One of the most difficult situations that often call for a business appraisal is divorce. Just about any jurisdiction considers business ownership interest a property that is part of the marital estate. As such, it must be distributed among the spouses.
In the US, the family courts follow two standards on how the property in the marital estate is to be divided:
- Community property
- Equitable distribution
Under the community property standard, all assets acquired during a marriage are treated as jointly owned by the married couple. They are thus divided into equal parts upon divorce.
Those jurisdictions that adopt the equitable distribution standard may or may not treat the business ownership interests as equally divisible. The courts have considerable discretion when deciding which party gets what share of the property.
Business valuations at different dates may be needed
In some cases the courts may treat business ownership acquired separately as part of the marital estate. To determine if the business value has appreciated during the marriage, the court may require that two business appraisals be performed:
- Initial valuation of the business at the beginning of the marriage.
- Re-valuation of the business at the time of divorce.
If the business value has increased over time, as demonstrated by the two business appraisals, a spouse may be able to claim part of that value, especially if that spouse was actively contributing to the business.
Needless to say, business value changes over time. In a lengthy proceeding, the valuation date can make a big difference to the amount of the final property distribution. Ask your lawyer if the court is likely to accept the business value:
- As of the marriage date
- On separation
- When the divorce is filed
- At the time of the court proceedings.
How business value is measured in a divorce
To make matters more interesting, courts do not have one standard of value. In reality, the following main standards of business value have been used in divorce cases:
Under this standard of business value, the argument holds that the divisible property should be valued at what it is worth to its present ownership, i.e. the married couple.
Fair market value
The proponents of this well-known standard maintain that one spouse should not be compelled to pay more or less than what the business can fetch if put on the market.
Used less often, this standard of business value requires an in-depth analysis of the business fundamentals to determine what the company is worth.
Defined by the legal system, this standard tends to be subject to the court’s interpretation. In fact, the fair value of a business may be equivalent to any of the above standards of value, depending on the jurisdiction.
Business valuation methods for divorce
As in most situations that call for a business to be appraised, you have a number of choices among the three valuation approaches:
- Asset – based on the values of business assets and liabilities.
- Income – based on the company’s earnings outlook and risk.
- Market – where the firm’s value is established in comparison to the sales of similar businesses or professional practices.
Business goodwill valuation in divorce
In many cases involving ownership of established businesses and, especially, professional practices, the question of business goodwill is of major concern.
A common business valuation technique used in marital dissolution situations is the Capitalized Excess Earnings method. Known as the Treasury Method, this technique offers a consistent way to determine the value of business goodwill and total business value.
This is important because of the way a particular court may handle business goodwill. Here are some common possibilities:
- Treat business goodwill as part of the marital estate and, therefore, distributable among the parties.
- Split the goodwill into the personal and institutional parts and handle only the institutional portion as distributable.
- Exclude business goodwill from the marital estate altogether.
Since business goodwill is often a large part of the total business value for many professional service firms, the amount and handling of goodwill can make a major difference to the final settlement!
Use of multiple business valuation methods is typical in divorce cases
It goes without saying that a comprehensive, defensible business appraisal is critical in divorce situations. Using a number of established business valuation methods, you can ensure the value of a business is accurately determined and can be defended in court.
Under the income approach, the courts consider both the capitalization and discounting valuation methods. Generally, direct capitalization valuation, such as the Multiple of Discretionary Earnings method, is best suited for companies with a track record of stable earnings. The Discounted Cash Flow method is the preferred choice for valuing young businesses or firms whose earnings vary considerably over time.
Market comparisons to recent sales of similar businesses offer an excellent and highly defensible basis to value your business. In cases of privately owned businesses, comparison to similar private firms is the preferred technique, known as the Comparative Transaction Method.
Defensible business appraisal is a must in divorce
More business appraisals are thrown out of court due to insufficient evidence or supporting information than any other reason. It behooves you to get all the facts together and review any business valuation critically if it is destined for a family court.
Discounts to business value
Depending on the jurisdiction, your business valuation may need to be adjusted for these factors: