Business Valuation Helps Reach Equitable Resolution in Divorce Proceedings

 

During a divorce, dividing the assets that have been acquired during a marriage is never easy. But when a business owned by one or both spouses is involved, a stressful situation is often escalated dramatically by additional legal and professional fees.

An independent business valuation is required to help determine how a business is to be split in a divorce. And, given the contentious nature of divorces, there are usually two business valuations performed — one on behalf of each spouse. In many cases, however, the two valuations reach different conclusions about the value of the business, escalating tensions even further.

Reasons and Methods

A business valuation is necessary in order to help the divorcing couple, and the court, reach a decision about equitable division of assets. Secondarily, understanding the value of the business can help determine the amount of spousal support (alimony) one partner will pay the other in cases where support is deemed necessary.

Generally, the methods or approaches used for a business valuation in a divorce case do not differ from those used when the valuation is done for other purposes, such as preparing to sell a business. In some cases, however, state law may require that certain standards be used when a valuation is related to divorce, such as fair value (FV) or fair market value (FMV). It’s important for the divorcing couple and their lawyers — as well as the business valuation professional involved — to know the laws of their state.

An experienced valuation professional who has worked divorce cases before will likely use a combination of two or three methods to reach a conclusion about valuation, such as the income approach, the market approach and the asset approach. By cross-checking each approach and applying either an FV standard or an FMV standard, the valuation professional can reach a realistic, defensible value for the business.

Factors in a Business Valuation

As with all business valuations, the fundamental drivers of a business’ financial performance are cash flow, risk and growth. But there are many factors that are considered, including:

  • Financial — The valuation professional will examine financial statements, including income and cash flow statements going back at least three years, as well as financial forecasts that indicate the growth trajectory of the company. Since the company’s past and future performance are critical information to determine value in a divorce proceeding, both historical and forward-looking financial indicators must be evaluated.
  • Market conditions — The value of a business can change depending on market demand, competition, industry trends and economic outlook.
  • Intangible assets — Businesses often have non-financial intangible assets that can increase their value, such as brand reputation, patents, trademarks and customer relationships, all of which can be difficult to quantify but which significantly impact the company’s value.
  • Business entity structure — A company’s ownership structure, including any partnerships or shareholder agreements, can affect valuation.
  • Tax implications — Business valuations must account for potential tax liabilities or benefits, which can affect the value of the business.
  • Legal considerations — Agreements, contracts and legal disputes can all influence a business’s value and must be carefully evaluated during the valuation process.
  • Personal goodwill — This refers to the reputational value of the owner’s name and professional skills and would apply to a physician, a lawyer or a professional services provider, among others. The value that this person’s name and involvement brings to a business cannot be duplicated by the other spouse, so its inherent value is difficult to quantify, but is essential for a fair valuation. It’s important to note that the inclusion of personal goodwill in a divorce-related valuation may vary from state to state.

If Only One Spouse Owns the Business

Typically in divorce cases, only one spouse owns the business, which means the non-owning spouse may have little knowledge of how the company is performing financially or operationally, or what factors may be used to determine its value.

In such a case, the non-owning spouse may consult an expert to evaluate financial benchmarking to determine if the company is being optimally run, and whether the financial performance is aligned with the operational performance.

This is a way to identify if the owner spouse is underreporting income or otherwise manipulating the company’s financials to result in a lower valuation.

When Valuations Conflict

When the two parties’ valuations come in showing significantly different values, it is common for each side to bring in expert witnesses (if the divorce has gone to trial) to make the case either for or against the valuation. This will usually focus on methodology or which value standard has been applied.

But it is possible that one side or the other is approaching the valuation with bias. There are value judgements that come into play in valuations, and they can be used to push the determination of value higher or lower. In this case, it’s important for a witness to point out the bias, explain it and try to influence the decision on value.

Unless the divorcing parties can come to an agreement, it generally comes down to the judge, who sometimes just splits the difference.

How to Prepare

A divorce will likely be one of the most traumatic experiences of your life and there’s no need to compound the pain by being unprepared or not understanding the process. Remember, a business is a business. It’s a stressful time, but you need to do several things to ensure your interests are protected and the outcome is fair:

  • Stay levelheaded — Rely on wise counsel in terms of attorneys and the allied professionals they may recommend bringing in — valuation professionals, expert witnesses, etc. They will help you navigate the process.
  • Consider hiring a forensic analyst — If you think your spouse who owns the business is potentially underreporting income or running personal expenses through the business, these activities need to be documented as they can depress the value of the company. A forensic accountant can identify the inappropriate expenses and normalize the business valuation to reflect the company’s true value without those expenses.
  • Ask your attorney to explain the type of valuation report that is needed — A calculation of value is a simpler report that is primarily charts and numbers, but a full report includes that and narrative explanations. If your divorce is headed for a court trial, a full report is needed.
  • Be prepared for the expense — You’re likely aware of what a divorce attorney’s services may cost, but when you add in the time and expenses of valuation professionals and expert witnesses, the costs add up quickly.
  • Consider whether there’s a better way — Some divorces are extremely contentious, whereas others are amicable. Owning a business needn’t dictate a contentious approach. Some divorce attorneys function more as mediators, working with couples to facilitate an equitable resolution. It cuts costs, not to mention emotional stress.
Questions?

If you would like to discuss a business valuation for any reason, contact an Adams Brown advisor.