Valuing a Business in a Divorce
Putting a price tag on a business is a complex task that gets even more complicated when divorce is involved.
Many states view ownership of business interests differently, including what share belongs to the non-owner spouse and how to value the personal talents of the business owner.
What Constitutes a “Business?”
According to one dictionary, a business is either: (1) the activity of making, buying or selling goods or services in exchange for money, or (2) work that is part of a job.
In the first instance, there is likely to be something of value that could theoretically be transferred to a separate party in exchange for cash or other assets. The second case is more akin to collecting a paycheck for work performed, whether the worker is self-employed or is on the payroll of an employer.
One of the challenges for divorcing couples is to identify in which category the business fits and, if appropriate, to determine the value of the business for equitable distribution to each spouse.
When and Why Does it Make Sense to Have an Independent Business Valuation?
In New York and many other states, there are two situations in which a business is considered to be a marital asset subject to equitable distribution in a divorce:
- A business was established during the marriage.
- A business was established before the marriage, and its value appreciated during the marriage.
An independent professional valuation offers several benefits:
- It objectively quantifies the value of the business interest. This gives the parties a means to offset the value of the business against other assets or, at a minimum, to make an informed decision about how to address the right to the value of the business. It may also defuse some of the emotional and subjective aspects of business ownership that frequently pop up; e.g., “Trust me, the business is hardly worth anything,” or “It’s her business; I don’t want [or haven’t earned] any of it.”
- It can also provide a road map for settlement of other issues like child support and maintenance, particularly if the business owner’s compensation is above or below what an employee would be paid for similar responsibilities, or if a non-owner spouse has provided services to the business that may or may not continue after the divorce.
- The business valuator is trained to identify and quantify all business assets. Sometimes a couple is unsure whether a self-employed spouse is truly a “business owner.” While many people operate as sole proprietors, it is very rare for an entrepreneur to have nothing of value associated with his or her efforts other than a paycheck. In some cases, there are tangible items that have value (computers, trucks, etc.). In other cases, there is valuable intangible property such as customer lists, proprietary processes or trademarks. In most instances, there is goodwill associated with the entrepreneur’s name based on performance.
What Does a Valuation Cost?
The cost of a valuation varies depending on the size and complexity of the business. For very small businesses, the ultimate value may not justify the financial outlay. Therefore, it’s best to consult with a valuation professional to determine whether it makes sense to proceed with an independent valuation or whether there may be other approaches that would be sufficient for mediation and divorce purposes.
The Mechanics of Valuation
The task for the valuator is to estimate the future earnings of the business based on the information provided, and then to determine what the value of those earnings are in today’s dollars.
Identify True Earnings
The valuation process involves identifying the true earnings of the business. This includes adjusting for discretionary items that frequently exist in family-owned businesses such as family cell phone charges, family travel associated with business meetings, and the like. In some cases, there may be personal credit card or other debt that is not on the business’ books but must be treated as business debt in the valuation.
Determine Business’ Value Today
Once the earnings capacity of the business is established, the business valuator applies his or her knowledge of the business’ characteristics, general economic indicators and the appropriate financial returns expected by owners of similar businesses to determine the value of the business as a whole today. If the business has any outstanding liabilities, those are subtracted from the total to arrive at the value of the ownership position held by the spouse(s).
Review Owner Compensation
In business valuations it is important to account for owner compensation at a rate that is competitive in the market for the responsibilities the owner carries out, regardless of the actual amount of compensation the owner is receiving.
In some cases, a family business owner may enjoy a level of compensation that is substantially higher than they would receive if they performed the same functions for a separate employer. In other cases, business owners may choose to pay themselves only as much as they need to cover personal expenses and keep the remaining profits in the business.
In order to determine the value of the business if it were sold to a hypothetical third party, it is therefore necessary to establish what the buyer would have to pay in compensation if they hired a person to assume the owner’s responsibilities.
Coordination with the Divorce Mediation Process
It is critical for the divorce mediator and the business valuator to work hand in hand to be sure that they are consistent in their treatment of income for the business valuation and other income-based divorce agreements such as child support and maintenance.
This avoids the possibility of “double-dipping” whereby the business owner’s above-market earnings are counted twice: once in the calculation of the value of the business and again for the purpose of determining support. The same is true for credit card debt or family-related expenses that are assigned to the business. Care must be taken to account fully for those items, but only once.
What Information Do I Need for a Valuation?
The more information available, the more accurate the estimate of value will be. A valuation professional will ask for both quantitative and qualitative data about the business, generally including some or all of the following:
- A detailed description of the business, its products and services, customers, competitors, business trends, and expectations for the future. This is frequently accomplished through conferences with the business owner(s).
- Documents describing what type of legal entity the business is (e.g., S corporation, LLC, partnership, sole proprietorship, et al.), including certificates of incorporation, by-laws, shareholder agreements and other official papers, as well as documents identifying all owners and their respective shares of the business.
- Tax returns (for the organization and/or the owner’s personal tax returns) reflecting the earnings of the business, generally for the most recent five years.
- Financial statements for the most recent five years from the organization’s internal records as well as from outside accountants, if available:
- Income statements: Reflect the business’ sales, expenses and resulting net income
- Balance sheets: Provide details of the business’ Assets (what it owns, like cash, amounts due from customers, inventory, equipment, and the like); Liabilities (what it owes, such as bank loans, payments to its vendors and taxes it collects and remits to government entities); and Net Worth (the residual value of the Assets after accounting for all the Liabilities)
- Cash flow statements: Show how much money came in during the year and how much money went out
- Statements from bank accounts, investment accounts, retirement accounts, et al.
- Any other supporting details, such as marketing materials, web sites, industry or trade association publications, that contribute to the valuator’s understanding of the business.
Once the Value of the Business Is Known, What Happens Next?
What happens next depends on a number of factors:
- Whether there are other marital assets to distribute in addition to the value of the business
- How your state treats business ownership in divorce cases
- Whether or not the business was started before or during the marriage
- How active the non-owner spouse was in the business
- Whether any marital assets were used in the operation of the business, and
- Whether the non-owner spouse will continue to play a role in the business after the divorce, among others.
Like many other items you will be addressing in divorce mediation, you may choose to mirror the judicial practices in your state or you may opt for a distribution of the value of the business interest that accomplishes your joint mediation objectives.
Like retirement accounts, professional licenses and other marital assets, the value of a business interest can be both hidden and significant. That’s why it is advisable to have a professional provide an assessment of the value of these assets to facilitate an informed, reasonable and equitable settlement agreement.
Other Resources About Business Valuation
About the Author: Whether you’re facing a family transition, preparing a succession plan, contemplating the sale or purchase of a business, or planning for any of a myriad of other possibilities, knowing the value of your assets is essential. Kristen Jenks, CFA, is a skilled financial executive with demonstrated abilities in asset valuations. For more information, please contact her at kjenks [ at ] luminapartners [dot] com.
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