Special Considerations in Business Valuation

One of the many reasons it’s so difficult to place an accuratevalue on a closely held business in divorce is that the rules vary dramatically depending on the kind of business. Here are three examples: the professional practice, the family limited partnership, and the business where one person is key.

Special Considerations for the Professional Practice

The key issue that arises with a professional practice is the goodwill of the enterprise. Goodwill is always an issue in any business valuation, but it may constitute more than half the value of a professional practice, because the hard assets of the enterprise are often relatively small.

One way to calculate goodwill is to use the “excess earnings” method. This involves calculating a hypothetical “normal” earnings that would be expected given the hard assets in place. Any earnings above that hypothetical figure must by definition be “excess” earnings, attributable only to goodwill. Capitalizing this excess earnings figure will yield the value of goodwill.

Another method of valuing a professional practice, gross but simple, is simply to take a multiple of annual billings. This multiple ranges from 75% to 150%, depending on the nature of the practice and the quality and consistency of the firm’s client base.

Special Considerations for Intellectual Property

When the business or either spouse owns a patent, trademark, copyright, or trade secret, husbands and wives often disagree about its value when they’re going through divorce. The issues are complex enough and appear often enough that I added a separate page on Valuing Intellectual Property in Divorce.

Special Considerations for the Family Limited Partnership

When the family business is held in the form of a Family Limited Partnership (FLP), the adjustment of the value depends on whether the interest being valued is that of a general partner or that of a limited partner. Limited partners generally have less say in the management of the enterprise. For example, they can’t force the partnership to go into dissolution, they can’t change the partnership agreement, and they can’t remove a general partner. Perhaps more importantly, they have little day-to-day control over the business. This means they can’t decide which vendors from which to buy goods and services, whom to hire and whom to fire, how much compensation to pay to employees, or when to make a distribution to partners. For this reason, a limited partnership interest is generally worth less than a general partnership interest.

In addition, again because of those control factors above, a limited partnership interest may be much more difficult to sell. It may be harder to sell to outsiders, and even harder to sell to anybody else within the partnership. Also, FLP’s are often structured so that a limited partner can’t sell his or her interest without the approval of one or more general partners.

If a limited partnership interest is worth less because of all those factors described above, by simple mathematics, that means a general partnership interest in an FLP is worth more, because it carries with it all those controls that are absent for the limited partner. What this means, of course, is that the owner of a general partnership interest in an FLP enjoys a premium in the value of his or her interest.

Special Considerations When One Person is Key

In most (but not all) states, the business asset to be valued in divorce is not the total worth of the enterprise but the value of the enterprise severed from the labors of the person going through the divorce. That is, if this person were gone, what would the company be worth?

Valuing the business becomes a process of imagining it without the key person, the business owner. Here are the key functions to analyze:

  • Sales and Marketing. This is a no-brainer, of course. Who are the key customers of the enterprise? How would they respond if the business owner were no longer involved with the business? Would they shorten the terms of their contracts? Would they be less likely to place deposits for orders? Would they be concerned about quality and therefore line up a competing source as a safety valve?
  • Credit. Does anybody besides the business owner know how reliably and how quickly customers pay? Whom to call with key customers to get invoices moved to the top of the stack?
  • Suppliers. From whom does the enterprise purchase goods and services? Would they stiffen payment terms if the owner were gone? Would they take advantage of a new owner by raising prices or letting quality slip? Does anybody besides the owner know who all the suppliers are and how to contact them?
  • Operations. Does the owner have knowledge of the production systems that nobody else can match? Can anyone else “tune” the systems? Does anyone else know whom to call for repairs, servicing, upgrading, and replacing components? Is the owner the only one who really knows how to program the computer(s)? Is the owner accustomed to spending large amounts of time supervising the production systems, time that would have to be compensated if somebody else had to do it in the owner’s absence?
  • Staff. Does the work force have confidence in the owner that keeps them anchored, so that there might be an exodus (or a demand for greater security or higher pay) if the owner left? Would staff take advantage of a new supervisor by slowing down or by stealing from the enterprise?

Click here for the page on valuing a family business.

Click here for a quick primer on business valuation.