Simply put, the task of valuing a closely held business for divorce purposes is to start with the income statement, value the benefit stream, and then to make adjustments. Oh, if it were only so easy.
- Start with the income statement
- Value the benefit stream
- Make adjustments
- Dutch Auction
- Special considerations for the professional practice
- Special considerations for the family limited partnership
- Special considerations when one person is key
Audited financial statements have an extra measure of scrutiny from a CPA, but most of the financial statements used forvaluing businesses in divorce will be unaudited. There is no inherent problem with unaudited financials, but it is helpful to know the purpose for which they were prepared.
To cite two examples at either end of the spectrum, statements prepared to share with a bank to support financing will usually be optimistic, and statements prepared to defend an estate tax valuation will be pessimistic. The task of the valuator is to “normalize” the earnings from whatever raw product is available.
As discussed above, ownership of a business brings with it a cluster of benefits, including not only the income of the business but also the eventual sales proceeds and various non-cash “perks.” The valuator uses a discount rate (sometimes several different discount rates) to reduce the stream of future benefits to their present value.
The discount rate used is a science in and of itself. Briefly, the discount rate is a combination of a “safe” rate, equivalent to the investment rate of return an investor would demand from a typical business investment, and a risk premium designed to compensate the hypothetical investor for the additional uncertainty flowing from a closely-held, often undercapitalized business. Click here for more information on the discount rate.
The possibilities here are limitless. Here are some of the most common adjustments:
- Related party transactions. A great example here is the business that rents office or shop space from the business owner. You can almost take it to the bank – the rent will be set based on the debt service and taxes, not on the actual rental value of the facility.
- Non-cash items. Business owners are allowed to claim against their tax return and for book purposes depreciation and amortization on their permanent assets. This depreciation and amortization may or may not be anchored in reality.
- Unreported income. Like it or not, it’s the fact that owners of cash businesses have a strong temptation to divert some of the cash so that it never makes it onto the income statement. A good valuator will be able to apply some simple rules of thumb to test the accuracy of some key ratios within the business. This will tell the valuator whether there’s some cash that disappearing as it comes across the transom.
- Unrelated expenses. These are the things like the cell phone that gets charged to the business, the condo that gets charged to the business, the country club membership that the business pays. They are benefits the owner enjoys from the business that make the business appear less successful than it really is.
- Compensation paid to owner and family. This is really just a sub-category of unrelated expenses, but it’s important enough, and used frequently enough, that it deserves its own grouping. Businesses have to pay their employees a reasonable wage to keep them working. When owners are trying to depress income, however, they may beef up their own and their family members’ compensation to reduce bottom-line income.
- Discount (or adjustment) for minority interest (or premium for control). You don’t want me to go into it all here. Just understand the key concept that a 51% ownership interest of a small business is worth a great deal more than 51% of the total business value. By the same token, a 20% ownership interest of a small business is worth a great deal less than 20% of the total business value. That’s because the person who controls the business can decide where it rents space, how much salary it pays its employees, from whom it buys raw materials, when it distributes earnings, and a bunch of other issues that can translate to real money. There’s a separate heading dealing with the discount for a limited partnership interest.
- Discount for lack of marketability. One of the reasons it’s so appealing to invest in the stock market these days is because there’s a ready market if you want to sell your shares. That’s the not the case with a small business. The universe of possible buyers for a closely held business is typically small, so the stock value may have to be adjusted for the difficulty of locating a serious buyer.
- Accounting method. Businesses are usually pretty careful about whether they use the cash or accrual basis of accounting. Depending on the industry, a shift in accounting method might bring about a huge change (for a family business, usually a positive change) in the business’s income.
- Inventory method. By the same token, a business can enhance or depress its income depending on how it values inventory – that is, whether it uses FIFO (first in first out), LIFO (last in first out) or some kind of hybrid. There’s also a great deal of attention that should be paid to the size of what’s called the LIFO reserve.
- Recent drop-off in performance. You can almost depend on it. In divorce, the performance of commission salespeople drops off, and the performance of closely-held businesses falls too. The business owner often has a legitimate explanation, like market conditions. Also, as you know, divorce diverts your focus. People who have been watching their business carefully for years may almost ignore it for months at the time while they struggle with divorce. And yes, it’s also true that nearly every entrepreneur going through divorce can tell you why the business is worth a great deal less than it seems. There’s some competitor on the horizon, or some cost about to explode, or some sea change afoot in the marketplace, that threatens the continued profitability, if not the very existence, of the business. I’m not trying to be cynical, but you really can count on it. A good valuator can usually weed through this to the essential truth that lies beneath it.
Sometimes the parties are simply not able to agree on value, but they may realize that the business value isn’t enough to make a professional valuation worthwhile. In these cases, a Dutch auction may be helpful.