Business Valuation in Divorce Proceedings: Understanding of the Basic Approaches to Value
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.
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 an Arizona State Bar Board Certified Family Law Specialist and attorney at the Phoenix law firm of Jaburg Wilk. He is a Board Member of the Executive Council of the Family Law Section of the State Bar and rated AV Preeminent by Martindale Hubbell. Mitch has been named a "Best Lawyer in America" by Best Lawyers, "Arizona Top 10 Family Law Lawyer" by Arizona Business Magazine and a "Southwest Super Lawyer." Now in his thirty-first year of practice, Mitch seeks to maximize the probability of each of his clients obtaining a favorable outcome in his or her family law conflict.