If you or your spouse owns a small business, dividing its value in divorce can be an extremely contentious issue. Indeed, this is one of the select few issues in family law that often results in a trial. Why? Because each party is likely to retain their own expert to value the company. Of course, the business owner’s expert will be highly motivated to minimize its value and thereby minimize his client’s financial obligations. Even if that expert professes to performing a neutral, by-the-books valuation, there may be subconscious or unstated biases at work. Conversely, the non-owner’s expert will be highly motivated to maximize the business’s value and thereby maximize his client’s payout in equitable distribution. Often, this results in expert opinions that are literally millions of dollars apart, and when that much money is at stake, trial starts to make sense from a cost-benefit standpoint.
For example, I recently tried a case in Somerset County Superior Court over the value of a small business that manufactured packaging materials primarily for automotive companies. The business owner’s expert valued the company at between $236,000 and $391,000 (depending on the valuation date employed by the Court). The non-owner’s expert valued the company at between $1,520,000 and $2,130,000. I represented the non-owner spouse, and we successfully convinced the Court to adopt our valuation. Trial in that case was the right financial decision.
Do those numbers concern you? They should. Business valuations are complex, and they can have dramatic consequences for your economic future. In most circumstances, the business owner cannot sell the company. Therefore, in dividing the business’s value, he or she will have to compensate the non-owner spouse by offsetting against other assets (assuming such assets exist). This can result in the business owner walking away from a divorce with a relatively small share of liquid marital assets and a substantial alimony obligation to boot.
THREE METHODS OF VALUATION
There are three basic methods of valuing a business: (1) the income approach; (2) the asset approach; and (3) the market approach. Each approach is unique and best suited for a particular set of circumstances.
THE INCOME APPROACH
Generally, the income approach is used to value companies that are profitable ongoing ventures. It is the most common approach for small businesses. The income approach is an umbrella term that includes the capitalization of earnings and discounted cash flow methodologies. To grossly oversimplify, the capitalization of earnings method involves taking the normalized earnings of a company and multiplying by the inverse of the capitalization rate (e.g., a 20% capitalization rate would mean a multiple of five, a 25% capitalization rate would mean a multiple of four, and so on). The discounted cash flow method requires analysis of the net present value of anticipated cash flow; in many ways, it is simply a variant of the capitalization of earnings method.
Generally, a valuation expert will “normalize” earnings by taking the reported income, adding back personal expenses run through the business and perquisites to the owner, and subtracting the reasonable compensation of the owner. Then, he or she will determine the capitalization rate by assessing the overall risk minus the anticipated growth rate. The capitalization rate typically requires starting with the risk-free rate, adding the equity risk premium, adding the size premium, adding the industry specific premium (if appropriate), adding the specific company risk, and then subtracting the perpetual growth rate. The result of that analysis is the capitalization rate, which is expressed as a percentage.
Finally, the normalized earnings will be multiplied by the inverse of the capitalization rate. Thus, a business with normalized earnings of $250,000 per year and a capitalization rate of 25% might be worth $1,000,000 under the capitalization of income method ($250,000 / 25% = $1,000,000). In my experience, three to five times the normalized earnings of a business is relatively typical. But of course, the facts and circumstances of a particular case may call for a higher or lower capitalization rate.
THE ASSET APPROACH
Generally, the asset approach is used to value distressed businesses or holding companies. Applying the asset approach is much simpler: The expert simply adds the business’s assets and subtracts its liabilities. Therefore, if the company has $800,000 in assets and $350,000 in liabilities, its value would be $450,000 under the asset approach. Nevertheless, there can be room for dispute over an asset-based valuation. What is the fair market value of the business’s assets? Should we consider things like intellectual property? What value should be assigned to intangibles? Are the business’s reported debts legitimate?
THE MARKET APPROACH
The market approach is deceptively simple. In sum, this approach permits valuation of a company by comparison to similar companies that have been sold in the past. For example, if Company A is similar to Company B, and Company B was sold for $5,000,000, then we can reasonably assume that Company A might sell for around $5,000,000. Unfortunately, such data is often unavailable for small businesses. Nevertheless, the market approach can be useful where industry-specific data is available (e.g., for larger companies and franchises). But determining whether two businesses are in fact similar can be a highly subjective process. Moreover, the reliability of this approach depends largely on the quantity and quality of the market data available. The sale of any one business may have more to do with the unique relationship between the buyer and seller, or the skill and persistence of their representatives in negotiations, than the actual fair market value of the company. Conversely, when there are sufficient comparable transactions to analyze, the market approach becomes highly predictive of a company’s value.
If you own a small business and are facing a divorce, choose your attorney wisely. Few issues can have a greater impact on your economic future. At Shaw Divorce & Family Law, we are intimately familiar with business valuation methodologies. We know which variables can have a substantial impact on the outcome and how to structure discovery and trial arguments in a way that moves those numbers in the right direction. Working with our trusted experts, we will design and execute a strategy to protect your financial interests.
To discuss how your business might be valued in a divorce, call us at 908 516 8689 to schedule a free consultation.