Common Issues When Valuing a Small Business for Divorce

Every valuation engagement is unique and depends on various considerations, observations, and assumptions. One business can have multiple valuation conclusions based on the purpose at hand, intended user, date of the valuation, state of the economy, revenue/earnings stream considered, and normalizing adjustments utilized in presenting financials, to name a few. The following article highlights the most common issues associated with divorce valuations:

Defining the Standard of Value

The first step in any valuation engagement is to determine the standard of value.  While Fair Market Value is often utilized for valuation purposes, in a divorce situation, a transaction is not necessarily taking place, and as such, utilizing Fair Value, or Fair Market Value without discounts, is more often employed. This consideration is often a matter of state law or precedent.

Determining Applicable Valuation Methodologies

All three methodologies are required to be considered in all valuations primarily because there are margins of error present in any opinion of value –ultimately, while it’s a highly informed opinion, it is just that- an opinion. While the Market Approach calls upon the use of completed transactions of like businesses, what exactly constitutes one business as being “like” another? There is a multitude of factors that can skew market multiples, including but not limited to:

• The company’s actual operations – Is the subject company a niche business that shouldn’t necessarily be grouped with a broader market segment?
• Expense classification—Does the company include an expense as a Cost of Goods Sold rather than an Operating Expense, skewing Gross Profit Margins?
• Geographic location – Is the business located in a metropolitan area with many alternative product/service providers, limiting revenue growth?

The Income Approach may also be a point of contention as the Discounted Earnings Method provides a value of a Company based on its future earnings stream. A divorce situation is concerned with a present value up to the date of the marriage dissolution, and not the anticipated future economic benefit a company may or may not present.  Capitalization of Earnings, which capitalizes the current earnings stream based upon a developed discount rate, is more commonly suggested.

Adjusting Shareholder Compensation

Privately owned, closely-held businesses have subjectivity in the working shareholders’ compensation. This can be an issue. While owners of small businesses typically wear multiple hats, deciphering the fair market value salary that would be required from a person or persons necessary to replace those roles can present a lot of room for contention. Oftentimes, Shareholders’ salaries can significantly impact the earnings streams utilized in subsequent market and income approaches. Adjusting for a lower fair market value salary will increase earnings levels, propelling company valuation, while stating that a Shareholder is underpaid and commands a higher salary will draw from that earnings stream and ultimately lower the conclusion of value. It is also important to note that the determined level of fair market compensation will play into any alimony set forth by the court (more on “Double Dipping” here); this is a key financial factor that needs to be discussed and researched.

Personal Goodwill

Goodwill is most easily thought of as a company’s “blue sky” value.  It’s the result of a company generating value that exceeds the business’s book value. Many things can create goodwill- commonly items such as favorable location, trade names, customer lists and relationships, and so forth. There are also instances where goodwill is created by a single person – hence the term “personal goodwill.” Some states consider personal goodwill a marital asset, while others treat it as a personal asset (and not available for distribution in the marital estate. Thus, sorting out if personal goodwill is applicable in a jurisdiction, and if so, how much it is worth, is critical to valuing a company in divorce matters.

Related: Enterprise vs. Personal Goodwill: How they differ and affect divorce valuations

Divorce Valuation Issues Summed Up:

Suppose you need to know the actual value of something, such as for a sale, buy-sell agreement, acquisition, or divorce. In that case, it is recommended that you have an actual valuation conducted by a qualified professional. While estimates can be helpful in informal scenarios, a certified valuation is necessary for legal and formal purposes.

Since 2003, Quantive has performed over 3,000 business valuations. Contact our valuation specialists for a no-cost consultation today.

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