Valuing a Closely Held Business in Divorce: Pitfalls and Best Practices
May 22, 2018
Valuing a closely held business can be a complex endeavor, requiring a through analysis of assets, financial statements, financial claims, earning potential and inherent risks. A host of other factors can also influence the determination. Valuations are especially tricky in the context of contentious divorces involving businesses. In such cases, each spouse should not only have his or her own lawyer, but also a forensic business evaluator to ensure the thoroughness and accuracy required to make an informed decision regarding equitable distribution and to secure the best result.
This article discusses the valuation process and methods used, notes common pitfalls, and offers practical pointers on what to do when divorce is or may be on the horizon.
Whether considering a divorce or facing one where either or both spouses have a closely held business, each spouse should consult a lawyer with extensive experience in handling divorces involving business valuations and in working with forensic business evaluators. That experience is key when determining whether the business has value or is simply providing a job to the owner, when selecting forensic evaluators, reviewing documentation, or challenging the opposing experts’ valuation and in ensuring the best possible outcome for the client. An experienced attorney can streamline the process and avoid the unnecessary expenditure of funds.
When considering an expert, look for someone credentialed, such as a Certified Business Appraiser, an Accredited Senior Appraiser (ASA), or a CPA. Hire one skilled at analyzing cash flow and accurately valuing businesses. But also be sure that the evaluator is clear and convincing, able to explain complex financial concepts in plain English in court and at the negotiating table. A lawyer experienced in handling business valuations and working with business evaluators will be able to provide invaluable guidance on selection.
Next, gather as much relevant documentation as possible to support a fair, if not favorable, business valuation. If the marriage is in trouble, be proactive. Don’t wait to be served with divorce papers. At that point, it may not be easy to obtain access to the information needed.
At a minimum it will be important to obtain copies of the following documents for the previous three to five years:
- Federal and state tax returns
- Financial statements, both personal and for the business
- Balance sheets
- Any buy-sell agreements
Note that Pennsylvania law, with a few exceptions, states that assets acquired during the marriage, without regard to how the assets are titled, are marital property subject to equitable distribution. It is not uncommon for a spouse to have owned a business at the time of marriage thereby making the business a premarital asset. In these situations, it is necessary to ascertain the increase in the value of the business that accrued during the marriage as only that increase in value is subject to equitable distribution. Unfortunately for the divorcing spouses, this typically requires two separate valuations of the business, one as of the date of the parties’ marriage and a more current valuation.
Business Valuation Methods
The three common approaches used when conducting a business valuation are the asset-based approach, the market approach and the income-based approach. Each is outlined below:
- The asset-based approach is the simplest, focusing on the sum of the various business assets minus liabilities. The evaluator assigns a value to the business assets based on their replacement cost. Tangible assets like inventory and intangibles such as patents, trademarks and accounts receivables are included in the valuation. Although this method can be quite accurate for tangible assets, it doesn’t consider the intangible goodwill value associated with the business.
- The market approach considers recent sales of similar businesses in the same market to arrive at a value. Here the evaluator looks at what ready, willing and able buyers have paid ready, willing and able sellers in arm’s length transactions involving comparable businesses. The problem with this approach is that many businesses are unique so that there simply are no comparable sales that can be used to determine the value of the business in question.
- The income-based approach is the most commonly used method. The evaluator first determines the income of the company, normalizes costs such as salaries and expenses, and then applies a capitalization rate to the earnings to establish the value of the business. The capitalization rate is based on the income the business is likely to generate going forward in light of inherent risks.
Expected earnings, attendant risks, the industry, market dynamics, competition and the economy as a whole, are among the many other factors that can impact the valuation determination. Therefore, a competent evaluator will consider all three approaches.
Is a Business Valuation Expert Really Necessary?
Depending on the type of business involved, the size of the business, the value of assets and the documentation at hand, it may or may not be necessary or cost effective to involve a forensic business evaluator. If the business is small, has little value and the spouses can agree on its worth, then the parties can simply agree on a value. If the business or an interest in the business was recently bought or sold, if the business was recently appraised, or there is a recent prior statement of the value of the business in a financial statement or a loan application, that information may go a long way in establishing the value of the business.
Absent such value indicators, the business-owning spouse will likely argue that the business is worth less than the nonparticipating spouse will claim. In such cases, if the value is significant, an expert should be called in to review the history of the business, its market position, finances, assets, liabilities, and future prospects, etc.
Potential Pitfalls and Practical Pointers
There are a number of pitfalls to avoid when valuing a closely held business in the context of divorce. Valuing goodwill is one of those potential pitfalls.
Enterprise goodwill, also known as business goodwill, is goodwill attributed to the business without regard to who owns or operates it. Customers are loyal to the business as opposed to its owner or a particular employee. Personal goodwill is specific to the business owner or a particular person in the company. If the value of the company would drop significantly if the owner left the company or a particular employee left, then that is a strong indicator that some of the present value of the company is attributable to the personal goodwill of the owner or employee.
Pennsylvania includes enterprise goodwill of a business in the marital estate subject to equitable distribution but excludes personal goodwill from the marital estate. Essentially, the value an owner personally brings to the business is taken out of the equation when determining the value of the business subject to equitable distribution. Equitable distribution in Pennsylvania does not include the business-owner spouse’s future earnings potential so the nonbusiness-owner spouse should ensure that the distribution agreement reflects that reality.
Double dipping is another pitfall. Double dipping may occur when income from the same source is counted twice, once in determining the value of a business for purposes of equitable distribution and then again as income to the business owner spouse in setting support or alimony. Although some Pennsylvania courts have recognized the inequity of double dipping, there is no Pennsylvania appellate decision that has addressed and definitively resolved the issue. Therefore, care must be taken by the business-owning spouse, its counsel and expert evaluator to clearly delineate what was included in arriving at their business value subject to equitable distribution to avoid having the same funds counted again in an alimony award.
As we’ve seen, business valuation in the context of divorce can be complicated, contentious and costly. When a business has significant value and the parties will not or cannot agree to its value, using a forensic expert will be the best course of action. In an effort to avoid the costs associated with more than one evaluator determining the value of the business, seasoned attorneys for the spouses may consider hiring one well-respected business evaluator to offer a neutral opinion as to the value of a business. However, the first question that must be answered is whether it makes sense to incur the costs associated with hiring a forensic evaluator. Remember this is not an “all or nothing” proposition. In many cases it makes sense to pay for a few hours of an evaluator’s time to get the evaluator’s initial impression as to whether the business is a minor asset, has little value beyond providing a spouse with a job or has a readily ascertainable value.