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 played 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.
Business valuation is a mixture of legal and accounting principles. Typically, courts and accountants use three approaches to business valuation.
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.
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. 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.
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.
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) and 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.
If you have questions about business valuation and divorce, contact us – we can help.