The Fourth Exposure Draft of proposed changes to the Uniform Standards of Professional Appraisal Practice (USPAP) raises an interesting question for business appraisers in the discussion of Section 3, Proposed Revisions Relating to Development and Disclosure of Exposure Time Opinion. The reporting requirements in Standards 2, 6, 8 and 10 include the following Comment:
Stating the definition of value also requires any comments needed to clearly indicate to intended users how the definition is being applied.
The rationale for the proposed change is discussed in the context of real and personal property appraisals and their consideration of the concept of exposure time. Exposure time is the assumed time that a property is marketed prior to the appraisal date as of which an valuation opinion is rendered. In other words, a property is assumed to have been exposed to the market for the assumed exposure time and the hypothetical market value transaction occurs on the appraisal date.
The proposed changes are designed to assure that intended users understand the context in which appraisal opinions are developed and to make sure that reasonable exposure time must be reported, in addition to developed, in all appraisal assignments. The ASB believes that there should be a requirement that the opinion of exposure time be provided, regardless of what type of value is labeled. As result, in the Fourth Exposure Draft, proposed language changes are being made to Standards Rules 2-2(a)(v), 2-2(b)(v), and 2-2(c)(v):
When an opinion of reasonable exposure time has been developed in compliance with Standards Rule 1-2(c), the opinion must be stated in the report. When reporting an opinion of market value, the appraiser must also report an opinion of reasonable exposure time linked to the value opinion.
Note that no change was made to the analogous reporting requirement in Standard 10, Business Appraisal, Reporting. But language quoted above from Standards 2, 6, 8 and 10 remains in Standard 10.
Proponents of what is sometimes called a “marketability discount for a controlling interest” in a business enterprise should take heed of the guidance. Appraisers typically develop indications of fair market value of controlling interests, for example, by capitalizing a company’s earnings at market multiples observed in the transactions markets for companies. Alternatively, they may develop indications of value by capitalizing some concept of “ongoing earning power,” or discounting discretely projected earnings or cash flows, including a terminal value estimation, to the present at an appropriate, risk-adjusted discount rate.
No problem so far. But what happens when a business appraiser then lowers the indicated controlling interest value by a “marketability discount for controlling interests” based, at least in part, on a concept of exposure to market? If that “exposure to market” occurs after the valuation date, then the concluded value is not fair market value. The essence of the definition of fair market value is that a hypothetical transaction between hypothetical willing buyers and sellers, both of whom are knowledgeable and neither of whom are under any compulsion, and both of whom have the financial capacity, occurs on the valuation date.
Valuation is all about expected cash flows, the expected growth in those cash flows, and the riskiness of the expected cash flows. That premise was stated in my post, What is Business Value? I believe that there no such concept as a “marketability discount for controlling interests” of businesses and have staked out that opinion formally since writing an article in Business Valuation Review in 1994 (modest charge). The concept is developed in my book (with Travis Harms) Business Valuation: an Integrated Theory in its Chapter 3, “The Integrated Theory of Business Valuation.” A small portion of the relevant section is quoted here:
Some appraisers have attempted to define a marketability discount applicable to controlling interests of companies.
The conceptual relationships of the three enterprise levels of value in Figure 3.6 suggests that such a discount does not exist. The conceptual math for each enterprise level indicates that value is a function of expected cash flow, risk and expected growth. If an appraiser adequately measures expected cash flow and the risks and growth of those cash flows, the result is an enterprise value.
The argument against the existence of a marketability discount applicable to controlling interests is simple. If enterprise value is determined based on expected cash flows, expected growth of those cash flows, and the riskiness of those cash flows, then what additional factors would support a discount from this value? The Integrated Theory suggests there are none.
Compare that discussion that follows in Business Valuation: An Integrated Theory with the discussion of “marketability discounts for controlling interests” in any other source. See which source answers the threshold standards question that can be inferred by the proposed changes to Standard 2 (above) and the existing language in Standards Rule 10-2(a)(vi) of USPAP:
(a) The content of an Appraisal Report must be consistent with the intended use of the appraisal and, at a minimum:
(vi) state the standard (type) of and definition of value and the premise of value and cite the source of the definition;
Comment: Stating the definition of value also requires any comments needed to clearly indicate to the intended users how the definition is being applied.
This would seem to apply to any concept of exposure time to market for controlling interests of businesses. Appraisers using a “marketability discount for controlling interests” would seem to need to explain how such a discount is consistent with the definition of the standard of value known as fair market value.