A business started during the marriage is likely community property subject to division by the court upon divorce. If one party wants to keep the interest in the business, the other will need to be fairly compensated. The court will award one spouse the right of continued ownership and the other one half the value of the business. The value will be determined by qualified expert review, report and testimony if required.
Initially, a date for valuation of the business will be selected. Documents will be reviewed and interviews may be conducted by the expert to investigate historic cash flows and earning trends, profit and/or loss calculations and compensation of employees, particularly the owners. The data collected will be compared to similarly situated business interests, much like reviewing “comps” in determining real estate values.
In the comparison process referenced above, if the expert believes certain expenses (i.e., owner compensation) are inflated or unreasonably low, he or she will adjust the line item expenses for purposes of the valuation to “normalize” the figures with similar companies. It should be noted that normalizing of owner compensation can also have an impact on the court’s determination of support to be paid.
The business will be valued by one or more of three valuation categories:
- Market based approach – This approach finds a value for a company by reviewing the economic performance of similar publicly held companies and comparisons are made to their “share” value on the open market.
- Income based approach – This is the most common form of valuation. In this approach, the income of the company is either capitalized or discounted based upon a required rate of return. The capitalization/discount rate to be used is often subjective and can account for a substantial portion of the differences in valuations from one expert to another.
- Asset based approach – This is also often referred to as the book value. The valuation is derived from the value of assets and liabilities of a company.
FAIR MARKET VALUE VS. FAIR VALUE
Fair market value is the price a willing buyer will pay and a willing seller will receive in an arms’ length transaction. Fair market value typically includes the application of certain discounts to the result achieved when the above approaches are applied. Common discounts are lack of marketability and lack of control.
However, in the context of divorce, fair value or investment value is typically applied. This is the value of continuing to hold the investment, in this case the business, and does not include the discounts mentioned above. As a result, fair or investment value is higher than fair market value. In the event that the business will actually be sold at or near the time of divorce, the court will be more likely to apply the fair market value.
EFFECTUATING THE “BUYOUT”
Once a value has been set, either by agreement with the assistance of experts, or by court determination, the non-owning spouse must be bought out of his or her interest. This may occur through offsets of other assets such as retirement, cash accounts or real estate. A payment plan for the amount due, typically with interest, may also be implemented. In the event there is no reasonable buyout arrangement available, the court may order that the business interest actually be sold.