of marketability discount should be applied to determine the fair market value. Conversely, if the estate is a public company, a lack of marketability discount is not warranted.
Recall that the comp co. valuation typically derives a marketable, minority interest value. Thus, a control premium is needed in order to arrive at a controlling interest fair market value. Again, if the estate is closely held, then a lack of marketability discount also needs to be applied.
Having reviewed the basic tenets of the three traditional valuation methodologies, one is able to better grasp the peculiarities of the definition of fair market value. This definition can be broken down into its three important elements: willingness to transact, having relevant information to transact and not being under compulsion to transact.
As the old adage states: "junk in, junk out." Having access to reasonably adequate and accurate information is essential in determining the fair market value of an estate.
Willingness to Transact
Whether the comp M&A or comp co. methods are being utilized, the underlying market data should be reflective of two parties that consented to the transaction. Comp co. multiples derived using the market prices of publicly traded companies should be reflective of consenting parties (i.e., a stockholder willing to sell shares at the market price to a buyer willing to pay a certain market price). The comp M&A method can be, but is not necessarily, more difficult to ascertain the willingness of the parties transacting. More specifically, in some M&A transactions the acquirer can lower the price paid due to the specific circumstances. For example, if the acquirer already owned a significant proportion of the target's shares prior to the time of the tender offer, it might utilize it for a "squeeze-out" and an unusually low offer for the remaining shares. A multiple based on such a transaction is likely to present a downward bias in the resulting valuation. The point here is that some M&A transactions may warrant an adjustment to the premium paid or multiple paid in order for the data to be useful to the relevant valuation.
Having Relevant Information
As the old adage states: "junk in, junk out." Having access to reasonably adequate and accurate information is essential in determining the fair market value of an estate. All three valuation methodologies reviewed above are prone to significant deviations from the "true" fair market value should some or all of the inputs be based on irrelevant information. For example, consider the following valuation scenario. Operationally, monies that the estate raised in the public markets were used to finance the growth of a franchise system. While the balance sheet on the surface appeared to present a reserve for uncollectible accounts, upon further investigation and fact-finding, it was discovered that the collateral underlying the company's large receivable balance was essentially worthless. As a result, the estate itself was rendered insolvent. In such a case, without having the relevant information pertaining to the collateral, a vastly different, but inappropriate, opinion as to the fair market value of the firm's assets could have been reached.
Not under Compulsion
Valuation methods that are predicated on market data that reflect duress or compulsion to sell do not determine fair market value. Take, for example, the following transaction in which we testified in court several years ago. The founder of a closely held sporting goods company passed away, leaving the business to his wife. The wife did not know how to operate the business as effectively as her late husband and did not have an interest in learning how to run it, so the business was put up for sale. An investment group was successful in acquiring the company at a deep discount to the fair market value determined using traditional valuation methods. The actual purchase price was not indicative of the fair market value, because the investment group capitalized on the wife's compulsion to sell. As a result, the purchase price paid in this particular transaction is not indicative of fair market value.
Both attorneys and valuation professionals frequently refer to fair market value. As a result, one often overlooks the in-depth meaning of the term. The components of fair market value include the willingness to transact, reasonable knowledge of the relevant information by both the hypothetical buyer and hypothetical seller, and the lack of any compulsion to transact. An attorney's understanding of these three elements and how they impact valuation methodologies will improve and clarify the determination of the fair market value of a bankruptcy estate's assets.