FALL 2015: Small Business, Divorce, and Alternatives to Valuation

Many issues arise when determining the marital assets in a divorce matter. Frequently, the value of small privately held businesses end up as hotly contested issues.  Small businesses, mixed up in divorce, can prompt many questions such as:

  • Is the privately held business simply a stream of income or a legitimate marital asset?
  • If the business owner spouse walks away, does the business still have value?
  • Should the parties rely on the business for support?
  • Is valuing a privately held business actually worth the cost?

In many instances, and while addressing such questions as those above, a valuation expert is hired to prepare, and often testify to, an independent conclusion of value of a business asset. A conclusion of value is a rigorous analysis, with high standards set for understanding the proper context of the analysis, gaining an understanding of the business, dissecting its financial history and prospects, gaining knowledge of the economic and industry environments, selecting valuation methods and assumptions, and delivering a report, among other things.

This article will explore how to recognize if the business is a marital asset and discuss potential alternatives to an independent conclusion of value used in a divorce context.

Recognizing Marital Assets

Counsel should first understand the client’s income history. This includes reviewing and discussing past and present employment, and specialized income sources such as K-1 income, real estate investment holdings, or trust ownership.  Counsel should request that clients bring copies of recent tax returns and discuss any of the following:

  • Income from wages, salaries, tips
  • Schedule C business income
  • Schedule E income from partnerships, property, royalty, S corporations and trusts
  • Any other sources, or potential sources of income, even if actual income has yet to be recognized and reported for tax purposes

Generally, any business ownership interests, stock options, or Form K-1’s received should warrant further exploration of the nature, source and magnitude of the item.

When to Consider Experts

If during the process of reviewing a client’s financial history, counsel discovers activity beyond the typical salaries and wages, counsel may need advice determining whether the ownership interest should be specifically valued.  If so, consulting with a valuation analyst early in the process can help define the costs and benefits of the procedures and support the overall case strategy.  A valuation analyst can be hired as a financial consultant or an expert and will help determine whether the client’s income sources require additional investigation.  For example, the client’s compensation from a business may be solely from personal efforts, represent a viable business enterprise (and a marital asset), or somewhere in between.

An ownership in a business where compensation is based on personal efforts means the income produced by the business generates enough income to fairly compensate the owner for their role in the business. For example, if an individual operates a small plumbing business with no employees, the income generated may represent personal efforts that only reasonably compensate the owner, rather than generated residual profits that a viable business entity earns.

An ownership in a business where income is based on both personal efforts and the efforts of others, means the business generates sustainable income to compensate the owner as well as the overall business. An example would be a prominent solo dental practice with employees and/or subcontractors.  In this situation, the business should produce enough income to support both compensation for the owner’s role and produce residual profits.  The residual profits are used to quantify the marital asset.

“If and When” Sale Negotiation

If you determine the marital estate includes an asset, such as a business, one strategy to avoid an independent conclusion of value is by negotiating an if and when settlement. An if and when settlement is when the business owner and the spouse negotiate a specific portion/percentage of the business’ future economic benefits that will be paid out to the spouse if and when said benefits are earned in the future, or in the event of a sale.

This type of arrangement can be outlined in the separation agreement and facilitates the process, if the value of the asset would be difficult to determine within reason, or if the parties are otherwise illiquid. Rather than fix the value of the business at a specific point in time, an if and when arrangement results in both parties sharing in the future uncertainties of the business, albeit with differing roles or abilities to navigate the uncertainties.  

Cash Flow to Owner

Among other scenarios, in situations where the individual’s income is generated from personal efforts, the analyst can perform an analysis of the business income for support purposes. This type of analysis is known as a cash flow to owner assessment. For this procedure, an analyst will review financial documents and the income and cash flows generated from the business in order to determine how much has been available to the owner historically. This type of assessment is useful because it is less complicated than a full business valuation but results in objective information for settlement purposes.  

Calculation of Value

A calculation of value is another alternative to an independent conclusion of value. A calculation of value often requires a significantly less extensive assessment of the business or ownership interest. This is because a calculation engagement allows the expert and the client to agree on approaches and methods used, as well as on the extent of procedures performed by the expert. As a result, the calculation of value will be absent an independent opinion that can be used for trial.  This type of analysis is often done jointly and can be used in settlement proceedings when the parties are negotiating the value of a marital asset.

Joint Valuation

When the value of a business marital asset remains contested, a full business valuation may be necessary. A cost efficient approach to complete a full business valuation is hiring an expert jointly to prepare a conclusion of value. A joint valuation is when divorcing spouses agree that a valuation is needed and a neutral expert is hired jointly by the parties to value the ownership interest(s).

An important task of the valuation expert conducting the joint valuation is to communicate with all parties during each stage of the valuation process, including document gathering, interviews with management, site visit, and final delivery of the project. 

One advantage of a joint valuation is efficiency. In theory, since both parties have agreed a valuation is needed and have agreed on who shall perform the valuation, it is easier to obtain documents and talk with management about the company being valued; which in turn, may reduce the time it takes for an expert to complete the valuation. 

A disadvantage of this method is the potential that the parties may not agree with the expert’s opinion regarding the value of the business or the compensation analysis used. If this happens, it will take more time and become more costly, especially if the parties decide to hire additional experts (jointly or separately) as a result of their disagreements.

To avoid possible negative outcomes to a joint valuation, the parties could agree in the beginning that the expert will deliver the results of the valuation in both a report and oral presentation. By having both a written and oral presentation, the parties are not only able to have all of the relevant considerations at their fingertips, but also are able to talk directly to the expert, and ask any questions they may have; doing so may help to bridge important gaps for the parties. 

Review What Best Suits Your Needs

A phone call to an expert at the beginning of the process may speed the process and negate the need for an independent conclusion of value.  Alternatives to business valuations can also reduce the cost and tension in a divorce case. Although a conclusion of value may be the most thorough form of obtaining a value for marital assets, it can be prepared jointly, and there are other valuation services available that may better suit your client’s needs and budget.

Ross Yogel is a Senior Valuations Associate at Edelstein & Company, an accounting firm in Boston, where he focuses on business valuation, financial analysis for litigation support, and forensic accounting cases. Ross is a licensed CPA and CVA and received his Master's in Business Administration from Suffolk University.