While it may seem at face value (pun intended) that the value of a note is equal to the outstanding principal balance; this is often not the case. The fair market value of a note is dependent on several factors, two of the most important being “counter-party risk,” which means the creditworthiness of the debtor, and cost of capital at the date of analysis. Understanding the creditworthiness of the debtor is the more complicated of the two, and potentially involves analyzing the debtor’s financial condition, and could involve a fairly complex analysis of an operating company, including an analysis of quality of assets and cash flows, the determination of a corporate credit score (Z-score), and other such analyses that are typical for underwriting debt. As an ancillary consideration, the lender should require access to relevant records so as to be able to perform such analyses if necessary.
The valuation of notes for tax purposes, regulated by U.S. Treasury Regulation §20.2031-4, states: “The fair market value of notes, secured or unsecured, is presumed to be the amount of unpaid principal, plus interest accrued to the date of death, unless the executor establishes that the value is lower or that the notes are worthless.” The Regulation goes on to say, “If not returned at face value, plus accrued interest, satisfactory evidence must be submitted that the note is worth less than the unpaid amount (because of the interest rate, date of maturity, or other cause), or that the note is uncollectible, either in whole or in part (by reason of the insolvency of the party or parties liable, or for other cause), and that any property pledged or mortgaged as security is insufficient to satisfy the obligation.”
According to the Regulation, there are a number of factors that could lead one to conclude that a given note is worth less than its face value, plus accrued interest. In effect, if the terms of the note differ from “market terms” for the note on the date of valuation, the value may be different than the stated value. As the Regulation implies, “because of interest rate, date of maturity, or other cause” there could be a variety of factors that affect value, not all of which necessarily affect value in the same way. Some factors might increase while others might decrease value. Likewise, the collectability of the note is key in assessing value. This is very similar to the public bond market, where we see bonds trade at discounts or premiums to their face value depending on market and business conditions.
Once all of the factors affecting the value of a particular note are identified, the process has only just begun. In assessing any note, comparison to “market” is the primary determinant of value. That is to say that an analyst must determine the rate of return that would be demanded by the likely pool of hypothetical buyers of the note. This is accomplished by assessing the terms of the note, the risks of repayment/default (a thorough analysis of the debtor), the security underlying the note, and the potential costs of collection for notes with a high risk of default. As the risks related to the note increase, so does the required rate of return. As the required rate of return increases, the value of the note decreases, relative to its face value.
Many of our note valuations have been performed for tax-related purposes, including estate tax or gift tax purposes. So, in order to be certain that the requirements of the regulations are met, “satisfactory evidence must be submitted that the note is worth less than the unpaid amount…,” and the proper fair market value is submitted.
Valuing a note is complex, and requires knowledge in all facets of valuation – operating companies, options, patents, warrants, and many other forms of securities. Please let us know how we can help you with your next valuation project.
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