More than 40% of all marriages end in divorce. What’s the likely outcome if a shareholder in a family-owned business is involved in a divorce, particularly if there’s no prenuptial agreement? A prenup establishes the property and financial rights of each spouse should the marriage end in divorce—it stipulates “who gets what” if the parties divorce.
Valuing and dividing the family’s property during a divorce can be quite difficult. Deciding who gets what can be quite a challenge, even under the most amenable of situations. If the divorce is contentious, this process can be especially complicated. A good attorney and an experienced business valuation specialist will make the process less intimidating and provide an opportunity to educate the divorcing spouses.
Valuation complications
As part of the process, assets and liabilities in the marital partnership need to be valued and divided upon divorce. To divide the assets and liabilities properly and equitably, each asset and liability must be assigned a dollar value. The point in time when assets and liabilities are assigned a dollar value is important and is commonly referred to as the valuation date.
When there is shared interest in a closely held business, the process can be especially difficult. If the business is privately held, there is no readily available market pricing for the shares. Using a qualified valuation expert to appraise the business is often the only way to determine an accurate asset value. While the process may sound straightforward (choose a valuation date, appraise the business as of that date, settle the case or go to trial), determining the valuation date is not typically a straightforward exercise and differs by state.
In many divorces, the closely held business ownership interest is one of the major assets of the marital estate as well as an area where divorcing parties can strongly disagree. The main issues under dispute typically revolve around both the value of the business interest and the amount the non-owner spouse should receive as part of either the overall settlement or trial judgment.
The business-owner spouse often works in the business and usually does not want the non-owner spouse to have an equity interest in the business post-divorce. During negotiations, when all the assets and liabilities in the marital estate are divided, the owner-spouse “purchases” the equity interest of the non-owner spouse. The business valuation expert determines the value of the business for this purpose.
Business valuation is more an art than science. While the theory involved in the business valuation process is typically similar in non-divorce valuations, there are many unique nuances to performing valuations in a divorce engagement imposed by the governing jurisdiction of the divorce.
The business valuation process generally utilizes a standard known as “fair market value.” Simply put, this is what a hypothetical “willing buyer” would pay a hypothetical “willing seller” in a “free and open market” where both buyer and seller are in possession of all material facts, with neither forced to buy or sell. It is an economic transaction between interested individuals as a result of negotiations with all known facts.
Business valuations for divorces are predominantly conducted in the same way as any other business valuations. In the context of a divorce, the following are considerations that need to be addressed:
- What is the appropriate valuation date?
- Is the business being valued as a “going concern” (i.e., will it continue to operate into the future)?
- What is the standard of value to be used (fair value, market value, asset value, other)?
- What impact do related-party items have on the business’ cash flow for valuation purposes?
While the concept of fair market value is generally understood, it is not necessarily the standard of value to be applied in a divorce. The process is governed by the state laws and statutes of the jurisdiction in which the divorce action takes place. Unlike a fair market value valuation, there is no hypothetical seller or buyer and, generally, no sale of the business takes place. As a result, many states have adopted standards of value that differ significantly from the commonly known fair market value approach. Various states use standards of value such as fair value, investment value, value to holder or intrinsic value. What can be more confusing — especially for divorcing couples, who already have high levels of emotion and anxiety — is that these terms can have different meanings in different states. Therefore, it is extremely important to establish a clear understanding of the valuation process from the beginning among the parties, attorneys and valuation experts.
Valuation processes
The process with most business valuations starts with an analysis of several elements that are recognized by the appraisal profession to be of relevance in valuing a privately held company. Many valuation professionals refer to Internal Revenue Ruling 59-60, which lists the following considerations:
- Nature and history of the business
- General economic outlook and specific industry prospects
- Net worth and financial condition
- Earning capacity
- Dividend-paying capacity
- Goodwill, if any
- Whether the stock in question is voting or non-voting
- Stock prices of comparable public companies
- Sale(s) of company stock at or near the valuation date
- Limitations or restrictions on the stock (e.g., transfer, dividends, etc.)
- Sale(s) of stock in comparable closely held companies
The aforementioned are mostly supplied by the business-owner spouse directly from the business and typically requested through the discovery process. Discovery is when the parties in the divorce exchange information as it relates to the valuation and support obligation about their personal and business finances. A request for information (“Request to Produce”) can be sent to the business owner or the non-business owner spouse or through the respective attorneys.
There are three generally accepted approaches to valuing any asset, business or business interest: (1) asset approach; (2) income approach; and (3) market approach. There are different methods the valuation expert may consider within each of these approaches. Each approach has inherent strengths and weaknesses, and some provide a more reliable conclusion of value depending upon the individual circumstances of each case. Generally, the valuation expert should consider all three approaches; however, they may be restricted in what can and cannot be applied.
The basic premise of valuation is that when an individual makes the decision to acquire or invest in a business, there is an expectation of a return on that investment (ROI). The ROI can be measured in several ways, including future earnings or using some level of cash flows. A main factor in determining the value of a business and ROI is operating performance.
In valuation engagements, the valuation expert will render a conclusion of value for a specific amount. However, in the context of divorce, a valuation expert often provides a preliminary range of values prior to the issuance of a formal report, because it may be easier for divorcing spouses to agree on a range of values rather than on a specific dollar amount. An amount within the range of values can also be used as part of the process of negotiating a desired level of spousal support.
The value that is determined for divorce purposes may not reflect the value of any other family member’s ownership interest. Different valuation standards would apply in other situations, such as a family shareholder dispute or a sale of the business. The facts and circumstances that apply at a particular point in time also affect the value.
It can take many hours, if not days, for even a seasoned valuation expert to arrive at a conclusion. As such, it can be costly to perform a valuation and conduct all the proper procedures. The amount of time spent is directly related to the extent of cooperation from everyone involved, especially the owner-spouse.
For divorcing couples, business valuation can be complex, confusing, frustrating, costly and overwhelming. The process involves valuing the assets, determining the income of the parties and establishing how to distribute the assets pending the conclusion of the divorce. All this requires in-depth examination of the business operations and the drivers of value. While there may be a disagreement as to what is fair, the parties, their attorneys and/or the court will have the proper information to make an informed judgment on whether to settle or go to trial.