Business Valuation in Divorce Proceedings:
Understanding of the Basic Approaches to Value
By: Mitchell
Reichman
In many cases, one of the most contentious and difficult issues in
a divorce proceeding is the valuation and distribution of marital
property. When the marital community owns an interest in a
business, this process can be complicated and expensive.
Often, the community's interest in the business is the most
valuable asset of the marital estate. Whether you are the
"in" or "out" spouse, it is crucial to understand the various
methods which are generally applied to determine the value of the
community interest in a business. Different approaches to
value often lead to dissimilar valuation conclusions and it is the
responsibility of the parties, their attorneys and experts (who may
be engaged by one or both parties) to persuade the judge, mediator
or arbitrator to reach a fair and appropriate division.
What kinds of assets are
considered?
While many businesses have unique features, generally, the types of
assets that a business will own are tangible and intangible assets.
Tangible assets consist of cash, accounts receivable,
inventory, and equipment - generally things that would considered
as physical assets. Intangible assets on the other hand are
non-physical assets, including trademarks, patents, copyrights,
goodwill and contracts that grant rights and privileges. To
value tangible and intangible assets usually requires experts who
may utilize different standards of value. While all
valuations are done as of a single date, if there is no agreement
between the parties as to the date for valuation, the experts may
choose different dates to present their opinions and conclusions as
to value.
The application of recognized valuation methodologies combined with
rigorous analysis provides the foundation for business
valuation. Many subjective judgments must be made by the
business valuation expert in arriving at a valuation
conclusion. It is rare when two business valuation experts
arrive at the exact same conclusion of value.
Determining the community interest business value in a divorce
proceeding commonly includes both parties engaging his or her own
expert who presents their opinion in a formal report. The two
experts will testify. They will explain their work, analysis
and opinions while critically commenting on the work of the other
expert. Frequently, it is in the judge's discretion to decide what
value to adopt. If one of the spouses is involved in the
operation of a business, he or she may want to use a "rules of
thumb" methodology which is used by business brokers to estimate
the value of a business entity. These are not the valuation
methods used by evaluation professionals and Arizona courts do not
adopt rules of thumb when determining the value of a community
business.
How are assets
valued?
There are only three approaches to value any asset, business or
business interest; they are (1) the asset approach; (2) the income
approach; and (3) the market approach. While there are no
other approaches to value, there are numerous methods that the
expert may consider within each of these approaches. Each
approach has inherent strengths and weaknesses and some provide a
more reliable conclusion of value than others depending upon the
individual circumstances. The valuation expert should
consider all three approaches; however, it is often the case that
all three approaches cannot be applied. For example, in an asset
approach, the business valuation expert may seek to value
intangible assets. The difficulty of finding reliable data to
value individual intangible assets may not only be an impossible
task but also intangible asset values are frequently captured in
proper application of the income and market approaches.
Ultimately, it is the responsibility of the parties and their
counsel to persuade the court that his or her expert's valuation
conclusion is more reliable based upon the approaches that are
applied and the judgment exercised by their
expert.
The Asset
Approach
An asset or asset-based approach determines a value indication of a
business or a business interest using one or more methods based on
the value of the assets, less liabilities. Generally, the
asset approach presents a value of all tangible and intangible
assets as well as the company liabilities. Although the asset
approach may seem to be simple, there are a number of complicating
factors. While the value of certain assets, such as cash and
accounts receivable, may closely approximate book value, other
reported assets may not. The value of certain asset classes
such as property, plant and equipment are seldom the equivalent of
book value. They may require separate experts to provide appraisals
for individual items. The value of inventory is typically
stated at cost and depending upon the inventory type and age, this
is another asset whose value for business valuation purposes is
frequently not the same as book value. Most challenging under
the asset approach valuation are unrecorded assets and liabilities
such as goodwill or intellectual property. Accordingly, the
asset approach is typically relied upon when the business is an
investment or holding company. It may also be used in the
valuation of very small businesses and/or professional practices
where there is little or no goodwill.
The Income
Approach
An income or income based approach determines a value indication of
a business or a business interest using one or more methods that
convert anticipated economic benefits into a present single
amount. It is the most widely recognized approach to valuing
an interest in a privately held business. There are several
methodologies within the income approach. The primary methods are
capitalized cash flow method, discounted cash flow method and
excess cash flow method. Each of these methods requires the
determination of a future benefit stream and a rate of return or
risk that the projected future economic benefits will actually be
received.
In the process of developing a conclusion as to future benefit
stream, the valuation expert will collect and review historical
financial data and make normalizing adjustments. The goal in
making these adjustments is to present a normal operating picture
to project future earnings. In most privately held
enterprises, it is not unusual for the controlling shareholder to
receive compensation in excess of a market rate. Often one of
the significant adjustments made by the valuation expert is to add
back excess compensation to cash flow. The expert must determine
fair compensation for the controlling shareholder's position and
responsibilities. There are many subjective judgments that
the business valuation expert makes in application of an income
based approached.
The Market
Approach
A market or market-based approach determines a value indication of
a business or a business interest using one or more methods that
compare the subject business to similar businesses or business
ownership interests that have been sold. The theory which
supports the market approach is that the value of a business can be
determined by reference to comparable transactions or reported
"comps" from the sale of other businesses. Most people are familiar
with the market approach because it is most commonly employed by
real estate appraisers. However, real estate appraisers,
particularly with residential appraisals, can find many comps from
which to choose from where homes have similar qualities, including
size and location. It is much more difficult for a business
valuation professional to find transactions that are comparable to
the business being valued. Often, because the business being
valued is a small, privately held firm and the transactional
information is from public companies, there are great differences
in size, sales, profits and geographic location. While the
market approach is simple to understand, it can often be difficult
to find transactions that are truly comparable in terms of the
business whose sale is being reported.
Valuation
Conclusion
There are many additional analysis and components that are included
in a business valuation expert's report before he or she arrives at
a final conclusion of business value. These can include
adjustments for control premiums, discounts for lack of control,
discounts for lack of marketability or lack of voting rights and
other adjustments. After the business valuation expert has
applied all three approaches and arrived at value indications by
application of each approach, a determination must be made on how
to weight each value indication to determine a final value
conclusion. Once established, the expert should perform
reasonableness tests to determine whether his or her opinion makes
economic sense.
The sheer multitude of variables imbedded in the valuation process
is complicated and can make business valuations difficult to
understand. Unfortunately, there is very little training
available to help family law judges understand the business
valuation intricacies. It is imperative that not only the
expert, but also the attorney are well versed in business valuation
methodology.
About the author: Mitchell
Reichman is a family
law attorney at the Phoenix law firm of Jaburg
Wilk. He is a certified family law specialist by the
State Bar of Arizona. Mitch frequently writes and speaks on
divorce and spousal maintenance. He has expertise representing high
net worth individuals who have closely held businesses in their
marital community. He can be reached at 602.248.1000 or mxr@jaburgwilk.com.
This article is not intended to provide legal advice and
only relates to Arizona law. It does not consider the scope of laws
in states other than Arizona. Always consult an attorney for
legal advice for your particular situation.
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. Arizona