Mine, yours or ours? When a business is part of a divorce
In even the most amicable of divorces, the end of a marriage can be an emotionally draining endeavor. When a profitable business is involved, it can be a remarkably financially draining one, too.
As the parties divide their assets and liabilities in a process called “equitable distribution,” it often becomes abundantly clear that “equity” is in the eye of the beholder— and the accountant.
During the equitable distribution process, a court decides whether property is either marital or separate. They will then value the property and distribute it amongst the spouses. The value used should reflect the fair market value of the property, but determining fair market value can be complicated.
While houses, cars and bank accounts are fairly straightforward to value or appraise, something like a business is more intricate. In one infamous case, a software company executive told his soon-to-be ex-wife that his stake in a company was worth $50,000, but soon after the divorce settlement, the company sold for millions, and he was back in court being sued by his ex-wife for fraud.
Mine, yours or ours?
The rule of thumb in determining “separate” versus “marital” property is this: If the business interest is acquired during the marriage, with joint funds, then it is considered marital property and the value should be shared equally by the spouses. If the ownership interest in the business occurred before the parties were married, or acquired with separate funds, then it should be considered separate.
Specifically, an accountant or attorney can review these critical factors to help determine whether a business interest is separate or marital. First, compare the date of marriage and the date the business interest was acquired. Second, determine the source of funds used to start the business. Third, assess the financial and labor-related contributions to the business given by either spouse during the marriage.
Then again, just because the business interest was acquired before the spouses said “I do” does not mean that the non-owner spouse can take no value from it, especially if the net worth of the business rose significantly during the marriage. If the value of a business rises half a million dollars during a 20-year marriage, then that growth is likely to be subject to equitable distribution as a marital asset.
Vexation in valuation
After determining whether a spouse is entitled to a portion of the value of a business interest, determining what that interest is worth is a much taller order.
There are three ways to determine the value of a business interest:
- Asset approach
In an asset-based approach, the primary emphasis is on the fair market value of the assets and liabilities of a business, including intangible assets such as goodwill. Often the Net Asset Value Method is used, where assets and liabilities are adjusted to appraised values to determine a company’s equity.
- Market approach
Under the market-based approach, comparative information generally uses market studies of publicly-traded companies and sales of closely-held businesses that operate in the same industry. Sufficient information concerning prices paid in transactions of controlling interests in companies or prices paid for the minority stock of a business in the same or similar lines of business is needed. Such information is often difficult to find, however.
- Income approach
The income approach considers income generated by an entity’s assets over a period of time. This approach relies on the fundamental valuation principle that the value of a business is equal to the present worth of future benefits of ownership.
Two of the most common methods under this approach are:
- Capitalization of Earnings/Cash Flow: a company’s current operations are divided by a capitalization rate (the value of the company’s real estate holdings divided by the net operating income) to estimate value.
- Discounted Earnings/Cash Flow: a company’s future earnings/cash flow is discounted to present value.
Who and How Much?
Sometimes, if the interest is small and not overly complex, attorneys may set a value on the business. Typically, however, the attorney advocating for the person who owns the interest in the business will argue that the business is worth far less than the attorney for the person who does not have the ownership interest.
Most often, an expert is needed to delve deeper into the history, finances, assets, liabilities, and other aspects of the business to determine a value.
In big-money cases, it is worth it for both spouses to hire independent experts who can testify in court, if necessary. Ultimately, a judge will decide which expert is more credible.
Ill will in determining “goodwill”
A key aspect of divorce and business valuation in Pennsylvania is “personal” versus “practice” goodwill.
Both statute and case law have determined that personal goodwill is not subject to equitable distribution because it is not portable and cannot be considered separately from the individual.
For example: if you are a dentist in a small practice or a sole practitioner, your earnings are probably attributable to you individually. Clients come to you for your own reputation and from your own referrals. That is “personal goodwill,” so that good will is not likely to be subject to equitable distribution.
On the other hand, if you work for a large, highly reputable practice, the reputation of the practice probably contributed to what attracted the clients to you. So for an owner of a practice like that, the distribution may reflect a smaller component of personal goodwill, plus a component of practice goodwill.
This rule also applies to accountants, doctors, attorneys, plumbers, contractors, barbers, and many other professions.
In assessing individual versus business reputation, an accountant looks at the seemingly simple question: “What makes the phone ring?”
For example, you may have a divorcing dentist who earns $150,000 a year. Another dentist makes $300,000. Is that income differential due to the dentist himself or because of the practice?
There are a number of methods used to bifurcate personal versus enterprise goodwill and the method used generally depends on the specifics of the business such as size and industry.
Many other nuances color the valuation of business. An expert, for example, must look at the industry they are operating in, look at the future benefits of owning the business, and what a willing buyer and willing seller would pay.
No magic wand exists when assigning values, and gamesmanship may loom large, but often, a loss in business value during a divorce may be due more to the stress of the divorce than intentional or mean-spirited actions.
There are three important considerations to keep in mind when selecting someone to help you value a business during a divorce:
- Do they have experience in this type of business or industry? Have they done many valuations before?
- Are they dedicated specialists doing this full-time? Often accountants will offer valuation services to supplement income after tax season. You want someone who does this full-time to avoid having your case put on hold during tax season. Rather than hire a part-time expert; you want someone who is exclusively devoted to valuations and litigation support service.
- Can your expert simplify concepts and financial issues? Can they explain a Byzantine mathematical formula to a judge or family law master so they fully understand? Can they abandon jargon and use clarifying examples, especially when they testify?
In the end, valuing a business is a combination of art and science. Finding the right financial professional can help you close one chapter of your life in a fair way, and move on to find better value in your personal and financial future.
Keith R. Gordon, CPA, CEF, CVA is Senior Manager, Business Valuations with Boyer & Ritter and has nearly 25 years of experience in business valuations, litigation support, accounting, income tax and management consulting. He can be reached at 717-761-7210 or email@example.com