Business Valuation

Divorce Lawyers Specializing In Family Law Business Valuation

The State Bar of California recognizes Family Law as a specialized practice area. Representing clients in divorce matters that involve the valuation of business interests is a far more specialized area. Handling these matters requires a working knowledge of valuation principles, taxation, compensation issues, accounting principles, general foundational business knowledge and the complex and conflicting divorce valuation statutes, relevant case law and divorce litigation skills.

The Potential Team
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Experts
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Business Valuation Experts

Representing a client in a divorce involving a business interest usually requires the retention of a number of experts including a valuation expert. Valuation experts can be invaluable in the negotiation process and in reaching a settlement, in that opposing experts often collaborate to reconcile the differences in their opinions. In fact, in many cases the divorce court will order the accountants to meet and confer long before the divorce trial to attempt to resolve or narrow their differences.

The expertise and competence of an expert will often have a significant impact on final settlement or trial results. The importance of the role played by an expert in a divorce cannot be overemphasized. In some divorces, the value of an expert can exceed that of the divorce lawyer. Experts should be retained at the commencement of a divorce and not after a potential settlement has fallen apart. The expert's input should be sought before any offers are made or responded to. Early retention of a divorce valuation expert can be critical in the crafting and development of settlement offers, case strategy and the game plan.

As with divorce lawyers, all valuation experts are not created equal. It would be very difficult to quantify the value of the right experts in a divorce. An unqualified expert may not qualify as an expert in a divorce trial which would prevent him from testifying. Such a result could be devastating to the outcome of the divorce in that the lawyerwould then not have the ability to present evidence of the valuation of the business interest to the divorce court.

It is not prudent to attempt to utilize a client’s personal accountant to perform the valuation even if he is experienced and qualified in the field of valuation. It is essential that the expert knows the divorce valuation nuances, has credibility with the divorce courts and is seen as being relatively unbiased and objective by the judge.

Business Valuation Overview

Date of Valuation
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Date of Separation
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Valuation Date

The valuation date in a divorce can have a very significant impact on the valuation itself. There is a specific family code statute and extensive case law that address the valuation date but generally a business is valued as close to the date of settlement or trial as is reasonably practical. Of course, there are exceptions to this rule. Under some circumstances, a business may be valued on the date of separation.  There are, also very specific rules relative to obtaining the consent of the divorce court to present evidence of a valuation on any date other than the date of trial (IRMO Green, IRMO Duncan and IRMO Stevenson).

Measure of Value
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Methods of Valuation
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Measure of Valuation

The measure of value can also be a significant issue in a divorce. The divorce court may use going concern value, fair market value or investment value. The basis for a divorce court using investment value is founded on the principle that the business is not being sold and the value is that of an investment held by the owner himself (IRMO Hewitson).

Valuation Method: Capitalization of Excess Earnings (Asset Based Approach)
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Valuation Method: Capitalization of Earnings (Income Based Approach)
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Valuation Approaches & Formulas

The value may be based on a number of different formulas. Capitalization of earnings and capitalization of excess earnings are the two approaches most often used in Orange County family law matters. A divorce court may also use the market approach for valuation but the use of this approach presents a number of very significant challenges including using truly comparable companies for comparison. Rules of thumb approaches are generally not accepted by the Orange County divorce courts.  It is difficult to prove the underlying basis for the rule of thumb formulas (IRMO Honer and IRMO Hewitson).

A divorce court may also consider the evidence of prior sales or purchases of interests in the business being valued. In family law, a business cannot be valued using the operating-spouses’ expected future earnings (IRMO Fortier). The widely recognized valuation method referred to as the ‘discounted future cash flow’ method (DCF) is not used in California divorces. The divorce court cannot value a business based on speculation relative to the business’s future success or failure.

Generally, a valuation in a divorce requires an analysis of the business’s financial performance during the past five years.  An expert may omit from the average, years or events if they are non-recurring and if the omission will result in a more accurate view of the normalized financial performance of the business.

Valuation and Goodwill

Goodwill is defined as the expectation of future patronage.  In other words, the likelihood that the business will continue to attract customers.

Simply stated, the value of the business is a combination of the net value of the assets of the business (assets minus liabilities) plus the value of goodwill.

Goodwill cannot be based on post-marital efforts of a spouse (IRMO Foster).  Goodwill should be calculated using the historical financial performance of a business over a representative period of time (IRMO Rosen).

It is not a matter of law that all business have goodwill but the issue must be addressed and allocated on the marital balance if it exists (IRMO Golden).  Business goodwill must be valued and allocated but individuals do not have goodwill (IRMO McTiernan and Dubrow).  A licensed financial advisor's client list has a value akin to goodwill (IRMO Finby).  The divorce court may average valuation methods in arriving at the value of a business (IRMO Webb).  Publicly traded companies are valued differently than privately held companies.  Divorce courts are not allowed to use a price earnings ratio in valuing a privately held company (IRMO Lotz).

The terms of a partnership may limit the community's interest in goodwill (IRMO Iredale and Cates).

The divorce court may issue a non-competition order to protect a spouse's value in the business (IRMO Greaux and Mermin).  A speculative non-competition agreement cannot be considered in the valuation of a business (IRMO Czapar).  A business valuation should not be adjusted by the hypothetical value of a future employment contact (IRMO Duncan).

Assets of a Business

It is generally necessary to value the assets of a business. For example, if the business owns real estate, machinery, computers, intellectual property or other tangible or intangible property, experts may be needed to value these assets. Typically, the valuation expert is not qualified to value the capital assets of the business.  Depending on which valuation method is being used, the valuation may also need to address operating vs. non-operating assets. A non-operating asset is an asset that is not needed for continued performance of the business.

Controllable Cash Flow

A valuation expert will render an opinion as to the operating-spouse’s total controllable cash flow. Determining cash flow is not simply looking at the income of the operating-spouse.

Income does not equal cash flow. A business may recognize significant income but have little or no cash flow in a particular year. On the other hand, a business may have substantial distributions in a year and have little or no income.

The amount of the controllable cash flow can be a significant source of conflict between the experts. Cash flow generally includes the compensation of the operating-spouse, various perks, and in certain situations the profits of the business. In divorces there can be an issue as to what portion of the profits can be distributed to the owner without adversely impacting the business operations.  This issue relates to the working capital needs of the business. Obviously, the operating-spouse should not take cash out of the business if it would jeopardize the business’s ability to remain current on its debts and remain solvent.

Economic depreciation (vs. non-economic depreciation) should generally be added back to cash flow.

Compensation
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Reasonable Compensation

There are also two distinct approaches to determining reasonable compensation of the operating-spouse.  Conflict in this area can lead to very significant differences in the values assigned to goodwill. One approach looks to the annual salary of a typical salaried employee who has similar experience to the owner-spouse. The other approach looks to the ‘similarly situated professional’ which is an approach that was addressed in the Orange County divorce case IRMO Ackerman. Using this approach, the divorce court looks at the cost of hiring a non-owner outsider to perform the same duties as does the owner-spouse.

Shareholder Agreements

California divorce courts may consider the value of a business to be the value that was agreed to in a partnership agreement but are not bound to value the business interest using that number. The value set forth in such an agreement is not controlling on the divorce court (IRMO Slater).

There are a number of issues that a divorce court looks to in deciding this issue. If a spousal consent was executed, one of the main focus points may be whether the agreement was executed by the non-operating spouse with the knowledge that the value being agreed to, would establish a value for the business interest in a future divorce. Whether the non-operating spouse had a lawyer at the time of the execution of the agreement may also be very important in the analysis. The terms of the agreement may be binding on the partners/shareholders but not be binding on the non-operating spouse.

Goodwill
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Goodwill

In arriving at a goodwill value, the following factors are considered: compensation of operator-owner, reasonable compensation, rate of return on tangible assets, and multiplier/ capitalization rate.

Areas of Conflict

Often times, the opinions of opposing experts are relatively close regarding the adjusted book value of a business. When there is a disagreement regarding the valuation of a business it often times relates to the value of goodwill.

Rate of Return

Calculating a rate of return on tangible assets is a component of the capitalization of excess earnings valuation method. The rate of return varies depending on the expert, the general economic conditions and prevailing interest rates. The rate is generally described as the "industry rate" or the "rate of return" that one would expect to earn on the specific assets utilized in the business in question. The rate of return is multiplied by the value of the tangible assets and the resulting sum then represents the portion of the total earnings of the business attributable to the tangible assets. The remaining portion of the earnings are then theoretically generated by the goodwill of the business itself.

Total Earnings
of Business
$$$$$$
Industry Rate of Return
x Tangible Assets
< $ >
Reasonable
Compensation of
Owner-Operator
< $$ >
Excess Earnings of
Business
$$$
 

Multiplier / Capitalization Rate Conversion Table

Multiplier Capitalization
Rate
1 1.00
2 .50
3 .333
4 .25
5 .20

Capitalization

If a capitalization approach is utilized, the excess earnings are multiplied by a ‘multiplier’ or divided by the capitalization rate.

The multiplier/capitalization rate relates directly to the risk of the investment. The riskier the business/industry the lower the multiplier. Consider the case of two businesses, one risky and one secure, each with $50,000 of excess earnings. An investor may pay only one times earning for goodwill of the riskier business ($50,000) because the business is less likely to continually return the excess earnings to the investor. Alternatively, an investor may pay three times earnings for the goodwill of the more secure business ($150,000) because the business is more likely to return those excess earnings to the buyer for a number of years.

Other Factors

As in valuations that are performed in other contexts, collectability of accounts receivable, barriers to entry, management team depth, pending legislation, toxic waste, new competitors, minority discounts, bank covenants and many other issues may be relevant.

Reimbursement to the Community of a Portion of the Increase in Value of a Separate Property Business During the Marriage

There is a very basic divorce presumption that provides that an asset acquired during the marriage is community property. The presumption generally applies to the acquisition of a business. However, if a business is acquired prior to the date of the marriage it is the separate property of the owner-spouse.

If the business increases in value during the marriage the community may be entitled to reimbursement of a portion of that increase. It is clear that the rents, issues, and profits of a separate property asset are the separate property of the owner-spouse. The natural enhancement of separate property during the marriage retains its separate property character (IRMO Ney). A change in the form of a business (sole proprietorship to a corporation) does not cause a business to lose its separate property character (IRMO Koester).  But, if the increase in value is due in part to the effort of a spouse, the community may need to be made whole.

Any reimbursement to the community relates to the equitable principle that a separate property business is required to repay the community for any unreimbursed community effort expended on the separate property business during the marriage. Reimbursement is determined by using one of several different theories or approaches.

Equitable Allocation Approach
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One of the theories, Pereira, (IRMO Pereira) assigns to the separate property business a reasonable rate of return on the value of the business as it existed on the date of the marriage and credits the community with the remaining portion of the increase in value. Under this approach there may exist a conflict over what interest rate is applied to the value of the separate property business between the date of marriage and the date of separation and whether the interest is simple or compound.

Another theory, Van Camp, (IRMO Van Camp) gives the community a right to reimbursement equal to the total under-compensation of the owner-spouse during the marriage and assigns the remainder of any increase in value to the separate property of the owner-spouse.

The divorce court may use one theory during a portion of the marriage and another theory during a different portion of the marriage (IRMO Brandes).  The divorce court may also use a compromise formula (Todd v. C.I.R.).

Any amounts paid by the separate property business to or for the benefit of the community may be deducted from the reimbursement owed by the separate property business to the community. The amount owed to the community under either theory is a right to reimbursement and not an interest in the business itself. Application of either of these theories requires a determination of the value of the business on the date of marriage and as of the date of separation.

Generally, if a separate property company increased in value during the marriage and the increase was not due primarily to the effort of the owner-spouse, the community is only entitled to reasonable compensation for the work performed by the owner-spouse.

Tax

Should the excess earnings and/or accounts receivable be tax impacted? The impact can be significant. Tax impacting relates to attempting to compare apples to apples when valuing c-corporations and s-corporations. The multiplier and the income stream should both be pre-tax or both be after-tax.

Disposition of the Business
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Initial Characterization of Business
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Disposition of Business Interests

It is rare that a business is sold as a result of the divorce. Unless there are very unique circumstances, a business is awarded by the divorce court to the operating spouse. If the parties operate a business together and both seek an award of the business, it is generally awarded to the party that is most critical to its continued success. It would be rare for a divorce judge to award a business jointly to the parties. Continued joint ownership would most likely occur only if the parties were to reach an agreement for such a result.

On occassion, the operating-spouse of the business opposes having the business awarded to him. In such a situation, it is generally not an option to propose that the business be sold or be awarded to the non-operating spouse. The operating-spouse often believes that there would be no business without him or her and he or she may be correct. In a divorce, that fact is not a determinative factor in the award of a business or the value of the business. Generally, the operating-spouse does not have the option to ‘shut down’ the business without the likelihood of being charged with the value of business as it existed before its closure.

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