During the divorce process, marital assets and liabilities must be divided between the parties through a process called equitable distribution. The values used for the marital assets and liabilities will be the fair market value as of the date of separation. The value of certain assets will be relatively easy to determine, such as a bank account or the marital residence. On the other hand, placing a value on a business interest is usually more difficult.
Community vs. Separate Property
In community property states such as Texas, a business formed during the marriage with joint funds is “community property,” meaning it’s owned equally between the spouses. A business formed before marriage, or with “separate property” funds, (money earned before the marriage or by gift or inheritance) is a separate property business (owned by one spouse). In order to determine whether the business is community or separate property, one must understand the following key factors:
- The date of the marriage and date the business was founded
- The source of funds used to start the business
- The financial and labor-related contributions of each spouse to the business during the marriage
The characterization of a business interest might be further complicated if joint or community funds were used to expand an existing business operation or invest in additional interests in the business, or if the spouses’ contributions to the business created incremental value.
The first step is determining who will carry out the analysis.
Rather than task employees with needed documentation and calculations regarding the business interruption loss, an entity may engage outside expertise to assist with the claim process. This practice is usually debated by management, as questions arise regarding whether the added fees outweigh the benefits. Although the entity would prefer the cost be less than the loss amount net of any deductible, management will not have a definite answer until the business interruption is analyzed.
Valuing a Community Business Interest
Valuing a business usually requires a professional business appraiser. The professional appraiser would review relevant information for the business, such as financial statements, forecasts and business tax returns, and apply the appropriate valuation methods based on the type of business and the availability of relevant information. There are three generally accepted valuation methods:
- Asset (Cost) Approach: The Asset Approach considers the replacement cost of net assets as an indicator of value, assuming that a prudent investor will pay no more for an asset or group of assets (less liabilities), either tangible or intangible, than the amount for which the investor can replace or recreate such net assets. Historical cost data may be used as a beginning indication of current costs of reproduction or replacement. Adjustments are made for physical deterioration or functional and economic obsolescence of the assets being appraised. Liabilities may be adjusted for contingent or unrecorded amounts, and for above or below market rates. The Asset Approach to value is often appropriate when the current or expected future operating earnings of a subject entity are insufficient to generate a return greater than that which could be generated through the sale of the underlying net assets.
- Market Approach: Using the Market Approach, recent sales of guideline companies or securities are analyzed to determine the value for a similar subject entity or interest. Adjustments may be made to the sales data to account for differences between the interest being valued and the various comparables, and for the timing and circumstances of the comparable sales. The Market Approach is particularly applicable to interests that are homogenous in nature and actively traded.
- Income Approach:
The Income Approach is based on the expected risk/return relationship of an investment. It measures the present worth of anticipated future economic streams of income generated by a subject entity or interest. Net earnings, cash flows, revenues or other streams of economic income are identified or forecasted for a representative period, then discounted to present value using an appropriate discount rate based upon the associated risk of the income stream. The Income Approach is often used to value going concern entities, intangible assets and investments with reasonably predictable returns.
Reasonable CompensationThe values derived using the various valuation methods can be dramatically different after adjusting for reasonable compensation. When it comes to valuing a business in divorce, one needs to consider perquisites, discretionary expenses, personal expenses disguised as business expenses, the various roles and responsibilities of the owner within the business and the possibility of family members or “friends” being paid out of the business but not performing the appropriate level of work for their compensation.
Goodwill value is usually the total value of the business minus the total value of the company’s tangible assets. In states such as Texas, the appraiser is required to separately quantify goodwill for divorce purposes as either “personal goodwill” or “enterprise goodwill.” Personal goodwill is the goodwill that is attributable to an individual’s skills, abilities and reputation. Personal goodwill is not community property, and its value cannot be “divided.” It stays with the individual. However, enterprise goodwill is attached to the business and is typically treated as community property that is subject to division between the spouses.
Assembling the right team is critical.
This is especially true, the more complicated the manufacturing process, or the more unique the industry and its markets. Engaging a technical team familiar with the nuances that exist in both the development of the business interruption damage model, and familiar with the claims process, may be the difference between a relatively short claim and recovery process and a lengthy, challenging process — with or without the anticipated recovery in satisfactory terms.
Fraud & Forensics
In some cases, a business owner going through a divorce may try to conceal or transfer assets, understate revenue or overstate expenses. In these situations, a forensic accountant can conduct a thorough investigation into the alleged fraud.
In short, there are many factors to be considered when valuing a business interest in a divorce. At HSSK we have the requisite valuation, accounting and forensic expertise to provide independent evaluations of business interests for the purpose of equitable distribution in a divorce, whether it is to support settlement efforts in mediation or to testify in front of a judge or jury.