Business Valuation in Divorce Proceedings: Understanding of the Basic Approaches to Value

by Jaburg Wilk
Contact

[author: Mitchell Reichman]

            In many cases, one of the most contentious and difficult issues in a divorce proceeding is the valuation and distribution of marital property.  When the marital community owns an interest in a business, this process can be complicated and expensive.  Often, the community’s interest in the business is the most valuable asset of the marital estate.  Whether you are the “in” or “out” spouse, it is crucial to understand the various methods which are generally applied to determine the value of the community interest in a business.  Different approaches to value often lead to dissimilar valuation conclusions and it is the responsibility of the parties, their attorneys and experts (who may be engaged by one or both parties) to persuade the judge, mediator or arbitrator to reach a fair and appropriate division.

What kinds of assets are considered?

            While many businesses have unique features, generally, the types of assets that a business will own are tangible and intangible assets.  Tangible assets consist of cash, accounts receivable, inventory, and equipment - generally things that would considered as physical assets.  Intangible assets on the other hand are non-physical assets, including trademarks, patents, copyrights, goodwill and contracts that grant rights and privileges.  To value tangible and intangible assets usually requires experts who may utilize different standards of value.  While all valuations are done as of a single date, if there is no agreement between the parties as to the date for valuation, the experts may choose different dates to present their opinions and conclusions as to value.

            The application of recognized valuation methodologies combined with rigorous analysis provides the foundation for business valuation.  Many subjective judgments must be made by the business valuation expert in arriving at a valuation conclusion.  It is rare when two business valuation experts arrive at the exact same conclusion of value.

            Determining the community interest business value in a divorce proceeding commonly includes both parties engaging his or her own expert who presents their opinion in a formal report.  The two experts will testify.  They will explain their work, analysis and opinions while critically commenting on the work of the other expert. Frequently, it is in the judge’s discretion to decide what value to adopt.  If one of the spouses is involved in the operation of a business, he or she may want to use a “rules of thumb” methodology which is used by business brokers to estimate the value of a business entity.  These are not the valuation methods used by evaluation professionals and Arizona courts do not adopt rules of thumb when determining the value of a community business.

How are assets valued?

            There are only three approaches to value any asset, business or business interest; they are (1) the asset approach; (2) the income approach; and (3) the market approach.  While there are no other approaches to value, there are numerous methods that the expert may consider within each of these approaches.  Each approach has inherent strengths and weaknesses and some provide a more reliable conclusion of value than others depending upon the individual circumstances.  The valuation expert should consider all three approaches; however, it is often the case that all three approaches cannot be applied. For example, in an asset approach, the business valuation expert may seek to value intangible assets.  The difficulty of finding reliable data to value individual intangible assets may not only be an impossible task but also intangible asset values are frequently captured in proper application of the income and market approaches.  Ultimately, it is the responsibility of the parties and their counsel to persuade the court that his or her expert’s valuation conclusion is more reliable based upon the approaches that are applied and the judgment exercised by their expert.

The Asset Approach

            An asset or asset-based approach determines a value indication of a business or a business interest using one or more methods based on the value of the assets, less liabilities.  Generally, the asset approach presents a value of all tangible and intangible assets as well as the company liabilities.  Although the asset approach may seem to be simple, there are a number of complicating factors.  While the value of certain assets, such as cash and accounts receivable, may closely approximate book value, other reported assets may not.  The value of certain asset classes such as property, plant and equipment are seldom the equivalent of book value. They may require separate experts to provide appraisals for individual items.  The value of inventory is typically stated at cost and depending upon the inventory type and age, this is another asset whose value for business valuation purposes is frequently not the same as book value.  Most challenging under the asset approach valuation are unrecorded assets and liabilities such as goodwill or intellectual property.  Accordingly, the asset approach is typically relied upon when the business is an investment or holding company.  It may also be used in the valuation of very small businesses and/or professional practices where there is little or no goodwill.

The Income Approach

            An income or income based approach determines a value indication of a business or a business interest using one or more methods that convert anticipated economic benefits into a present single amount.  It is the most widely recognized approach to valuing an interest in a privately held business.  There are several methodologies within the income approach. The primary methods are capitalized cash flow method, discounted cash flow method and excess cash flow method.  Each of these methods requires the determination of a future benefit stream and a rate of return or risk that the projected future economic benefits will actually be received.

In the process of developing a conclusion as to future benefit stream, the valuation expert will collect and review historical financial data and make normalizing adjustments.  The goal in making these adjustments is to present a normal operating picture to project future earnings.  In most privately held enterprises, it is not unusual for the controlling shareholder to receive compensation in excess of a market rate.  Often one of the significant adjustments made by the valuation expert is to add back excess compensation to cash flow. The expert must determine fair compensation for the controlling shareholder's position and responsibilities. There are many subjective judgments that the business valuation expert makes in application of an income based approached.

The Market Approach

            A market or market-based approach determines a value indication of a business or a business interest using one or more methods that compare the subject business to similar businesses or business ownership interests that have been sold.  The theory which supports the market approach is that the value of a business can be determined by reference to comparable transactions or reported “comps” from the sale of other businesses. Most people are familiar with the market approach because it is most commonly employed by real estate appraisers.  However, real estate appraisers, particularly with residential appraisals, can find many comps from which to choose from where homes have similar qualities, including size and location.  It is much more difficult for a business valuation professional to find transactions that are comparable to the business being valued.  Often, because the business being valued is a small, privately held firm and the transactional information is from public companies, there are great differences in size, sales, profits and geographic location.  While the market approach is simple to understand, it can often be difficult to find transactions that are truly comparable in terms of the business whose sale is being reported.

Valuation Conclusion

            There are many additional analysis and components that are included in a business valuation expert’s report before he or she arrives at a final conclusion of business value.  These can include adjustments for control premiums, discounts for lack of control, discounts for lack of marketability or lack of voting rights and other adjustments.  After the business valuation expert has applied all three approaches and arrived at value indications by application of each approach, a determination must be made on how to weight each value indication to determine a final value conclusion.  Once established, the expert should perform reasonableness tests to determine whether his or her opinion makes economic sense.

            The sheer multitude of variables imbedded in the valuation process is complicated and can make business valuations difficult to understand.  Unfortunately, there is very little training available to help family law judges understand the business valuation intricacies.  It is imperative that not only the expert, but also the attorney are well versed in business valuation methodology.

About the author: Mitchell Reichman is a family law attorney at the Phoenix law firm of Jaburg Wilk.  He is a certified family law specialist by the State Bar of Arizona.  Mitch frequently writes and speaks on divorce, spousal maintenance, and valuations of closely held businesses. He has expertise representing high net worth individuals who have closely held businesses in their marital community. He can be reached at 602.248.1000 or mxr@jaburgwilk.com.


This article is not intended to provide legal advice and only relates to Arizona law. It does not consider the scope of laws in states other than Arizona.  Always consult an attorney for legal advice for your particular situation.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Jaburg Wilk | Attorney Advertising

Written by:

Jaburg Wilk
Contact
more
less

Jaburg Wilk on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.