The value of a business interest is valid as of a specific date. The effective date is a critical cutoff point because events that occur after that date generally are not taken into account when estimating value. However, there are two key exceptions related to subsequent events.
1. When an Event Is Foreseeable
Subsequent events that were reasonably foreseeable on the effective date are usually factored into a valuation. That’s because, under the definition of fair market value, hypothetical willing buyers and sellers are presumed to have reasonable knowledge of relevant facts affecting the value of a business interest. Examples of potentially relevant subsequent events are:
- An offer to purchase the business,
- A bankruptcy filing,
- The emergence of new technology or government regulations,
- A natural or human-made disaster,
- A pending legal investigation or lawsuit, and
- The loss of a key person or major contract.
But not all of these examples would be reasonably foreseeable. For example, you probably can’t predict when your company will be affected by a tornado or a data breach.
This issue has come to the forefront during the COVID-19 pandemic. To determine what was known or knowable about this ongoing crisis on a valuation’s effective date, experts must put themselves in the shoes of hypothetical buyers and sellers on that date and consider how they would have perceived the situation.
Many businesses have been adversely affected by the pandemic; others have taken advantage of opportunities that emerged from the crisis. The effects also may vary depending on the company’s geographic location or industry, so valuators must evaluate the situation closely to determine what’s appropriate for the specific subject company.
In addition to facts that are publicly available, “reasonable knowledge” includes facts that a buyer would uncover over the course of private negotiations over the property’s purchase price. During normal due diligence procedures, a hypothetical buyer is expected to ask the hypothetical seller for information that’s not publicly available.
2. When a Transaction Provides an Indication of Value
A subsequent event that’s unforeseeable as of the effective date may still be considered if it provides an indication of value. However, it generally must be within a reasonable period and occur at arm’s length.
For example, in a landmark case — Estate of Jung v. Commissioner (101 T.C. 312, 1993) — the U.S. Tax Court ruled that actual sales prices received for property after the effective date may be considered when valuing a business interest, “so long as the sale occurred within a reasonable time … and no intervening events drastically changed the value of the property.” This ruling differentiates subsequent events that affect fair market value from those that provide an indication of fair market value.
When you hire a business valuation expert, it’s important to share all information that could potentially be relevant to the value of the business. This includes information about subsequent events that affect value or provide an indication of value. Once the valuation expert is aware of this information, he or she can determine whether an event is appropriate to consider when valuing the business interest. Contact us for further advice.