Business Valuation

One of the most complex areas in family law is the valuation of a business and the equitable apportionment of any increase in the value of a separate property business during the marriage.

The valuation process includes the analysis of goodwill, book value, adjusted book value, compensation, perquisites, reasonable compensation, multipliers, date of valuation, and methodology of valuation.

The two most frequently utilized valuation methods are the Capitalization of Earnings (an earnings approach) and the Capitalization of Excess Earnings (an asset approach). Examples of each are shown here. The court may award a business to either party, order the business sold (rare) or award it jointly to the parties (rare). It is essential to involve an expert in the valuation process. The most challenging areas of a business valuation are the determination of reasonable compensation and the multiplier/CAP Rate.

Valuation Method: Excess Earnings

1. Capitalization of Excess Earnings (Asset Based Approach)

Book Value $200,000    
Adjustment of assets to FMV + 100,000    
Adjusted Book Value   $300,000 (A)  
Total Earnings / Compensation
(5 years average)
400,000    
Return on adjusted book value
(8% x $300,000)
- 24,000    
Reasonable Compensation - 150,000    
Excess Compensation 226,000    
Multiplier × 2    
Goodwill   $452,000 (B)  
Total Fair Market Value     $752,000 (A) + (B)

Asset Based Approach

Book value (assets less
liabilities)

Adjust assets to fair market
value

Add goodwill (likelihood of
continued public patronage/
business's ability to generate
superior earnings)

Valuation

2. Capitalization of Earnings (Income Based Approach)

Earnings/Compensation (5 years average) $400,000
Reasonable Compensation - 150,000
Excess Earnings 250,000
Multiplier x 3
Fair Market Value $750,000
   

Income Based Approach

Determine Excess Earnings

Apply a Multiplier/CAP Rate*

Add Back Any
Non-Operating Assets

* The multiplier/CAP Rates used in an asset based approach versus an income based approach are generally different numbers

The Valuation Process

Initial Characterization of Business (Separate vs Community)

Valuation

Award of Business to Husband or Wife if Community Property

Potential Allocation / Apportionment / Reimbursement to Community Re: Increase in Value of Separate Property Business if Separate Property

Experts

An expert is needed relative to the valuation of a business. ‘Experts’ are persons who have specific and specialized knowledge and qualifications that place him/her in a position to be of assistance to the court in the relevant area of expertise.

Date of Valuation

Businesses are generally valued on the date closest to trial that is reasonably practical. However, if the value of the business has changed between the date of separation and the date of trial the valuation date may be set on an alternate date including the date closest to the date of separation that is reasonably practical, depending on the reasons for the change in value.

If the valuation date is on the date of separation, the community may receive a return on the value of the business between the date of separation and the trial date. (In Re: Marriage of Watts)

If the valuation date is on the date of trial, the increase in value after the date of separation may be allocated between the operating-spouse and the community depending on the circumstances. (In Re: Marriage of Imperato)

Measure of Value

A business may be valued at fair market value or at its investment value to the operator-spouse. This measure is referred to as investment value or marital value. In certain situations the court may use other measures of value like liquidation value.

Methods of Valuation

A court has wide discretion in selecting a valuation method so long as the method achieves substantial justice. The method may not take into consideration future speculative events or the owner-operator’s future work or services. In general there are three broad valuation approaches:

  1. Income Approach
  2. Market Approach
  3. Asset-Based Approach

Within these three broad approaches there are also various different methods.

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.

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 involved and utilized in the industry 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
$$$

Compensation

The total compensation of a business owner must be calculated. Compensation includes salary, bonus, personal expenses (perks), and potentially undistributed earnings depending on the working capital needs of the business. It may also include deferred compensation and/or contributions to a retirement plan.

There are issues relative to which period of time should be used to measure compensation, whether to use an average and what type of average to use.

‘Reasonable’ compensation is a critical part of the analysis which requires the determination as to whether to use the ‘average salaried person’ standard or the ‘similarly situated peer’ standard.

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 those 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.

Tax Impact

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.

Initial Characterization of Business

If a business is acquired prior to the date of the marriage it will be characterized as the owner’s separate property.

If a business is acquired during the marriage it will generally be characterized as community property.

Allocation/Apportionment/Reimbursement Re: Separate Property Business

If the business is characterized as community property, the business will be awarded to one of the parties, to the parties jointly or sold. Generally it is awarded to the operating party.

If the value of a separate property business increases in value during the marriage, the community may be entitled to receive reimbursement of a portion of that increase. The right, if it exists, is not an ownership interest in the business - it is a right to reimbursement.

If the community is entitled to a right of reimbursement, the amount of the reimbursement will be determined in such a manner so as to achieve substantial justice. The court will generally use the Pereira approach or the Van Camp approach. However, the court may apply Pereira in certain years and Van Camp in other years. The court may also utilize a different equitable approach.

Pereira:   Value of Separate
Business at Marriage
+ Reasonable Rate
of Return on Value
  = Separate Property Portion
of Value Awarded to Owner
Excess is Reimbursed
to Community
Van Camp:   Any Owner-Operator
Spouse's Under-Compensation
- Community Expenses Paid From
Distributions of Separate Business
  - Price Paid for Community Assets from
Distributions of Separate Business
 

Equitable Allocation Approach

Using the Van Camp approach if the owner-operator's spouse was paid adequate and reasonable compensation during the marriage, there will be no reimbursement to the community. If the owner-operator spouse was under-compensated but the business distributions used for community expenses or the purchase of community assets exceeded the amount of the under-compensation, the community will not be entitled to any reimbursement.

Using the Pereira approach, the owner of the separate property business receives an investment return on the value of his business as it existed on the date of marriage and the remaining portion of the increase in value is reimbursed to the community.

If the court uses the Pereira approach in some years and the Van Camp approach in other years, the approach would follow the approach used in Re: Marriage of Brandes.

Pereira + Van Camp = Brandes

In calculating the allocation/apportionment/reimbursement amount, courts look to a number of factors depending on the approach used: valuation on date of marriage, valuation on date of separation, other valuation dates as applicable, actual earnings, personal expenses (perquisites), undistributed income, reasonable compensation, rate of return on separate property value and compound versus simple interest.

See: Allocation of Increase in Value of a Separate Property Business During the Marriage infographic. This area is addressed in two sections and in two different formats to further assist in understanding this complex area.