Dividing a Business: What You Need to Know About Valuation in Divorce
As part of the divorce process, many assets and liabilities will have to be divided between the parties through a process called equitable distribution. Essentially, a court will classify property as either marital or separate, place a value on the property, and then distribute between the spouses. The value used will be the fair market value as of the date of separation. For some items, the fair market value will be easy to determine, while others will be more complicated.
A bank account is an example of an easy item to value; simply look up the account balance as of the date of separation. The marital residence is fairly easy to value as well, parties can order an appraisal or agree to use the tax value of the property. On the other hand, placing a value on couples’ frequent flier miles or a qualified pension plan might prove more difficult. Along those lines, one of the more difficult assets to value is a business interest. Through business valuation, you can properly discern to value of your business and divide it appropriately.
Separate v. Marital
First we should discuss that there are factors that will determine whether the business interest is considered separate or marital. If the business interest was acquired during the marriage, with joint funds, it is considered marital property, and the value should be shared by the spouses equally. If the business interest was owned prior to the date of marriage, or acquired with separate funds, it should be considered separate property.
There are several important factors that can help determine whether a business interest is separate or marital. First, you will need to look at the date of marriage and the date the business interest was acquired. Second, you should look to the source of funds used to start the business, and finally, the financial and labor-related contributions to the business given by either spouse during the marriage.
Keep in mind, simply because the business interest was acquired prior to the date of marriage, it does not mean that the non-owner spouse can take no value from it. Let’s look at an example. Say a husband owns a furniture company with his father, and acquired the interest ten years before the date of marriage. During the marriage, however, he invested $20,000 worth of marital funds to renovate the building that the furniture company was housed in. Then, thanks to an advertisement campaign that was run by the husband during the marriage, the furniture business saw a dramatic increase in income. In our example, the wife would be entitled to half of the $20,000 of marital property that was given to the business as well as half of the value of any increase due to the advertising campaign.
As you can see, the first step of determining whether a business interest is separate or marital property can be complicated. This difficulty, however, only scrapes the surface of the complexity of business interest valuation.
Difficulty in Valuation
Once you have determined whether or not a spouse is entitled to a portion of the value of a business interest, how do you actually determine what that interest is worth? Imagine having to place a value on the furniture business in the example above? The store has equipment like cash registers and computers, it is full of inventory, has accounts receivable, and earns a profit. Clearly, it would be difficult to place a dollar amount on the husband’s 50% interest in the furniture company. Also, keep in mind that the husband’s attorney will argue that the business value is fairly low, while the wife’s attorney will contend that the value is high. For this reason, it’s best to conduct a business valuation that will satisfy both parties.
Let’s begin by noting that in situations where the business interest is clearly a minimal asset, the parties may be able to easily agree on an amount and move forward. However, sometimes it is obvious that a business interest is a significant asset, and will be the cause of a major dispute between the spouses. The following example shows how important it is to properly valuate a business interest when dividing assets.
A young couple of seemingly modest means decided to divorce. Sarah was a stay-at-home mom and Michael drew a salary of $50,000 annually at a software company that he was part owner of. When they decided to go their separate ways, things were fairly amicable. Michael claimed on his financial affidavit that his ownership interest in the software company equated to $40,000. In the property division suit, relying on the affidavit, the judge ordered Michael to pay Sarah $100,000 in order to equally divide the marital property (including his interest in the software company).
Mere months after the ink was dry on the order, the software company that Michael had ownership stake in was sold for millions of dollars; his payout was handsome. The truth was that Michael knew his interest in the company was worth a lot – there were other comparable offers that came in before the divorce had been finalized. Despite this knowledge he casually reflected on his financial affidavit that his ownership interest was only valued at $40,000. Sarah had no reason to believe that this figure was only 3% of what his actual ownership interest was worth.
When the truth came out, Sarah sued Michael claiming fraud. She engaged in a ten-year legal battle before the parties were able to reach a settlement. After paying her extraordinary legal fees as well as fees for expert witnesses, Sarah only realized $200,000.
This story clearly exemplifies what can happen if a spouse successfully lowballs a business valuation. If there is an ownership interest in a business, be sure to take the business valuation process seriously, or you could end up dealing with a situation similar to Sarah in our example.
How to Value a Business Interest
There are three approaches to how you can go about determining a business valuation: the asset approach, the market approach, and the income approach.
The asset approach calculates a value using a fairly simple formula: assets minus liabilities = value. Assets include both tangible and intangible assets. Tangible assets include the infrastructure, inventory, and anything else related to the business that you can actually touch. Intangible assets are patents, accounts receivables, and other assets that are not actually physical objects. While this approach seems straightforward, it can actually be rather difficult. For instance, how do you place a value on the business assets? Some items, like company vehicles, may be easy to value by using a value book. Other items, such as the computers in the office, or the tables in a restaurant would be harder to place a value on. Additionally, an issue arises when it comes to valuing inventory as well. Typically inventory is valued at cost, but this can vary based on the age and type of inventory. Further, there may not be a value book that covers the type of inventory at issue. This approach also doesn’t take into consideration any unrecorded assets and liabilities which could create further issues; consider a significant unrecorded loan being given to a family member around the same time the business was being valued. Because of the complications mentioned, this approach tends to work best for small businesses.
The market approach calculates the value of a business by comparing it to similar businesses that have been sold. This approach is similar to how appraisers will look at “comps” in a neighborhood when determining the value of the house being appraised. This approach can prove difficult, however, if there are no similar businesses that have recently been sold that can provide an accurate comp.
The income approach of business valuation uses historical information and particular formulas to predict expected cash flow and profits in calculating the value of the business. The formulas used consider future benefits as well as the rate of risk or return. This is the most common approached used to determine a value of a business.
Who Values the Business Interest
The answer to this question can be as simple or as complex as you want it to be. If the business interest is small, and there is no dispute as to its worth, then the parties can easily stipulate to its worth and use that value when dividing the marital property.
Sometimes, if the interest is small and not overly complex, attorneys may place a value on the business. Typically, however, the attorney advocating for the person who owns the interest in the business will argue that the business is worth less than the attorney for the person who does not have the ownership interest.
Most often, an expert is needed to dig into the history, finances, assets, liabilities, and other aspects of the business to determine a value. These experts will use one of the approaches listed above in arriving at a number they feel is a fair estimate of a person’s interest in a particular business. Usually, the expert will be a Certified Business Appraiser (CBA) or an Accredited Senior Appraiser (ASA). Sometimes a Certified Public Accountant (CPA) will be called on to help value a business interest. If your case calls for such an expert, your attorney will certainly have a referral for an expert of this caliber to help in your case.
In cases where the business interest could have a high monetary value, typically both spouses will hire independent experts. A “battle of the experts” will ensue and both experts will do research and value the business. If the parties end up in litigation, then both experts will testify in court as to the value they concluded the business is worth. Ultimately it will be up to the judge to decide which expert she finds more credible.
It is worth noting that spouses who engage in a “battle of the experts” can expect their legal fees to increase dramatically. Hiring an expert may increase your legal fees, as the attorney will have to spend time learning and understanding the expert’s analysis. Also, your expert will need to be compensated, and the more complex the valuation is, the higher you can expect the fees to be. That being said, if the business interest is negligible it doesn’t make sense to engage in a “battle of the experts” to fight over an asset with little value. On the other hand, where the ownership interest is worth a significant amount of money, it may be worth it to retain an expert.