In most business valuations, the standard is “fair market value.” This method seeks to determine what a hypothetical “willing buyer” would pay a hypothetical “willing seller” in a hypothetical “free market” in which both buyer and seller are in possession of all material facts and neither is forced to make a deal.
In a divorce, however, the buyer and seller are known. Typically, the manager-spouse “purchases” the community property interest of the non-manager-spouse through the process of community property division. The standard of value in this case should be “investment value,” because it reflects what it is worth to the manager-spouse to own all of the community’s interest in the company, rather than just his or her community property half.
As with a fair market valuation, an investment value process analyzes a number of elements that are recognized by the appraisal community to be of particular relevance in valuing any privately held company. Internal Revenue Ruling 59-60 lists the following:
- Nature and history of the business
- General economic outlook, and specific prospects for the industry
- Net worth and financial condition
- Earning capacity
- Dividend paying capacity
- Extent of goodwill, if any
- Size of the block of stock being valued, especially if it represents a majority or minority interest
- Whether the stock in question is voting or non-voting
- Stock prices of comparable public companies, if any
- Sale(s) of company stock at or near the valuation data
- Limitations or restrictions on the stock, such as on transfer, dividends, etc.
- Sale(s) of stock in comparable closely-held companies, if any (implied)
Of these, the two most important are earning capacity and financial condition.
When a company or individual acquires, or invests in, a business of any kind, the main reason is almost always the expectation of a return on that investment. ROI comes from future earnings. Sometimes, these earnings are presented as the bottom line on the Profit & Loss statement. In other cases, the calculation may reflect cash flow. But, the principle is identical. Future operating performance determines the return on investment and, therefore, future earning capacity is a key factor in determining value.
Financial condition is also extremely important for a number of reasons. {Note: a future post will discuss in detail practical financial analysis for a privately held company.}
- A strong balance sheet allows management to pursue opportunities for growth, either self-funded or with outside debt.
- Banks require the maintenance of specific financial numbers (such as Working Capital and Net Worth) and ratios (such as Current Ratio and Quick Ratio) to maintain an existing line of credit. In today’s economy, most banks are far more rigid regarding these standards than they were previously.
- Regardless of the prospects for earnings growth, most companies experience occasional “bumps in the road” on the P&L. A strong financial condition will allow the business to weather these times. The company that has been paying last quarter’s Accounts Payable with the collection of next quarter’s Accounts Receivable has no margin for error. The loss of a major customer or receivable can put such a company in serious financial jeopardy.
If the business being valued in a divorce is a sole practitioner professional firm, the Excess Earnings Method will often be the most appropriate. Here, the difference between the practitioner’s earnings (salary + benefits + pre-tax profit) and “reasonable compensation” (what s/he could earn in the same position as a non-owner / non-partner employee of a comparable firm) is called “excess earnings.” {See previous post on Reasonable Compensation.}
Excess Earnings times a multiple (reflecting the level of confidence that these excess earnings will continue in the future) equals “Goodwill”. Goodwill plus Net Worth (minus a reasonable return on Net Worth) equals value in the Excess Earnings Method.
In most valuations, in or out of court, the expert will deliver an opinion on a specific value. In the context of divorce, however, it is far preferable to provide an initial range of value for two important reasons:
- It is much easier for the spouses to agree on a range of value than on a specific dollar amount. Once they have done that, settling on a final number becomes a much more manageable task.
- Often, the value of the business can be juxtaposed against, and negotiated against, spousal support.
For example, if the spouse to be supported is mid-30s with a high paying job, s/he may be keenly interested in a substantial buy-out that can be used as an investment or retirement vehicle. Contrariwise, consider the individual in late 50s with little income history or prospects, who has been living a very comfortable lifestyle (probably supported by the business.) This person may be far more concerned with maintaining that lifestyle (e.g. keeping the children in the same school district) and would be willing to give a little in the value of the business to achieve this objective. A range of value assists the couple to carve out this kind of win-win.
Another important contribution that the valuation expert can make to this difficult and highly emotional process is to produce a preliminary report that is open to criticism. If either spouse can make a persuasive case that the expert has erred in some aspect of the valuation process, and that revisiting the issue(s) could have a significant impact on the expert’s opinion, s/he should be quite open to doing that. The only objective here is the welfare of the clients, and pride of authorship has no place.
In the final analysis, the expert’s role is to assist the divorcing couple to agree on a value for the business that they understand and believe is fair. If the expert is able to accomplish this goal, s/he will have made an important contribution to the family and, most importantly, to any children in that family.
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This article has been contributed by Steven D. Popell CMC (Certified Management Consultant.) Steve has been qualified as a business valuation expert since 1974, and has published extensively on this topic. CMC, a certification mark awarded by the Institute of Management Consultants USA, represents evidence of the highest standards of consulting and adherence to the ethical canons of the profession. Steve was a 2007 winner Collaborative Practice California Eureka Award for contributions to Collaborative Practice in this state and is a Senior Partner in Popell & Forney, with offices in Los Altos Hills and Pleasant Hill, California.
