Valuation & Marketability Discounts in Divorce

Valuation & Marketability Discounts in Divorce

November 8, 2022

Rachel E. Biro

Appropriateness & Arguments Seen in Arizona Courts

Carl and Mora are divorcing and the value of their business, a carwash chain, is the central issue of the divorce. You are Mora’s attorney and have just received a business valuation from your expert witness. You flip to the conclusions and, low and behold, there are two values — fair value and fair market value. So, you pick up the phone, dial the expert and ask, “what is the difference and how do I position my argument?”

First, the standard of value for divorce purposes is a legal determination, which can vary based on jurisdiction and case law interpretation. For example, fair value applies to virtually all federal and state tax matters and is also the legal standard of value in many other, but not all, valuation situations. Conversely, fair market value is a definition found in the Internal Revenue Code, Revenue Ruling 59-60, and in literature from professional valuation organizations such as the American Society of Appraisers.

As a CPA, ABV, CVA, or ASA, an expert should really only:

  1. educate on concepts regarding fair value versus fair market value,
  2. explain some of the arguments heard from other family law attorneys, and
  3. share the decisions made by various courts.

So, let’s dive into those specific points.

FAIR VALUE VS. FAIR MARKET VALUE:

Fair value and fair market value are two commonly used standards of value. They are also separate and distinct terms of art. Fair market value is a hypothetical concept. It is used to express the price an informed buyer would pay to an informed seller, both having reasonable knowledge of relevant facts and neither under compulsion to enter into the transaction. In most interpretations of fair market value, the willing buyer and seller are hypothetical persons dealing at arm’s length, rather than any particular buyer or seller. Fair market value is a phrase generally understood by valuation professionals, accountants, attorneys, and the courts. In terms of owner disputes (e.g., marital dissolutions and shareholder oppression cases), fair value is an equitable concept, not a hypothetical concept. Accordingly, fair value definitions and interpretations are found in state statutes and court decisions rather than in professional valuation literature. Generally, fair value is closer to a value based on proportional interest in a business entity. So, what does all this mean? Simply put, the discounts for lack of control and for lack of marketability are not typically applied under the definition of fair value as they may be under the definition of fair market value.

Now, at this point in your conversation with the expert you’ll probably want to ask, “what is the difference between lack of control and marketability?” Well, the discount for lack of control (DLOC) is applied when the business owner has a non-controlling or minority interest. [1] Whereas the discount for lack of marketability (DLOM) is applied when a market is not readily available for the business owner to convert their interest into cash (at minimal cost). It measures the difference in the price of a liquid asset to an otherwise comparable, illiquid asset (i.e. ownership interest in a business). [2] As an example, your valuation expert opined that Carl and Mora’s carwashes had a fair value of $2 million and a fair market value of $1.8 million. During your call, the expert explains that as Carl and Mora own 100% of the business, no DLOC was applied. However, the expert explains they did apply a 10% DLOM under the fair market value standard based on the particular circumstances regarding Carl, Mora, and their business.


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THE ARGUMENTS TO BE MADE:

When cases involve a closely-held business, we’ve found attorneys and their clients are often most concerned with DLOM. We’ve heard attorneys make the point that the business owner would have difficulty finding a qualified buyer for the business — and, therefore, the discount is appropriate. We’ve also heard attorneys make the point that, as no actual sale is occurring or contemplated, the division of the marital asset should be equitable — and, therefore, the discount is not appropriate. And we’ve also heard attorneys make the point that the business should be treated like all the other marital assets held by the parties. In Arizona, the expert retained will most likely respond, “in my experience, judges determine whether to accept fair value or fair market value based on the facts and circumstances presented by the parties.”

POTENTIALLY RELEVANT COURT DECISIONS:

There is limited published case authority relating to fair value versus fair market value in Arizona. We understand this is because Arizona courts seek to apportion business interests in a manner that achieves substantial justice for both parties in a martial dissolution case. For example, in 2015, the Arizona Court of Appeals opined on Schickner v. Schickner. In the Schickner opinion, the court noted Arizona has no “bright-line” rule as it relates to discounts. And, as the DLOC applied in Schickner lead the appellate court to vacate one valuation and affirm the other, the Arizona Court of Appeals referred to other cases discussing DLOC:

  • Hanson v. Hanson (Alaska, 2005) – Explained that minority share discounts may be used in proper settings but need not be applied in all instances.
  • In re Marriage of Davies (Montana, 1994) – Concluded that the application of a minority discount is appropriate in some cases.
  • Brown v. Brown (New Jersey, 2002) – Held that the application of a minority discount to determine a non-owner spouse’s fair share of marital assets undermines the purpose of equitable distribution.

As the Arizona Court of Appeals opinion on Schickner v. Schickner primarily discussed DLOC, we wanted to provide additional decisions made by various other state courts on the appropriateness of DLOM:

  • In a Tennessee Appellate Court decision, the court upheld the trial court’s acceptance of a marketability discount as the information gathered by two separate valuation experts supported the application of such a discount (Telfer v. Telfer, 2018).
  • In a South Carolina Supreme Court opinion, the court determined that as one spouse was retaining ownership of the business, the court found no legitimate reason to indulge a marketability discount. (Moore v. Moore, 2015)
  • In a Massachusetts Appellate Court decision, the court found that as no actual sale of the business was being contemplated, the marketability discount unfairly devalued the marital asset. (Caveney v. Caveney, 2012)
  • In a Colorado Supreme Court opinion, the court stated trial courts have the discretion to apply marketability discounts in order to avoid penalizing owners who cannot find a ready market for the sale of their business. (In re Marriage of Thornhill, 2010)
  • In an Alabama Appellate Court decision, the court determined martial dissolution cases, like dissenting shareholder disputes, should rely on the fair value definition to avoid artificially reducing the value of the marital asset. (Grelier v. Grelier, 2009).

As you can see, there is little consensus on fair value versus fair market value in family law. As for Carl and Mora’s carwash chain, both sides need to be prepared that several considerations may be weighed when determining the appropriateness of DLOM, DLOC and the eventual final value of their business.


[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 in 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.

 

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