When one or both spouses start or operate a business during the marriage, the gains in the value of the business become marital assets. But determining the value of a business for the purpose of splitting the marital equity in that business can be a bone of contention in a divorce.
Typically, a financial expert (an accountant usually with background training in business valuation) will review the various financial records of the business. The first important piece will be cash flow analysis – income in expenses out. How reliable are the cash flows? How variable are the expenses? How solid are the clients? These factors help determine a more accurate picture of the business as opposed to a snapshot in time where the business did exceedingly well or surprisingly poor. Also, getting a sense of the degree to which the business can sustain income trends gives a “cap” to the earning potential of the business.
The expert will likely also conduct a market share analysis to determine how much of a “player” the business is in its defined market, and how that limits or expands growth potential.
Next, the expert will examine the tax returns and financial statements and see how they compare to the actual cash flows. Any major differences will raise red flags and can become the source of expert witness fights.
Valuing a business can fall under one of three categories – income approach, market approach, and asset approach. Most often, analysts use the income approach because it best measures cash flows over the years. It is individualist to the business. The market approach looks at what a comparative business would command in the market, so it is quite the opposite of individualism and can be subject to many criticisms. However, it does have the advantage of providing a comparison to see if the actual business is over-performing or underperforming in the industry, and use those points of departure as reasons to explore why the difference is there – is it a legitimate problem of the business or is it clever accounting? The asset approach seeks to find the fair market value of the business assets less its actual liabilities. This approach only makes sense in a business heavy on assets over services, and with assets that are easily measured in a market – real estate or automobiles for example.
While the income approach is most common, performing multiple approaches to see what differences appear can help give a better and more nuanced value of the business. It can point to issues like market dominance, service capacity, and risk in the short and long term. Risk rating refers to the probability that the income reported will continue versus shrink. The lower the risk, the better the valuation. High volatility in risk suggests either a problematic market or a questionable valuation.
Business valuation accuracy is critical because the trial court must rely on the evidence presented by the parties in dividing the shares of the business. While the spouse owning the business will want to undervalue to minimize loss to the other spouse, and the spouse not owning the business will want to overvalue to maximize gain in property division, the court need not just average the two numbers. The court will look at how each party arrived at the value. Hence, having the best analysis that is objectively fair helps that party prevail.
Your attorney will definitely need the assistance of one or more valuation experts, so you should expect this expense as part of the dissolution process. Without an excellent valuation expert, you could lose a significant amount of money.
If you have questions about business valuation and divorce, contact us – we can help.