Valuation of a Closely Held Business in Divorce
Dividing the family’s property during divorce can be quite difficult. Deciding who should get what can be quite a challenge, even under the most amenable of situations. If the divorce is contentious, then this can be especially complicated.
As part of the divorce process assets in the marital partnership need to be valued and divided upon divorce. In order to divide those assets properly and equitably, each asset must be assigned a dollar value. The point in time in which an asset is assigned a dollar value is important and is commonly referred to as the valuation date.
If there are closely-held businesses, professional practices and/or licenses’ the process can be especially difficult. For many divorcing couples, a closely held business is often one of the largest marital assets. The situation is often complicated by the fact that, as a privately held entity, there is no readily available market pricing for the shares. Using a qualified valuation expert to appraise the business is often the only way to get an accurate value for the asset. While the process may sound straightforward – choose a valuation date, appraise the business as of that date, settle the case, or go to trial –the determination of the valuation date isn’t typically a straightforward exercise and differs from state to state. As a result, the valuation process can be quite complex.
Since in many divorces the closely held business ownership interest is one of the major assets of the marital estate it is also an area where divorcing parties strongly disagree. The main issues that typically are disputed revolve around not only the value of the business interest, but the amount the non-owner spouse should receive as part of the either the overall settlement or trial judgment.
Usually, the business-owner spouse works in the business and performs certain executive, administrative and operational duties. It is common practice that the owner spouse does not want the non-owner spouse to have an equity interest in the business post-divorce. As a result, the owner spouse “purchases” the equity interest of the non-owner spouse in the course of negotiations in dividing all of the assets in the marital estate. The function of a business valuation expert is to determine the value of the business for this purpose.
In practice, business valuation is known more as an art than an exact science. While the theory involved in the business valuation process is typically similar in non-divorce valuations, there are many unique nuances to performing valuations in a divorce engagement imposed by the governing jurisdiction of the divorce.
The business valuation process, for the most part, utilizes a standard known as “fair market value.” In simple terms, this concept is a method where a hypothetical “willing buyer” would pay a hypothetical “willing seller” in a “free and open market” where each person, both buyer and seller, is in possession of all material facts with neither forced to buy or sell. In summary, it is an economic transaction between interested individuals as result of negotiations with all known facts.
Business valuations for divorces are predominantly undertaken in the same manner as any other business valuation. In the context of a divorce, some but not all of the considerations can include:
- What is the appropriate valuation date?
- Is the business being valued as a “going concern” (that is, it will continue to operate into the future and not, for example, be liquidated)?
- What is the standard of value to be used (i.e., fair value, market value, asset value, or some other standard)?
- What impact do related party items have on the cash flow of the business for valuation purposes?
While the concept of fair market value is generally understood, it is not necessarily the standard of value to be applied in divorce. The process of divorce is governed by the state laws and statutes of the jurisdiction in which the divorce action takes place. In addition, unlike a fair market value valuation, there is no hypothetical seller or buyer, and generally, no sale of the business takes place. As a result, many states have adopted standards of value that differ significantly from the commonly known “Fair Market Value Approach.” Various states use standards of value such as fair value, investment value, value to holder or intrinsic value. What can be more confusing, especially for divorcing couples who already have high levels of emotion and anxiety, is that between states, these terms can have different meanings. Therefore, it is extremely important there is a clear understanding between the parties, attorneys, and valuation expert from the beginning as to the valuation process.
The process with most business valuations starts with an analysis of a number of elements that are recognized by the appraisal profession to be of particular relevance in valuing any privately held company. Many valuation professionals refer to Internal Revenue Ruling 59-60, which lists the following factors to be considered:
- Nature and history of the business
- General economic outlook and specific prospects for the industry
- Net worth and financial condition
- Earning capacity
- Dividend paying capacity
- Extent of goodwill, if any
- Size of the block of stock being valued, especially if it represents a majority or minority interest
- Whether the stock in question is voting or non-voting
- Stock prices of comparable public companies, if any
- Sale(s) of company stock at or near the valuation date
- Limitations or restrictions on the stock, such as on transfer, dividends, etc.
- Sale(s) of stock in comparable closely-held companies, if any (implied)
The above information is mostly supplied by the business-owner spouse directly from the business and is typically requested through a process called “discovery.” The discovery process can be described as when the parties in the divorce exchange information, at least as it relates to the valuation and support obligation, about their personal and business finances. A request for information can be sent to the business owner, non-business owner spouse, and/or through the respective attorneys.
There are three generally accepted approaches to value any asset, business, or business interest: (1) the asset approach; (2) the income approach; and (3) the market approach. There are then different methods the valuation expert may consider within each of these approaches. Each approach has inherent strengths and weaknesses and some provide a more reliable conclusion of value depending upon the individual circumstances of each case. Generally, the valuation expert should consider all three approaches; however, it is often that all three approaches cannot be applied.
The basic premise of valuation is that when an individual makes the decision to acquire or invest in a business of any kind, there is an expectation of a return on that investment. The return on investment can be measured several ways, including future earnings or using some level of cash flows. A main factor in determining the value of a business and return on investment is operating performance.
In valuation engagements, the valuation expert will render a conclusion of value for a specific amount. However, in the context of divorce, it is not uncommon to see a valuation expert provide a preliminary range of values prior to the issuance of a formal report for two reasons:
- It may be easier for divorcing spouses to agree on a range of values rather than on a specific dollar amount.
- An amount within the range of values can also be used as part of the process of negotiating a desired level of spousal support.
It is important to note that while the valuation expert is an advocate for their opinion, they are not an advocate for either side in the litigation.
The valuation process can take many hours for even an experienced expert to arrive at a conclusion of value. It is therefore fair to say the cost of performing a valuation and conducting all of the proper procedures can be very high, and is directly related to the cooperation from everyone involved.
To divorcing couples, the world of business valuation can be confusing, frustrating, costly, and overwhelming when faced with the entire process as well as life after divorce. However, with the help of a good attorney and experienced business valuation specialist, the divorce process can become less intimidating and become an opportunity for the divorcing spouses to become educated and involved in the process. Additionally, the valuation expert can provide their technical expertise to the attorneys in aiding them with respect to a valuation result that all sides can accept. While there may be a disagreement as to what is fair, the parties, their attorneys, and/or the court will have the information and knowledge to make an informed judgment on whether to settle or go to trial.