Bill owns a business called Clean Wipers, Inc. that sells unique, high quality windshield wipers to luxury car companies and car owners. Bill and his wife Brenda decide to divorce. Bill tells Brenda he takes an $80,000 salary from the business each year and that he’s thought about selling the business recently because sales were down. The business broker told him the business was worth only $150,000.*
Brenda thinks that can’t be possible. After all they live in a nice neighborhood, their children attend private schools and they vacation in Europe twice a year. Where is all the money coming from?
If Bill or his attorney offers Brenda a business valuation report, Brenda and her Certified Divorce Financial Analyst™ should review the report together. Together they will find and highlight the variables that may need to be reconsidered. Brenda and her analyst might conclude that Brenda needs to hire her own qualified business valuation expert.
Brenda will want an expert with accreditation and experience. Look for an AVB, AVA or CVA designation. The ABV is the Accredited Business Valuation designation given to CPA’s and issued by the American Institute of Certified Public Accountants. AVA is the Accredited Valuation Analyst designation (sometimes now called a CVA or Certified Valuation Analyst) issued by the National Association of Certified Valuation Analysts (NACVA). The ABV was created based on the AVA/CVA requirements.
Brenda also needs to know something about the valuation process and so should you!
- A business valuation is ripe for manipulation.
There are many ways that a business owner could attempt to alter business value, especially if he believed that his divorce might be on the horizon years before. A business valuation expert experienced in divorce will be well aware of these “tricks” and reverse their effects in in his or her analysis.
Here are some examples of how Bill could alter the value of Clean Wipers Inc.
- Delaying new contracts
- Increasing inventory or changing how inventory is valued
- Hiring new employees or paying friends or family members for “services”
- Pre-paying taxes or keeping any tax refund on deposit for the following year’s taxes
- Selling a partnership interest in the business at below market value to a friend or family member
And there is more. Believe me, I’ve seen and heard about some creative moves.
Further, while Brenda and her advisor should review the business tax return, remember that a tax return is structured to minimize income (and reduce taxes). Taxable income is different from business cash flow. A business valuation expert will “add back” some non-cash expenses to taxable income in order to get close to the average ongoing cash flow (cash revenue less cash expenses) used for valuation.
- There are different methods of valuation, and each will produce a different result.
There are three basic methods to value a business in divorce – liquidation, market and capitalization.
Liquidation value – Liquidation value is the value of all the “tangible” assets like inventory and equipment. Unless business operations are obsolete and sales are way down (Did Bill have a drinking problem?), this will yield the lowest value and is not appropriate for services businesses like law firms or doctors’ practices.
The market approach – In the market approach, business value is either a multiple of revenue or cash flow (revenue less expenses) for businesses that sold recently. For example, if a company in your industry and geographic region sold for 5 times its revenue, your company might sell for 5 times its revenue. This method is hard to use because each business is unique. It’s hard to find a “similar” business. On the other hand, if the divorcing couple’s business recently sold portion of its operations to a new partner, the price the new partner paid can factor into the value of the divorcing partner’s interest – assuming the new partner was a real investor and not someone helping Bill manipulate value.
Discounted cash flow or capitalization method – This method uses cash flow, cash flow growth and cash flow certainty to determine the value of a business. After coming to agreement of about the cash flow that may be adjusted for things like the personal expenses or any unusual/one-time expenses, this method requires assumptions about cash flow growth and cash flow certainly in the future. While this is a fairly common method used in divorce, any change in the assumptions can greatly impact the resulting “value”. For example a company with $1 million of cash flow that’s expected to grow and these cash flows are fairly certain based on the long history of the company, the value might be $1 million / 10% = $10 million. If the cash flow growth is assumed to be slower or less certain, as any marketplace buyer would argue, a valuation expert might use a greater denominator say $1 million/ 17% = $5.9 million.
Typically the divorcing business owner (Bill) acts like a buyer of the couple’s business and his or her spouse (Brenda) acts like a seller. Bill will argue for a lower value – like a marketplace buyer would – so he can buy out his spouse’s interest for less money and get more of the couple’s other assets. Bill will argue that cash flow growth is slow and uncertain and the economy is bad. Brenda will argue for a greater value since her she will likely get offsetting property or money in exchange for her martial share of the business. Thus Brenda will argue that cash flow growth is strong and stable – like Bill would if he was looking to sell the business to a qualified marketplace buyer (sold for “Fair Value”).
- And, yet there are other complicated variables to fight about.
The court will look at the proportion of the company that is “goodwill, as well. There are two types of goodwill, personal and enterprise. Personal goodwill is just that. Clients come to see the business owner for his services. For example an investment advisor or a high end stylist might have significant good will in his or her business. Enterprise goodwill would be associated with a services business that, for example, has a great location or where changing ownership doesn’t have an impact on the business value (a franchise owner, for example). 24 states and the District of Columbia exclude personal goodwill from the marital estate (Texas); 19 states include personal goodwill in the marital estate, and eight states have no formal precedent. The degree of goodwill any business’s value is debatable and the subject of many a courtroom drama.
If a couple or spouse owns less than a controlling interest (less than 50%) in the business, the business value is discounted for lack of control and marketability of their interest. These discounts can be steep, 25-35% of value.
This quick primer on business valuation in divorce only scratches the surface of the many considerations in business valuation. Be sure you have a qualified expert value the business in your case. These experts will make you aware if any “tricks’ have been deployed and whether it is worthwhile to continue to fight in court.
Feel free to ping me with questions by going to http://divorceplanningofaustin.com/contact-us/
Silicon Hills Wealth and Divorce Planning of Austin work with clients and their attorneys to help insure that financial accounts are divided in the most efficient manner possible. Please contact Pam Friedman, CFP®, CDFA™ at firstname.lastname@example.org
Neither Silicon Hills Wealth Management nor Divorce Planning of Austin are accountants and do not provide tax advice. Please consult with your tax professional regarding your specific circumstances.
*This is a hypothetical example. It does not illustrate any investment products and does not show past or future results