Understanding FMV in Bankruptcy

Fair market value is often the standard of value
in bankruptcy matters, particularly in preference or
fraudulent-conveyance cases. In a preference action, the plaintiff
prevails if the court accepts the notion that the fair market value of
assets is less than the firm's debts at face value. Similarly, in
fraudulent-conveyance cases, one of the means by which the plaintiff
prevails is to establish either that the firm cannot pay its debts as
they come due, or that the fair market value of the firm's assets is
less than its debts, thereby rendering the company insolvent. Thus,
understanding what constitutes fair market value is essential for
attorneys practicing in the bankruptcy arena. </p><p>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. </p><p><b>Valuation Methodologies: Discounted Cash Flow</b>

</p><p>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 (<i>e.g.</i>, 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. </p><p>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.
</p><p>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. </p><p><b>Comparable M&amp;A Transactions</b> </p><p>The
comparable mergers and acquisitions transactions approached evaluation,
sometimes referred to as the precedent transactions (comp M&amp;A)
approach to valuation, examines the multiples paid for similar target
companies in M&amp;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&amp;A transactions involving the
purchase of a controlling interest (<i>i.e.</i>, 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&amp;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&amp;A information tends to
exist for publicly traded target companies vs. private target
companies, the comp M&amp;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.

</p><p><b>Comparable Companies</b> </p><p>Similar to the comp M&amp;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, <i>e.g.</i>, lower or upper quartile)
trading multiples (<i>e.g.</i>, 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.
</p><p>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. </p><p>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.
</p><p>Assuming the comp M&amp;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. </p><p>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. </p><p>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.

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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.
</center></i></big>
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<p> <b>Willingness to Transact </b></p><p>Whether the comp M&amp;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>i.e.</i>, a stockholder
willing to sell shares at the market price to a buyer willing to pay a
certain market price). The comp M&amp;A method can be, but is not
necessarily, more difficult to ascertain the willingness of the
parties transacting. More specifically, in some M&amp;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&amp;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. </p><p><b>Having
Relevant Information </b></p><p>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. </p><p><b>Not under Compulsion</b> </p><p>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.

</p><p>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.