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Distinguishing Methodologies of Business Valuations Used in Divorce Proceedings

By Frieda Gordon, CFLS

In divorce proceedings the valuation and distribution of marital property is one of the most difficult and complicated procedures.  The Community Property or marital interests in business entities must be determined prior to assigning the assets to one spouse or the other.  Obtaining appropriate values for such assets is quite a difficult and expensive process.  The family business, along with the family residence, are usually the most valuable assets of the marital estate.  Both the “in spouse” and the “out spouse” need to know how the judicial officer is going to make a finding of value for the family business.  This entails an understanding of the three (3) most common methods that experts use to determine such value.  For the most part, only valuation experts are qualified to provide evidence of value, both for purposes of settlement, as well as trial.  Often times, different experts will use different methodologies, which then often lead to different opinions.  Each side must use all their powers of persuasion, usually through the expert that they hire, in order to assure that the outcome will be fair and equitable. 

Assessing the Type of Asset will Determine the Methodology Used
Businesses generally own tangible and intangible assets.  Tangible assets include cash, receivables, inventory and equipment. These are physical assets.  Intangible assets include trademarks, patents, copyrights, business goodwill and certain contracts. Each type of asset requires use of a particular standard of value.  Valuations must be determined as of a certain date.  When Parties argue over which date to use, litigation will follow to determine the answer.  This entails that experts provide their opinions of value as of several different dates in order to assist in the settlement process and, unless the issue of alternate valuation date is resolved by motion ahead of trial, to present their conclusions of value as of the different dates to the judicial officer who will then determine the value of the asset itself as of a single date based upon the evidence presented on that issue by the Parties.

There are certain recognized methodologies that utilize complicated forms of analysis which provide the structure for valuating businesses.  Opinions are often quite subjective, which renders the conclusions subject to attack. It rarely happens that different business valuation experts come to the exact same conclusion as to the value of a particular business. 

In a divorce proceeding, sometimes the Parties hire the same expert to make a determination of the community interest in a business and other times each side will hire their own experts to question the integrity of the other Party’s expert in choosing the type of methodology used by the opponent’s expert.  The expert is hired to present an opinion in a formal report and also to testify both in deposition and in court.  These experts need to have the ability to clearly explain their work, provide an understandable analysis and share their unbiased opinions while critically commenting upon and distinguishing from the work of the other expert. The judicial officer has the discretion to decide which value to adopt. 

If one of the spouses is involved in the operation of a business, sometimes he or she might want to use the "rule of thumb" methodology so that he or she might avoid the expense of hiring an expert.  This is commonly the approach used by business brokers to estimate the value of a business entity.  These are not the valuation methods used by evaluation professionals and California courts do not adopt rules of thumb when determining the value of a community business.

The Three Basic Approaches to Business Valuations
Commonly, business valuation experts will use either the asset approach, the income approach or the market approach.  Within these three approaches there are numerous sub-methods to consider. Each approach will work better in some situations than in others and exhibit strengths and weaknesses which can sometimes undermine the conclusions.  Care needs to be given in or to provide the most reliable conclusion of value in any given situation. The business valuation expert needs to consider all three approaches.  Nevertheless, rarely do all three approaches apply.  The business valuation expert may seek to value intangible assets.  The difficulty of finding reliable data to value individual intangible assets is sometimes an impossible task.  The dueling experts will then attempt to persuade, or discredit, as the case may be, the other expert’s opinions, based upon the approaches that were applied and the conclusions rendered by the other expert.

The Asset Approach 
Using the asset-based approach, an expert determines the value of a business, or interests therein, based upon the value of the asset minus its liabilities.  Generally, by using the asset approach, the expert can value all tangible and intangible assets, including all liabilities of the company.  There are several situations where the asset approach may be too complicated to achieve the soundest results.  Certain assets such as cash and accounts receivable, may be valued at approximate book value. However, other types of assets may not.  For example, the value of assets such as plant machinery and equipment seldom is the same as book value. Thus, under these circumstances, separate experts may be required in order to provide appraisals for different types of assets within the company.  Depending upon the inventory type and age, valuing at cost may also not be the same as book value.  Most difficult valuations of all under the asset approach methodology are valuations of the unrecorded assets and liabilities of a comp any, such as goodwill or intellectual property.  Thus, the asset approach is typically the most reliable in such cases as when the business is an investment or holding company.  It may also be used to value very small businesses and/or professional practices where there is little or no goodwill.

The Income Approach 
The income based approach to value business interests uses one or more methods that convert the economic benefits one anticipates receiving into a value that represents single estimated amount.  It is mostly used to value interests in privately held companies.  There are several methodologies experts commonly use within this approach. Primarily an expert will use either the capitalized cash flow method, the discounted cash flow method or the excess cash flow method.  Each one of these methods require a finding stream of future benefits and a rate of return or risk that those projected future benefits will actually be realized.  

In the process of developing an opinion as to the future benefit stream, an expert in this field will collect and review historical data and make certain adjustments to “normalize” the results.  The goal in making these adjustments would be to present what is the “normal operating procedure” in order to project future earnings.  In most privately held companies, it customary for the controlling shareholder to receive compensation in excess of  market rate.  Often one of the significant adjustments a valuation expert will make is to add back excess compensation to the cash flow. The expert must then determine what would be fair compensation, given that controlling shareholder's position and responsibilities.  There are many subjective conclusions that the business valuation expert must make if using the income based approached. 

The Market Approach
A market-based approach is based on a determination of value using one or more methods comparing the business being valued to similar businesses or business ownership interests that have recently been sold.  The theory behind the market approach is that the value of a business can be readily determined by referencing comparable sales of other businesses. People are most familiar with this approach because it is most commonly used by real estate appraisers.  However, while residential real estate appraisers can find many “comps” of homes that have similar qualities, it is much more difficult when valuating businesses to find transactions comparable to the business being valued.  Often, because the business being valued is a small, privately held firm and most transactional information comes from public companies, there are great differences in size, sales, profits and geographic location.  While the market approach is simple to understand, it can often be difficult to find transactions that are truly comparable in terms of the business whose sale is being reported.

There are many various analyses that a business valuation expert's will utilize in his or her report before he or she arrives at a final conclusion of business value. The experts must, where appropriate, include adjustments for control premiums, discounts for lack of control, discounts for lack of marketability or lack of voting rights and the like.  After the business valuation expert has applied all three approaches and arrived at value indications by application of each approach, a determination should be made as to how much weight should be given to each valuation in order to determine a final opinion of value. Once a value has been determined, the expert would normally perform “reasonableness tests” to determine whether his or her opinion makes economic sense.

The number of variables existing in the valuation process cause the process to become complex and unwieldy at times, which sometimes makes the business valuation hard to understand. Unfortunately, there is very little training available to help family law judges understand the intricacies of business valuations. It is imperative that attorneys hire expert well versed in business valuation methodologies and that the attorney also be familiar his or herself with the various approaches.