Tuesday, March 6, 2012

Book Value v. Fair Market Value

Recently we were asked why ESOPs use "Fair Market Value" instead of "Book Value" when acquiring shares and making distributions to participants. The quick and easy answer is that the Internal Revenue Code and the Department of Labor regulations that interpret the IRC require that ESOPs cannot pay more than appraised Fair Market Value when acquiring the shares, and must pay out benefits to participants using the most recent appraisal.

As it states in the "ESOP Requirements" section of Title 26 of the Federal Code, 54.4975-11,

"(5) Valuation. For purposes of 54.49757(b) (9) and (12) and this section, valuations must be made in good faith and based on all relevant factors for determining the fair market value of securities. In the case of a transaction between a plan and a disqualified person, value must be determined as of the date of the transaction. For all other purposes under this subparagraph (5), value must be determined as of the most recent valuation date under the plan. An independent appraisal will not in itself be a good faith determination of value in the case of a transaction between a plan and a disqualified person. However, in other cases, a determination of fair market value based on at least an annual appraisal independently arrived at by a person who customarily makes such appraisals and who is independent of any party to a transaction under 54.49757(b) (9) and (12) will be deemed to be a good faith determination of value."

There are many acceptable methods of determining "Fair Market Value," e.g., discounted projected cash flow, comparable enterprises, and so on, but the very best is a genuine "arm's length" offer for the company, i.e., what a willing buyer and a willing seller agree between them is fair. All valuation methods attempt to reach this figure in the absence of such an offer.

So, why not "Book Value"? The simple answer is, "Because the IRS says so." The actual reason is that book value, defined as acquisition cost less depreciation, does not necessarily — and in most cases does not actually — bear any relation to the real value of the capital assets owned by the company, either individually or joined as a "going concern." Book value simply wouldn't be fair to ESOP participants, paying them out in most cases at a value far below the actual value of the company as a viable enterprise producing marketable goods and services.

For example, an assembly line in a manufacturing plant is composed of many individual capital goods. The productive capacity of any individual piece taken by itself, regardless of its cost, might be zero. Assembled as a system, however, all the parts work together and become productive. The capital cost of the entire, larger system of which the assembly line is a component from start to finish may have cost, e.g., $1 million, but produces goods with a retail value of $2 million every day. Is the value of that company the book value — that is, the cost of the capital assets less depreciation? Or is it the present value of the production that comes out of the company every day projected over the remaining useful life of the assets?

That's not a ridiculous example, either. Using a few simple hand tools that, total, cost much less than $100 — a saw, chisel, mallet, a drill and bits — and some relatively inexpensive materials such as 2x4s and 2x6s, screws, pegs, glue and a couple of hinges, you can make a "Morris chair," a reclining armchair, that sells for anywhere from $500 on up. Nor do the tools wear out very fast. They can be reused, sometimes for a century or more, making the capital investment negligible compared to the value of the product.

So, let's add a "complication." Suppose that the assets owned by a company are fully depreciated, and thus have a book value of zero. Is the value of that company — and thus the shares owned by the workers — also zero? Going by book value . . . yes. Using book value in an ESOP transaction would cheat workers by "paying" them out at a value of zero.

Someone may argue that labor is adding all value, and that once it is fully depreciated, an asset is, in fact, worth nothing. The owner of the capital has recovered his or her cost, the "congealed labor," in the form of recognizing the depreciation expense over time, and that is all he or she is entitled to. All other value is added by labor, and therefore labor is entitled to all profits from production; the capital contributes nothing other than its cost, which is the owner's congealed labor. This was Marx's argument in Das Kapital. If there are profits in excess of labor's contribution and the cost of the capital (congealed labor), it represents surplus value stolen from the consumer.

The problem is that Marx's analysis falls apart when confronted with reality. He stumbled badly when trying to explain, for example, why diamonds, that might require little labor to acquire if you happen to look down and find one, are so valuable. Of course, Marx assumed that all diamonds are used only for jewelry, but most are used in industry as abrasives. Regardless of the cost of finding them, industrial diamonds are in high demand because of their utility, and are consequently of high value.

Under the Marxist analysis, of course, there is no economic incentive for anyone to engage in productive activity — not even for yourself, for you are (presumably) guaranteed what you need regardless of your contribution of labor or capital. As Marx stated the principle in his Critique of the Gotha Program (1875), "Jeder nach seinen Fähigkeiten, jedem nach seinen Bedürfnissen!" — "From each according to his abilities, to each according to his needs!"

In any event, labor in and of itself produces nothing, as even Marx acknowledged ("it does not count as labor"). Labor must be "mixed" with capital — that is, expended on something — before anything can be produced. Even waving your arms in the air "mixes" your labor with the air and moves it, producing a slight breeze, whereas in a vacuum (assuming you don't explode from the lack of pressure) you can wave your arms all you like and only exhaust yourself. That capital is an "independent variable" (though not autonomous) in the production process is demonstrated by the fact that you cannot produce anything with labor alone, but capital by itself — e.g., a completely automated factory — can be and is productive without an ongoing or direct human labor input.

The problem with marketable goods and services produced by capital, or predominantly by capital, is that if the capital is owned or controlled by a small number of people, as is the case in both capitalism and socialism, there is really no reason to produce. Unless consumption power is broadly distributed by having capital instruments widely owned, there will be no incentive to produce anything.

This is why under both capitalism and socialism the State steps in and attempts to enforce desired results. It does this by imposing more and more control on the economy through money manipulation, redistribution, and increasingly complex tax schemes — today's Internal Revenue Code sans all the voluminous regulations that tell you how to interpret the IRC runs to cir. 7,500 8-1/2 x 11 print pages: 3.4 million words. The policy is generally to try and balance the presumed need for the rich to save to finance new capital, and for the poor to spend to justify the new capital. Ultimately what results is what Hilaire Belloc called "the Servile State" as capitalism and socialism begin to resemble one another and finally merge.

Of course, lifting the barriers that inhibit or prevent propertyless citizens from becoming capital owners on the same terms as the rich — such as lack of access to capital credit and the demand for collateral — would solve the problem by emancipating humanity from the slavery of past savings. Capital Homesteading is designed to do just that. The question becomes how do we acquaint our leaders and prospective leaders with the advanced financing concepts of the Just Third Way to bring us out of this economic Slough of Despond?

To summarize our answer to the original question, however, insisting on using "book value" as the basis of distribution to ESOP participants would not only be unjust, but would effectively constitute a virtual rejection of reality verging on the delusional — as the current shape of the global economy bears witness.

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