The Challenges of Valuing Promissory Notes
Business valuation professionals are sometimes asked to determine the fair market value of a promissory note, typically in connection with gift or estate tax matters involving intrafamily loans or sales. This task is often more complicated than it seems at first blush.
Measuring Fair Market Value
Many people assume the value of a promissory note equals the unpaid principal plus accrued interest as of the valuation date (typically, the date of death or a gift). However, the IRS often will accept a lower value. So, it’s important to have promissory notes valued by a qualified professional, rather than estimate the value yourself.
The techniques a valuation pro uses to value a promissory note are like those used to value businesses. For example, the value of a business might be based on future cash flows that are discounted to present value using a discount rate that reflects the risk to a hypothetical buyer. Similarly, the value of a promissory note might be based on future payments of principal and interest that are discounted to present value using a discount rate that reflects the note’s risk profile.
To determine an appropriate discount rate, a valuation specialist may research required rates of return for publicly traded bonds. Then he or she will adjust those rates for differences between public debt and the private note being valued.
Factoring in Terms and Conditions
When valuing a promissory note, it’s necessary to examine the factors that affect its perceived risk, including:
Interest rate and duration. Generally, the shorter a note’s term, and the higher the interest rate relative to market rates, the greater its value. The longer the term, the greater the risk to a hypothetical investor that market rates will increase. And a below-market interest rate reduces the value of a note.
Value of collateral. If a note is secured by enough collateral, it will reduce the risk of default and increase the note’s value.
Financial condition. A borrower’s financial condition affects its ability to make payments and, therefore, the risk of default.
Protective covenants and default provisions. These provisions are designed to protect the lender. More restrictive terms lower the note’s risk and increase its value.
In addition, there’s no active public market for private notes. So, it may be appropriate to apply a discount for lack of marketability, which lowers the note’s fair market value.
More Than Meets the Eye
Valuing promissory notes can be deceptively complex. Contact a valuation professional who can incorporate all the relevant factors into his or her analysis and help minimize the taxes due.