Over thirty million small businesses currently operate in the United States, and many of these “mom and pop” shops end up the subject of divorce when “mom and pop” decide to end their marriage. Sometimes, the parties need to determine if the business can continue if both play key roles in its operation. If not, the business may need to be sold and the parties would share the proceeds as a marital asset, subject to any separate property distribution that may be necessary as a result of one party using premarital funds to start the business. But when the business may continue with the operation of one spouse, the other spouse must be bought out, and that involves a complex process known as business valuation – the determination of the exact value of the business, what part is marital property, and the share that should be given to the other spouse.
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 poorly. 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.
Business valuation is a mixture of legal and accounting principles. Typically, courts and accountants use three approaches to business valuation – income approach, market approach, and asset approach.
First, a business may be valued using the income approach, which looks at the history of the business over a period of years and averages income streams and expense streams to reach a projected value in the near future. For example, if a business averages an income of $500,000 and expenses of $300,000, the business has a net income value of $200,000. The income approach works well with predominantly service businesses. Most often, analysts use the income approach because it best measures cash flows over the years. It is individualist to the business.
Second, a business may be valued using the market approach, looking at what price an investor would pay for the business on the open market. 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? An analyst would compile similar businesses and their stock prices to get a sense of the value in the industry. The market approach can also serve as a “check” on the income approach to see if what the company earns fits with what the market would bear if purchasing the business.
Third, a business may be valued using an asset approach that looks at the liquidated value of the assets of a business. This method would make no sense in a predominantly service-based business but makes great sense in a company that holds lots of physical assets, like real estate. 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.
In looking at these different methods, the court may also take into consideration the role the spouse plays in the success of the business. For example, if the business could not succeed without the spouse, that could impact how it will be priced. Also, the health and continued participation of that spouse needs to be assessed.
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.
The whole point of business valuation is to get a fair market appraisal of a business looking through different lenses. Once the court finds that number, the court needs to remove any separate property from the valuation (contributions of the spouse prior to marriage or that used premarital property), find the marital portion, and then make an equitable division. The court needs to think carefully about how to order the share paid to the spouse, as it does not want to harm the actual operation of the business by the payment of a large lump-sum amount. The court may decide, for example, to award the other spouse a percentage of profits for a certain number of years, or to liquidate one particular asset as compensation.
Parties should try and reach a decision about valuation and compensation for an interest in the business before leaving it to the court because the parties can do a better job tailoring the payments than the court given the parties’ level of knowledge.
Should you need the assistance of an experienced divorce attorney in Creve Coeur and O’Fallon or have questions about your divorce or child custody situation, know that we are here to help and ready to discuss those questions with you.