Common Issues When Valuing a Small Business for Divorce
Every valuation engagement is unique and dependent upon a wide range of 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 its 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 are a multitude of factors that can skew market multiples including but not limited to:
- The actual operations of the company – 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 versus an Operating Expense, skewing Gross Profit Margins?
- Geographic location – Is the business located in a metropolitan area where there are a multitude of 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. As such, 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 compensation the working shareholders receive. 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, Shareholder salary 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” in an upcoming post), this is a key financial factor that needs to be discussed and researched.
Goodwill is most easily thought of as the “blue sky” value of a company. It’s the result of a company generating value that exceeds the book value of the business. There are lot’s of things that 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 is it worth, is critical to valuing a company in divorce matters.
The exploration and information-gathering steps of each valuation will pave the way for your valuation analyst to determine the best methods to utilize. When obtaining a valuation for divorce proceedings, there are various key considerations to discuss with your valuation professional that may have material impact on the outcome of their analysis.