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Top Five Issues When Valuing a Business in Divorce

Divorce is a big issue in today's ever changing economy.  According to the national center for health statistics, as of 2014 in the United States there were 2,140,270 marriages, however, on average 50% of marriages end in divorce.  Divorces can typically be complicated, but even more so when a business is involved.  Below are five issues that business valuators consider when valuing a business for a matrimonial action.
 

1. Standard of Value
 

In all tax business valuations and many other “non-divorce” valuations, the standard of value utilized is fair market value—which is defined in the International Business Valuation Glossary as “the price at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm's length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”
 

Fair market value is based on an actual transaction.  In a divorce there is generally not an impending sale or transaction of a business interest.  Even when there is a transaction it generally is not similar to that of a hypothetical willing buyer or hypothetical willing seller because the buyer and seller are known and there are often (significant) emotions involved in a divorce-related transaction.
 

Recognizing the difference between the fair market value situation and the divorce situation, many states have decided by statute or precedent to use a different standard of value for divorce cases.  In New York, for example, where the appropriate standard of value is fair value—which is defined as fair market value without discounts, except for lack of marketability which is generally allowed.  The divorce scenario is related to that of a distressed/oppressed shareholder (where fair value is utilized) where it would be inequitable to the non-propertied spouse to discount the ownership interest being valued.
 

There are differences among the states as to what the appropriate standard of value is so you need to know what is acceptable within your state.  Your opinion could be thrown out for not using the appropriate standard of value.
 

2. Use of the Market Approach
 

The Guideline Public Company Method is usually disallowed in small divorce cases because of the lack of truly comparable companies and the size of differentials.  In larger cases where the method may be appropriate, practitioners need to make sure they account for the different attributes and levels of risk between the comparable public companies and the subject company.
 

Another commonly used method under the market approach is the Comparable Transactions Method.  Unfortunately, the most commonly used databases provide limited data.  If the seller knew he was going to sell, wouldn't he have tried to paint the best positive picture?  In addition, information regarding whether or not the data contains any normalizing adjustments was not provided.  How many family members are over or underpaid and included in the data?  What was the motivation of the seller?  Are the economy and industry in the same geographic area as the subject business?  These questions only address whether or not the information provided is similar enough to the subject company to warrant use.
 

3. Use of Income Approaches
 

In some states, such as California and Missouri, Discounted Future Earnings methods are prohibited in a divorce because they are deemed as too speculative and the ex-spouse is not entitled to receive any benefit from post-marital efforts.  In other jurisdictions, such as Colorado, there is ongoing debate about the topic.
 

Although there are more variables in the Discounted Earnings Method to be attacked by the other side, the Capitalized Earnings Method is the same as the Discounted Earnings Method with the use of a constant growth rate.  In the current economic state, the Discounted Earnings Method may be more representative of future operations and yet some states completely throw it out without consideration.
 

On the other hand, when the weatherman can't predict the weather accurately for three days from now, how will future incomes for the next three, five, or seven years be predicted—particularly if the business has had a rocky past or is in a growth stage?  Industry projections can be used, but different industry experts have different projections. Depending on the business, it may be easy to project the future if there are contracts in place.
 

Another income approach issue is unreported income.  A large number of practitioners would say add it in and tax effect it.  That is reasonable, but what if unreported income is going to continue?  Do you still tax effect it?  If you do, you are decreasing the income available for support by a meaningless amount that will benefit the business-owning individual.
 

4. Reasonable Compensation
 

The application of the various market approaches and the income approaches can be dramatically affected by adjustments for reasonable compensation.  When it comes to divorce, it is important to remember that there is more to consider than just the value of the business.  Perquisites, discretionary expenses, personal expenses disguised as business expenses, the many duties of an individual, and also family members or “friends” being paid out of the business but not performing the appropriate level of duties for their compensation, must also be considered.  The Double Dip argument is a significant issue in family law matters.  If husband's reasonable compensation is $300K, the value of the business is $2M and alimony is based on $300K per year.  If his reasonable compensation is adjusted to $400K, the value of the business is now worth $1.5M and alimony is based on $400K.  Attorneys will generally look at where their client is getting the most bang for their buck and will likely end up negotiating with the non-propertied spouse's percentages (in this example) in order to settle the case.
 

  5.  Application of Discounts for Lack of Control and Lack of Marketability
 

The first question that needs to be asked is whether or not the state where the divorce is being tried even allows discounts for lack of control and lack of marketability.  If they do not then this is an issue that the practitioner does not have to worry about.  If the state does allow for one or both of the discounts then one needs to address the issue.
 

There are numerous court cases, primarily dealing with estate and gift tax cases; studies, and databases available to support the selection of discounts, however, rarely are two cases exactly alike.   Many practitioners would likely admit, if they thought about it honestly, that they were pulling their numbers out of the air based on what is generally accepted in the (family law) community.
 

These five issues are enough to give a practitioner a headache.  It's imperative that an expert is hired when a valuation is needed and that that expert can fully understand these situations and apply them in the context of the facts and laws pertaining to the action—as no two actions are exactly alike.
 

For more information on these proposed changes and how they may affect you, contact Pat Rafanelli, Valuation Manager at Grassi & Co., at prafanelli@grassicpas.com.