Points of Interest in Family Law
Many an asset is attained during marriage — a beach house, a vintage truck, a ski boat, two pieces of fine art, lots of gold jewelry. Dividing these assets during divorce can be contentious. But, often times, the largest and most contentious division of assets is when one or both parties in a divorce own a business. If you have a case involving a business, here’s what we want you to know.
APPROACHES TO VALUE:
There are three main approaches to value a business — the asset approach, the income approach, and the market approach.
- Asset Approach – Provides the value of the tangible net assets of the business (i.e. tangible assets less any liabilities).
- Income Approach – Bases the value on the future economic benefits the parties are anticipated to receive from the business.
- Market Approach – Generates a value by comparing the parties’ business to other comparable businesses, to other transactions within the subject company, or to any bona fide offers.
STANDARDS OF VALUE AND VALUATION DISCOUNTS:
You will typically see business valuations with two standards of value — fair value and fair market value. In martial dissolution and shareholder oppression cases, fair value is typically a proportionate share of enterprise value (i.e. no discounts are taken). However, case law is not always consistent in this regard. Under the fair market value standard, you may see discounts for lack of control and lack of marketability.
- Lack of Control – The discount for lack of control is applied when the parties do not control the business (i.e. generally, when a minority interest is valued).[1]
- Marketability – The discount for lack of marketability, if applicable, is adopted to measure the difference in value between a liquid asset and a comparable, illiquid asset (i.e. ownership interest in a business).[2]
Please keep in mind, discounts may be relevant only in certain circumstances – they are dependent on the nature of the business, its underlying assets, and the character of the ownership interest.
Interested to learn more about discounts? See Valuation and Marketability Discounts in Divorce»
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NORMALIZING ADJUSTMENTS:
It’s not uncommon in closely held businesses to have non-operating, discretionary or other unique accounts and transactions. We’ll give some examples shortly, but be aware, if such items or expenses exist in your client’s business, you can expect a valuation expert will adjust the business’s cash flows available for distribution.
WHAT IS A NON-OPERATING ADJUSTMENT?
Non-operating accounts and transactions will have little to do with the core, day-to-day operations. For example, if the parties own a trucking company, you might expect to see an account for a vehicle fleet on the balance sheet. But if the parties own an information technology company, a valuation expert will likely make an adjustment for a non-operating automobile. In addition, if the I.T. company later sold the vehicle, the gain or loss reported on the income statement will also be considered a non-operating item.
WHAT IS A DISCRETIONARY ADJUSTMENT?
Discretionary items are paid for by the business but are really just personal benefits to the owners. So, let’s say this previously mentioned I.T. company is a top tier service provider for the entertainment industry. Well, in this case, it might not be uncommon for the company to pay for season sports tickets to entertain and build client rapport. But, if your client is personally going to most of the games, then a valuation expert may make an adjustment for the discretionary expense.
OTHER ADJUSTMENTS:
In addition, there are a few other unique items subject to adjustment. For example, you can expect to see adjustments to normalize sweet-heart rental rates paid between the business and a related property owner. Or if the business owns significant machinery and equipment, you can expect to see adjustments to roll back accelerated depreciation. And there will certainly be adjustments for non-recurring transactions such as mergers, lawsuits, or even the pandemic era paycheck protection program loans.
OWNER’S COMPENSATION:
Speaking of adjustments, one of the most common (and dare we say most important) normalizing adjustments made by a valuation expert is for owner’s compensation. This is because, whether for tax planning, operational organization, or management purposes, a business owner may pay themselves above or below market rates for services performed. For example, the business owner might receive a lower-than-expected salary in combination with distributions of business earnings. Therefore, you can expect a valuation expert to adjust owner’s compensation to market rates. This normalizing adjustment is best made by asking the question, “what would the business pay if the duties of the owner were completed by an unrelated party?”
INFORMATION TYPICALLY NEEDED FOR A BUSINESS VALUATION:
- Financial statements and/or and tax returns for the business
- Payroll for the parties and any family working in the business
- Appraisals of equipment and property owned by the business
- Business operating agreement or partnership agreement
- Other relevant documents and information, depending on nature, size, and complexity of the business and its industry
Plus! Depending on how contentious the case, you may also want to have the business QuickBooks file (or similar accounting record), business bank statements with copies of cancelled checks, and statements for credit cards paid down by the business.
Determining who gets the gold jewelry and who gets the ski boat is one thing — determining the business value is more difficult and time consuming. In fact, there’s so much more that goes into a business valuation including methods, multiples, rates of return, and apportionments. However, this Business Valuation 101 provides a solid introduction for the key terms and topics that may be helpful in your next divorce case involving a business valuation.
Contact Us
Contact REDW Principal, Valuation & Related Financial Services Brian Foltyn, CVA, or Senior Analyst Rachel E. Biro, CPA below. We welcome your questions.
[1] 100% ownership interests are generally considered to possess essentially all prerogatives of control. Regarding ownership interests of less than 100%, the degree of control associated with a specific ownership interest may be impacted by factors such as cumulative versus non-cumulative voting rights, contractual restrictions, regulations and statues, and distribution of ownership including the presence of swing votes.
[2] 100% ownership interests in business entities are generally considered marketable, though typically require exposure to the market, completion of financial arrangements, and due diligence procedures by potential buyers. The concept of marketability pertains to the liquidity of an interest – how quickly and certainly it can be converted into cash. A discount for lack of marketability may be relevant to some extent, regardless of whether a controlling or non-controlling interest is being valued— though it is generally recognized that a marketability discount would be greater for a non-controlling interest.
