Fair Value Versus Fair Market Value: Dissenting Shareholders and Minority Oppression Valuations

Fair Value Versus Fair Market Value:
Dissenting Shareholders and Minority Oppression Valuations
By Michelle Falkstein-Roth, MBA, AVA
Fair value is typically the standard of value applied in measuring the value of an organization for the purpose of a dissenting shareholder or minority oppression action. Fair value has long been a standard of value that is interpreted at the state judicial level, through case precedence, due to the lack of uniform direction in applying the standard through regulations or statutory laws. Interpretations of fair value have varied from state to state, as well as the acceptance of applying a marketability or minority discount to derive fair value. Due to the varying definitions of fair value and the limited guidance of application of those definitions in GAAP, the Financial Accounting Standards Board (FASB) has released Statement of Financial Accounting Standards (SFAS) No. 157, effective for financial statements issued for fiscal years beginning after November 15, 2007. It was the FASB’s intention that SFAS No. 157 increases consistency and comparability in fair value measurements. As a valuation practitioner, it is important to understand the differences in the standard of fair value as, clarified by SFAS No. 157, versus fair market value and also to understand how the valuation methodologies in both standards of value differ.
How the Standard of Fair Value Differs from Fair Market Value
Fair Market Value
Fair market value is the most commonly used standard of value relating to business valuation. The definition of fair market value as defined in the Internal Revenue Code and Ruling 59-60[1] is a follows,
“the amount at which the property would change hands between a willing
buyer and a willing seller when the former is not under compulsion to buy
 and the latter is not under any compulsion to sell, both parties having
 reasonable knowledge of the relevant facts.”
It is clear that fair market value is a market based transaction, which takes into consideration both the buy and sell side of the transaction. We will see that what distinguishes the fair market value standard from the fair value standard in valuation is that consideration of the buy side of the transaction is eliminated in determining fair value, expected appreciation or depreciation of the value past the measurement date are not factored into the fair value measurement, and discounts and premiums are also largely disregarded.
Fair Value
Fair value has been interpreted in various ways prior to SFAS No. 157. For many valuation practitioners the definition of fair value seemed so close to fair market value in nature that differences in the intended use of the standard of fair value has been confusing. This fuzzy distinction between the two standards of value may be the leading cause of erroneous assumptions made in valuations in which fair value is the standard. Discounts for marketability and minority shareholders have been an especially troublesome issue when deriving fair value. Previously, fair value was defined in various pronouncements by the FASB, which required or permitted the use of fair value. There was no single pronouncement from which to derive a clear understanding of fair value. SFAS No. 141 defined fair value as
“the amount which an asset (or liability) could be bought (or incurred)
or sold (or settled) in a current transaction between willing parties, that
is, other than in a forced or liquidation sale.”
This definition for fair value is similar to Internal Revenue Regulation 59-60, as defined previously. Both sides of the transaction are considered in the fair market standard of value and it would seem that both an exit price and an entry price are taken into consideration when developing a fair value measure when using SFAS No. 141 as guidance. However, this notion becomes obsolete with the release of SFAS No. 157. SFAS No. 157 retains the exchange price notion as defined in earlier definitions but is expanded upon to more clearly define fair value as
“the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the
measurement date.”
As we derive from SFAS No. 157, fair value is a market based measurement, not an entity based measurement, which is based on the exit price, which would be received to sell an asset, or paid to transfer a liability. Fair value is focused on one side of a market based transaction, that of the seller. The buy side of the transaction is not considered in fair value as it is considered in fair market value. The reasons for this become clear when we discuss the transactions in which fair value are applied to the practice of valuation.
Discounts for Marketability and Minority Ownership
Fair Market Value
Fair market value is a control value. Publicly traded shares, are by definition, minority interests. Though minority interests do have varying levels of control, the elements of control may reduce but rarely eliminate the discount for lack of control. The level of this discount is dictated by the level of control the minority shareholder does or does not have. A review of the company’s articles of incorporation and bylaws can shed light on the overall subject company’s relative rights of non-controlling and controlling ownership interests. [2]
Marketability is a term used to describe the ability to quickly convert the business ownership interests to cash at the investor’s discretion. In the capital markets, a non-controlling owner can quickly convert their share ownership to cash by selling the stock to an active market of buyers within seconds. In contrast, a non-controlling ownership interest in a privately held company is more time consuming to convert due to the limited pool of investors willing to purchase the investment. On top of that, there are fees paid to brokers to find a buyer and conduct the transaction. Computing a discount for lack of marketability is generally facilitated by restricted stock studies as the IRS specifically recognized the relevance of restricted stock transaction data as evidence for quantification of the discount for lack of marketability in Revenue Ruling 77-287.[3]  
Fair Value
Discounts for marketability or lack of control have generally been disallowed as they further oppress minority and dissenting shareholders and enable controlling shareholders to indirectly accomplish what they cannot accomplish directly.[4] Courts have varied in their rulings as to the reasons for overruling these discounts but they tend to err against them. SFAS No. 157 gives some clarity on the use of marketability discounts as the standard states
            “ The price in the principal (or most advantageous) market used to
measure the fair value of the asset or liability shall not be adjusted for
transaction costs. Transaction costs represent the incremental direct
costs to sell the asset or transfer the liability in the principal
(or most advantageous) market for the asset or liability. Transaction costs
are not an attribute of the asset or liability; rather they are specific
to the transaction and will differ depending on how the reporting entity
State Statutes
The definition of fair value can vary from state to state. Judicial decisions have varied, even among courts within the same state. SFAS No. 157 should give more guidance and continuity to judicial decisions made regarding minority oppression and dissenting shareholder actions. It is prudent to review the statutes of the state in which you are practicing. Upon reviewing the statutes, you will have a more clear idea of what the court will find acceptable. Texas state statutes, as presented below, are closely aligned with SFAS No. 157.  
Texas State Statute Article 5.12. Procedure for Dissent by Shareholders As Said to Corporate Actions state
            “ The fair value of the shares shall be the value thereof as of the day
immediately preceding the meeting, excluding any appreciation or
depreciation in anticipation of the proposed action. In computing the
fair value of the shares under this article, consideration must be given to
the value of the corporation as a going concern without including
in the computation of value any control premium, any minority discount,
or any discount for the lack marketability.”
Texas state statute makes clear that valuation practitioners performing valuations, for the purposes of dissenting shareholders, should not apply premiums or discounts to the measurement of fair value. Researching your state statutes and case precedent will assist you in more confidently performing your valuation.
Fair Value Hierarchy
Inputs to fair value valuation techniques are classified by SFAS No. 157 as either observable or unobservable. Observable inputs reflect market participant assumptions used in pricing the asset or liability based on market data obtained from sources independent of the reporting entity. Observable inputs are deemed more reliable than unobservable inputs, which reflect the reporting entity’s own assumptions about the market participant’s assumptions, and are developed based on the best information available in the circumstances. Inputs are classified in three categories, Level 1 to Level 3 inputs, Level 1 containing independent observable outputs and Level 3 containing unobservable outputs. 
Level 1 Inputs
Level 1 inputs are unadjusted quoted prices taken from active markets for identical assets or liabilities at the measurement date. Level 1 inputs are considered the most reliable
evidence of fair value and should be used when ever available unless 1) an active market exists but is not readily accessible for each of the assets or liabilities individually or 2) the quoted price does not represent fair value at the measurement date. If the active market exists but the information is not readily available, an alternative pricing method may be used, rendering the fair value measurement a lower level measurement. If significant events occur after the close of a market but before the measurement date, the reporting entity can adjust for new information, however, the fair value measurement is once again a lower level measurement as the inputs have been adjusted.
Blockage factors are prohibited in the fair value standard, as opposed to fair market value. Even if the market cannot absorb the trade without affecting the quoted market price.
Level 2 Inputs
Level 2 inputs are inputs other than quoted prices included within Level 1, which are observable either directly or indirectly. If the asset or liability has a specified term, a Level 2 input must be observable for substantially the full term of the asset or liability. Level 2 inputs include:

  1. Quoted prices for similar assets or liabilities in active markets
  2. Quoted prices for identical or similar assets or liabilities in inactive markets or markets in which little information is released publicly
  3. Inputs other than quoted prices that are observable for the asset or liability
  4. Inputs that are derived principally from or corroborated by observable market data by correlation or other means

Level 2 inputs will be adjusted depending upon the specific factors relating to the asset or liability including condition, location, level of activity in the market, and comparability of inputs. Adjustments may render the measurement a lower Level 3 measurement depending upon the significance of the adjustment to the fair value measurement.
Level 3 Inputs
Should observable inputs not be readily available, unobservable inputs based upon the reporting entity’s own assumptions may be used. Level 3 inputs should still reflect that the fair value is based upon an exit price. Inputs should be based on the best information available and they shall be adjusted if information is reasonably available which indicates that market participants would use different assumptions.
SFAS No. 157 makes the fair value measurement more distinguishable from fair market value and clarifies the valuation expectations associated with the standard. While fair market value takes into consideration value expectations of both sides of the transaction, each side acting without compulsion to derive a market value that is satisfactory to both sides, fair value is focused on the seller, specifically the dissenting shareholder and the oppressed minority shareholder. Through the use of the most observable market inputs, and the avoidance of discounts and premiums, SFAS No. 157 makes clear that the valuation methodologies should bring about the most advantageous value to the market participant that holds the asset or owes the liability. 

[1] Internal Revenue Ruling 59-60, 1965-2 C.B. 370

[2] Valuing a Business: The Analysis and Appraisal of Closely Held Companies, by Shannon Pratt with Alina V. Niculita, McGraw Hill, NY, Pg.

[3] Revenue Ruling 77-287, 1977 2 C.B. 319

[4] Offenbecher v. Baron Service, Inc., 2001 WL 527522 (Ala. Civ. App. 2001)