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Valuing Promissory Notes In Difficult Economic Times

Posted in Business Valuation, on Jun 2020, By: Mark S. Gottlieb

 

Despite the recent partial rebound of the stock market, the economic realities developed in the second quarter of 2020 is having a devastating effect on the economy.  Unemployment is at an alarming rate, several prominent businesses have declared bankruptcy, and many businesses, small and large, are debating their future.  That being said, this new reality may provide estate planning opportunities to reduce gift and estate taxes.  In this blog, I’d like to discuss the valuation of promissory notes and how their valuation may be affected during times of economic hardship.

Promissory notes are commonly used to transfer assets between family members.  Sometimes these notes are part of a gifting program; other times, it may be an asset of an estate.  In either instance, the note needs to be valued.

Standard of Value

The standard of value in gift and estate matters is fair market value. Fair market value is defined in Revenue Ruling 59-60 [2.2 Section 20.20231-1(b) of the Estate Tax Regulations (Section 81.10 of the Estate Tax Regulations 105) and Section 25.2512-1 of the Gift Tax Regulations (Section 86.19 of Gift Tax Regulations 108)] as “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” The fair market value standard assumes that the price is transacted in cash or cash equivalents. Court decisions also frequently state that the hypothetical buyer and seller are assumed to be able and willing.

Valuation Methodology

The selection of the most appropriate valuation method(s) is mainly dependent upon the purpose of the valuation, the characteristics of the subject, and the availability of reliable information requisite to the various methods.  A valuation approach is defined as “a general way of determining value using one or more specific valuation methods.”

In this instance, the fair market value of a promissory note is calculated as the present value of the future principal and interest payment of the note using a market rate of interest-based on the risk of the note.

Simply stated, the value of the subject note is determined as follows:

  1. Compute the base rate of interest.
  2. Determine the specific risk premium.
  3. Combine the base rate of interest to the specific risk premium and calculate the required market rate of interest.
  4. Apply the present value discount factor of the required rate of interest to the forecasted future interest and principal payments per the notes’ amortization schedule to determine the fair market value of the note.

Base Rate of Interest

There are several court cases that address the valuation of promissory notes. A number of them focus on the composition of the base rate of interest. The base rate of interest rate may be determined in a number of fashions; however, it should always consider a measurable alternative investment with comparable levels of risk.

Often, valuation experts will use the interest rates of notes held by publicly traded Business Development Companies (BDC’s) to provide comparable rates to privately held promissory notes. There are almost 50 BDC’s actively traded in the public market to consider.

Specific Risk Premium

Small privately held promissory notes represent more risk than publicly held Business Development Companies.  As such, a specific risk premium (a/k/a incremental risk) is required to be added to the base rate of interest to determine the total market rate of interest.  The addition of a specific risk premium is based on the principle that, as the risk of investment increases, the required rate of interest will also increase.  In other words, this addition to the base rate is used to compensate the note holder for additional risk factors not reflected in the base rate.

As outlined in Technical Advice Memorandum 8229001, there are several factors to consider in assessing the additional risk associated with determining the fair market value of a (promissory) note.  The stated interest rate and amortization terms are frequently considered the two key factors.  However, there are several others to consider.  The following is a list of factors commonly considered.

FactorComment
Stated Interest RateA note with a below-market interest rate will sell at a discount because the buyer will require to earn a higher rate of return (increase rate) on the note.
Amortization ScheduleLong-term notes are riskier than short-term notes. Similar to publicly traded bonds, investors require a higher rate of return for long-term notes because of the exposure to more risk over the life of loan. Interest-only or balloon notes are generally riskier than notes that contain interest and principal payments because the principal is not entirely repaid until the end of the note term.
CollateralNotes collateralized by tangible assets are less risky than un-collateralized notes. An un-collateralized privately held note would be difficult to sell to a third party.
Payment HistoryNotes with a history of on-time payments are less risky than notes with no payment history or notes in default.
MarketabilityUnlike a publicly traded bond, a privately held note takes time to sell to a third party or interested investor.  This increases the risk of an investment in the note.
Note CovenantsNote provisions should allow the holder to take legal action in the event of default to take possession of the collateral. Notes without strong protective covenants are riskier.
Horizon RiskLong-term notes require higher interest rates than short-term loans since the buyer of a long-term note is exposed to changes in macroeconomic factors over the notes’ holding period.
 
Personal GuaranteeNotes typically require a personal guarantee by the issuer.  The net worth of the issuer is important to gauge the impact of the personal guarantee and the risk of the note.

 Market Rate of Interest

As previously stated, the market rate of interest is the sum of the base rate and specific risk premium.  However, when valuing a minority interest of the subject note – a lack of control must also be considered.

The concept of minority interest deals with the relationship between the interest being valued and the total note.  Depending on the level of control of the subject interest, the value may require an adjustment based upon non-controlling attributes.

Fair Market Value Computation

The final step is to forecast the future interest and principal payments of the note and determine the present value using the market rate of interest.

The Affect on Valuation During Uncertain Financial Times

So, now that we understand the mechanics of the valuation model let’s identify those components that are most affected during difficult financial times.

  1. If borrowing interest rates are higher, the present value of the note will generally be lower.
  2. If the conditions, guarantees, and covenants of the loan are severe, then a higher specific risk premium may be used, which will decrease the present value of the note.
  3. If the note is repaid over a more extended time, then the present value of the note may be less.
  4. Instead of a standard equal amortization, the note may have a balloon payment, which may cause a decrease present value of the note.

As the case in most valuation analyses, It all comes down to risk.

Our firm has extensive experience in valuing promissory notes and other assets for gift and estate purposes.  Please feel free to contact our office to discuss your valuation needs.