Lawyers Specializing In Family Law Business Valuation
The State Bar of California recognizes Family Law as a specialized practice area. Representing clients in family law matters that involve the valuation of business interests is an even more specialized area. Handling these matters requires a working knowledge of family law valuation principles, taxation, compensation issues, accounting principles, general foundational business knowledge, and the complex and conflicting family law valuation statutes, relevant case law, and divorce litigation practicalities.
Business Valuation Experts
Representing a client in a divorce involving a business interest requires the retention of a valuation expert in family law business valuation. Valuation experts can be invaluable in the divorce negotiation process and in reaching a settlement in that experts often collaborate to reconcile the differences in their findings and opinions. In fact, in some cases the divorce court will order the accountants to meet and confer long before the trial to attempt to resolve their differences.
The expertise and competence of an expert will usually 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 family law cases, the value of an expert can exceed the value of the divorce lawyer. Experts should be retained at the commencement of a case and not after a potential settlement has fallen apart. The experts input should be sought before any offer is made or responded to. Early retention of a family law valuation expert can be critical in the crafting and development of settlement offers, case strategy, and the game plan.
As with lawyers, all valuation experts are not created equal. It would be very difficult to quantify the value of the right divorce lawyer and the right experts in a family law matter. An unqualified expert may not qualify as an expert in a family law trial which could prevent him from testifying in the trial. Such an ruling would be devastating to the outcome of the litigation in that the client would then not have the ability to present his evidence of the valuation of the business interest to the divorce court. Without evidence, the judge cannot rule in a client’s favor.
It is not prudent to attempt to utilize a client’s own accountant to perform the valuation work even if he is experienced and qualified in the field of valuation. It is essential that the expert knows the family law valuation nuances, has credibility with the family law courts, and is seen as being unbiased and objective by the judge.
Business Valuation Overview
The valuation date for a business in a family law matter 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. There are, also very specific rules relative to obtaining the consent of the family law court to present evidence of a valuation date at trial on any date other than the date of trial.
Measure of Valuation
The measure of value of a business interest can also be a significant issue in family law matters. The divorce court may use going concern value, fair market value, or investment value. 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.
Valuation Approaches & Formulas
The value may be based on generally accepted valuation formulas: ‘capitalization of earnings’ and ‘capitalization of excess earnings.’ These two approaches are most often used in Orange County family law matters. A family law court may also use the market approach for valuation but the use of this approach presents a number of very significant challenges including finding truly comparable companies for comparison. Rules of thumb approaches are not accepted by the courts in that they lack foundation.
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’ projected future earnings. 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, valuation in a divorce requires an analysis of the business’s financial performance during the past five years. The expert will usually need to convert the financial statements from cash basis to accrual financial statements in order to have a realistic picture of the financial performance of the business. An expert may omit from the analysis certain 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.
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 family law 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.
At times 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 may believe that there would be no business without him and he may be correct. In a family law matters, that fact is not a determinative factor in the award of a business or the value of the business. 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.
Assets Owned By the Business
It may be necessary to value the assets owned by 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. The valuation process may also address operating vs. non-operating assets. In certain businesses an inventory may need to be completed.
Controllable Cash Flow
Generally a family law valuation expert will render an opinion as to the operating-spouse’s controllable cash flow. Determining cash flow is not simply looking at the income of the business. Income does not equal cash flow. A business may recognize significant income but have little or no cash 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 the source of conflict between the experts. Cash flow generally includes the compensation paid to the operating-spouse, various perks, and in certain situations the profits of the business. In family law matters there can be an issue as to what portion of the profits can be distributed to the owners. 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 also be added to cash flow.
There are also two distinct approaches to determining reasonable compensation of the operating-spouse. The conflict in this area can lead to very significant differences in the values assigned to goodwill. One method 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 referenced in the Orange County family law case In re: Marriage of Ackerman. Using this approach the family law court looks at the cost of hiring a non-owner outsider to perform the same duties as does the owner-spouse.
California family law 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 at that number. The value set forth in such an agreement is not controlling on the divorce court.
There are a number of issues that a family law court looks to in deciding this issue. One of the main focus points may be whether the agreement was entered into by the non-operating spouse with the knowledge that the value that was being agreed to could establish a value for the business interest in a future divorce. Whether the non-operating spouse had an attorney 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.
Allocation to the Community of a Portion of the Increase in Value of a Separate Property Business During the Marriage
There is a very basic family law presumption that provides that an asset acquired during the marriage is community property. The presumption clearly applies to the acquisition of a business. 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. But, if the increase in value is due in part to the effort of a spouse, the community will need to be made whole.
Any reimbursement to the community would relate to the equitable principle that the separate property business be 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.
One of the theories (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 and whether the interest is simple or compound. Another theory (Van Camp) gives the community a right to reimbursement of an amount 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.
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 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 settlement or trial.
The Internal Revenue Code (IRC) provides that gains and losses are not recognized relative to the transfer of community property between spouses, if the transfer is incident to a divorce and the transfer occurs within one year of the entry of a decree of divorce. In limited situations, the same rules may apply if the transfer occurs within six years of the entry of a decree of divorce. These transfers are characterized as “non-taxable transfers.” The code provides that there is a presumption that the transfer is incident to the divorce if it occurs within the one year period which is contrasted with the six year period where the taxpayer must bear the burden to show the connection. In other words, the IRC provides for an exception to the rule that capital gains resulting from the sale of an asset are taxed. The tax basis of an asset does not change if the transfer is a non-taxable event.
As in valuations that are performed in other contexts, collectability of accounts receivable, barriers to entry, management team depth, pending legislation, toxic issues, new competitors, minority discounts, bank covenants and many other issues may be relevant.
Areas of Conflict
Often times the opinions of opposing accountant’s 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. The specific areas of conflicts generally fall in the categories of: reasonable rate of compensation, multiple or capitalization rates, number of years of analysis, the omission of non-representative years/events, and valuation methodology.