Abstract: Splitting up a marital estate can be a long, complicated process. This article discusses questions about valuation that business owners typically have during the divorce process — and how valuation experts can help simplify matters. A sidebar looks at one case that illustrates the importance of obtaining a valuation conducted by such an expert.
Lacoste v. Lacoste, No. 2014-CA-01724-COA, Miss. App., July 19, 2016
Valuation takes center stage when business owners divorce
Splitting up a marital estate can be a long, complicated process, particularly if it includes a private business interest. Fortunately, a valuation professional can provide answers to these critical financial questions:
How much is my business interest worth?
There are three ways to value a business: the cost, market and income approaches. All of these techniques start with the company’s financial statements. But discovery shouldn’t stop there, especially for spouses who aren’t involved in day-to-day business operations. Valuation experts should be given equal access to financial records and opportunities to tour the company’s facilities and interview management. Inadequate discovery can cause an expert to miss critical information and possibly lead to inaccurate value opinions.
Another related question is: How much of the value should be included in the marital estate? If the business interest was owned before the marriage, it might be appropriate to include in the marital estate only the appreciation in value over the course of the marriage, depending on the facts of the case and relevant state law. Estimating appreciation in value requires a comparison of the current value of the business interest vs. its value on the couple’s wedding day.
Does the asset allocation overlap with maintenance payments?
Another reason to exclude a part of the business’s value from the marital estate relates to the concept of “double dipping.” This may occur when a spouse receives double recovery for a single asset. For example, courts in some states have decided that it’s inequitable for a spouse to receive maintenance payments based on his or her spouse’s future income, along with half of the value of a business that’s based on its ability to generate future income.
In states that find double dipping unfair, the value of the business’s goodwill (or a portion of it) may be specifically excluded from the marital estate. Before goodwill can be excluded, however, it must be valued. Often, this requires goodwill to be split between personal and business goodwill. The former is linked to the individual owners and their abilities to generate future income. Usually personal goodwill is based on the individual owner’s ability to generate income and can’t be transferred to a third party.
Is the controlling shareholder hiding anything?
A controlling shareholder spouse may try to hide income or assets to achieve a more favorable divorce settlement. Downplaying assets and income (or, conversely, exaggerating liabilities and expenses) can lead to 1) lower business valuations, and 2) reduced payments for child support and alimony — unless the valuation expert identifies the anomaly and makes an adjustment to record the value of the missing or inaccurate item(s).
Reasonable “replacement” compensation — based on the market value of the owner’s contribution to the business — is a common adjustment that’s made in divorce cases. Additionally, some business owners try to deduct their personal attorney’s fees or expert witness fees as business expenses. Running personal expenses through the business not only reduces the value of the business interest, but it could also expose the noncontrolling spouse to IRS inquiry.
Other adjustments may be needed to normalize the income stream to benchmark the subject company against comparable companies. Examples include adjustments for nonstandard accounting practices (such as cash-to-accrual basis of accounting changes) and for nonrecurring income or expenses (from, say, a discontinued product line or the sale of a nonoperating asset).
If your marital estate includes a business interest, it’s probably one of the biggest line items on your personal balance sheet. A fair settlement hinges on an accurate valuation. That can be achieved by hiring an experienced valuation expert who understands how courts handle challenging divorce issues in your jurisdiction.
Sidebar: Why an appeals court requested an expert valuation
At trial, the parties in a divorce case might not be required to present expert valuations of marital assets. But Lacoste v. Lacoste, a Mississippi appellate court ruling, shows why it’s a good idea to hire an expert from the start.
Here, the husband owned and operated a fitness training company. Although the business was the couple’s main asset and source of income, neither spouse presented valuation evidence.
Left to her own devices, the chancellor hearing the case decided that the income approach was most appropriate for valuing the business. She noted that a valuation professional would review the company’s historical earnings, adjust the income to reflect normalized earnings and divide the normalized earnings by a capitalization rate. Lacking such testimony, the chancellor valued the business using the only information she had: one year’s income statement.
The husband appealed, arguing that the chancellor had erroneously valued the business. The appellate court found the chancellor had done the best she could with the evidence presented, but it reversed and remanded the case for an adequate valuation. The court determined that a valuation was so important here that it was essential to obtain further testimony by the parties, their experts or an independent expert appointed by the chancellor.