Which Half Is MINE?
According to the U.S. Census Bureau, for individuals under age 45, approximately 50 percent of first marriages for men and between 44 percent and 52 percent of women’s first marriages end in divorce. The likelihood of a divorce is lowest for men and women age 60, for whom 36 percent of men and 32 percent of women may divorce from their first marriage by the end of their lives. Business owners of course, are not excluded from these daunting statistics.
For many married business owners the business is both the most valuable and most illiquid asset in the marital estate. Therefore, it is reasonable to assume that if owners divorce, the business will be an asset that will spark substantial controversy and conflict between the divorcing parties. Further, without preparation and precaution, the consequences of divorce can have a devastating financial impact on your business. If either you or your business partners are contemplating divorce or if divorce is imminent, together with legal counsel, you should consider three very important questions: 1) who should perform the business valuation? 2) what is to be valued? and 3) How will the divorce impact the business?
Who should perform the business valuation?
If the business is to be included in the dissolution of the marital estate, it is highly recommended you have a business valuation performed by an appraiser who is:
- Independent – An attorney is an advocate of the client whereas an appraiser is only an advocate of the business’ value. Therefore, having your CPA, or other individual you already have an existing personal or professional relationship with, perform the business valuation is a big no-no. Opposing legal counsel (for the non-owner spouse) can easily dispute the credibility and objectivity of the business valuation report. Not only that, any appraiser you have an existing relationship with and who knowingly accepts such an assignment is bordering on a violation of professional ethics.
- Certified – An individual may have an alphabet soup of letters after their name, but at least one set of those letters should be from a recognized professional business valuation organization. Many courts have disallowed valuations performed by uncertified individuals. Hiring an uncertified appraiser not only wastes your time but your money as well.
- Experienced – Unfortunately, it’s not enough to hire an independent, certified appraiser. You must also hire one who has substantial valuation experience in your company’s industry. Experience is critical and typically can make or break the validation of the appraiser’s value opinion, especially if your company operates in a niche market. Further, your appraiser may be required to provide a verbal attestation of the value opinion in court.
What is to be valued?
Level of ownership
The amount (or percentage) of ownership to be valued will guide your appraiser in the valuation analysis and application of the appropriate valuation methodology. Typically, a 51 percent or more business ownership represents a controlling interest and is worth more than one that is of a non-controlling nature, or 50 percent or less. Depending on the particular state case law, a valuation discount for minority ownership may apply. However, if the ownership of the company is 50 percent-50 percent between co-owner spouses, a noncontrolling premise may not apply. In this case, the individual 50 percent ownership may be recognized as a controlling interest due to the familial relationship of the parties involved.
State case law Your appraiser should be very familiar with the relevant state case law. Many states mandate a particular standard of value be utilized valuing closely held stock or ownership for divorce purposes. For most tax matters concerning the IRS, the standard of value is fair market value, i.e., hypothetical willing buyer and seller. However, for divorce purposes, the standard may not be fair market value. The value might be referred to as “divorce value” or “marital estate value.” The standard of value may also impact the court’s allowance of valuation discounts, such as marketability and minority ownership discounts. Further, the particular state case law may specify the separation of corporate goodwill and personal goodwill. This is particularly pertinent to professional service companies, such as engineering firms, accounting firms, or healthcare practices.
Corporate goodwill is the goodwill of the business. It is a transferable asset, and is included in the valuation of the enterprise. Personal goodwill is goodwill that adheres to an individual. It is not transferable, and consists of the personal attributes of an owner including personal relationships, skill, personal reputation and various other factors. The existence of personal goodwill may indicate dependence on a key person. If your company has key person issues—meaning, your business could not sustain its current level of operations and financial performance without the significant participation of any one particular individual, such as the owner—the value that individual brings to the company must be excluded from the value of the business IF that state specifies the exclusion of personal goodwill from the value of the business.
Entity structure and taxation
The entity structure of your company is also relevant. A hotly contested topic in business valuation is the tax affecting advantages and disadvantages of C corporations versus those of pass-through entities, such as S corporations and limited liability companies (LLCs). Although there are different schools of thought on the issue, the taxation of business earnings is controversial because it may make a material difference in the value of your ownership interest. If your company is taxed as an S corporation your appraiser may use the SEAM (S Corporation Economic Adjustment Model), for example, to ascertain the effect the income tax treatment the passthrough entity has on the value of your pro rata ownership.
How will the divorce impact the business?
Aside from the obvious emotional impact a divorce may have on you, the financial implications on your business can be overwhelming and more than anticipated. As mentioned, the business may be the largest asset in the marital estate as well as the most illiquid. However, funding the marital settlement can place a financial burden on your business if you do not have sufficient personal liquidity. Supporting the settlement without interrupting business operations typically requires sufficient cash on hand, readily available liquid assets or other type of funding vehicle such as a business loan.
Some common mistakes an owner, who is facing a divorce, may make in relationship to the business are:
- Run personal or non-business related expenses through the business;
- Blatantly neglect operations;
- Sell off or destroy business-owned assets;
- Dramatically deplete profits or cash on hand; and
- Cease operations.
Oddly enough, these tactics may have zero to little effect on the business’ value and it is recommended owners avoid extraordinary actions or business decisions outside the company’s day-to-day operations. Firstly, the court and opposing counsel will probably be savvy enough to recognize the actions of possible self-inflicted sabotage. Secondly, the court will typically specify a valuation date, which could be the date of separation or another specified date, and the value of the business may be based on historical operations up to that date. Lastly and most importantly, anomalies and extraordinary events may be “normalized,” meaning the appraiser will recast the financials to reflect the normal course of business. Nevertheless, an appraiser can bring sanity to divorce business valuation situations. Therefore, as a business owner, do not make the mistake of choosing an inexperienced, unaccredited appraiser. A wrong choice could not only cost you unnecessary aggravation but the payout of unnecessary money.
Although it may seem a bit pessimistic to suggest planning for divorce, the consequences of not planning for any untimely life event, whether it is divorce, disability, or death, can have a devastating financial impact on your business. Regular business valuations allow you to proactively care for the viability of your business investment and therefore ‘anticipate’ an untimely event requiring immediate liquidity. However, if planning is not an option and the unexpected event is already upon you or your partner, be smart in your selection of an appraiser. A business owner who is contemplating marital dissolution should always seek professional legal advice to determine the scope of the valuation engagement and the necessary course of action. Due to the variances in the appraisal process by state, company and personal circumstances, the business appraiser should work closely with your designated counsel in defining the focus for the valuation process. Not doing so may waste precious time and money.