Posted September 30, 2018
Starting and operating a small business is much easier today than ever. And while success and profits might prove elusive, a business valuation for divorce is a critical component to divorce separation agreements. The variety of businesses makes valuation for divorces more challenging as well- consulting gig versus internet sales versus landscaping company versus interior designer. Regardless of the complexities, there are acceptable techniques for providing an accurate business valuation for divorce settlements.
Three Business Valuation Approaches
There are three basic approaches to providing a valuation regardless if it a business valuation for divorce or sale. They are-
These approaches are generally self-evident by name, but we’ll briefly run through these.
This approach focuses on the valuation of the underlying assets. While the book or depreciated value of the assets is quickly discernible, the fair market value of each asset is much more accurate. Consider an eye laser machine used in a medical practice- commonly accelerated depreciation is taken, but the machine might have a fair market value that is much higher. Having said that, it might be too onerous to get appraisals and valuations of each underlying asset and book value is the most efficient way.
The Income Approach focuses on the economic benefit that the business produces. Under this approach are two primary methods- Discounted Future Income method or Capitalized Economic Income method. The differences between these two methods is subtle, and is beyond the basics of our discussions- basically if the income varies wildly either as inconsistent or rapid growth, or if there is not enough historical data to adequately project the future, then the Discounted Cash Flow (DCF) method is preferred. In a theoretical and mathematical sense, DCF and Capitalization can be identical.
This approach can take on many different methods. If the small business is publicly traded, this approach can be useful. Or, if there are comparable sales of similar businesses in the same demographic, the market approach is once again useful. There are other considerations within these approach such as industry practices. For example, financial advisors typically sell their books of business for about two times the revenue. Tax and accounting firms sell for a multiplier of 1.1 to 1.4 of gross revenue. While these two examples were based on income, the historical comparable sales are what the market was willing to bear.
A good business valuation will compare all three approaches to determine a final value or value range. And this is where we run into problems in the business valuation divorce world. Why? Let’s say you are an interior designer which is a very personalized business. What is the market value to a willing buyer? Close to zero. How about your tangible assets? Close to zero as well. But the business has value otherwise you wouldn’t do it, and therefore it is marital property that must be assigned a value. Enter the Capitalization of Excess Earnings method which is a hybrid between Asset-Based and Income approaches.
As an aside, the Bench Bar Book from the Colorado Bar Association lists four headings as Income Approach, Market Approach, Discounted Cash Flow (DCF) and Cost/Asset Approach. It is unclear if the book intends to suggest that Discounted Cash Flow is a separate approach- in practice, it is a method under the Income Approach. The Bench Bar Book is a handy book for judges and divorce lawyers to quickly find references to generally accepted practices and case law.
Divorce Business Valuation
The Excess Earnings method is a common technique for divorce business valuations since it allows for a simulated value of goodwill. Why does this matter? Consider our interior designer example above- this small business might not a fair market value since it has no assets and is very personalized. However, an interior design business might have significant value to the owner, and if this owner is getting divorced, most divorce courts will consider the value to the owner has marital property.
You are thinking, “Huh? If I cannot sell my business how can it have value?” Theoretically if the business is valuable to you, it is valuable to the marriage. And if that marriage is ending, the value to the marriage must be determined and separated. This is also referred to as Investment Value (as opposed to Fair Market Value).
So the core of the Excess Earnings method is to determine the intangible value beyond the assets and income. We call this goodwill, and once calculated it is added to the tangible assets to come up with the overall value. Here is a quick example-
|Net Tangible Assets||500,000|
|less Earnings Attributed to Tangible Assets (500,000 x 15%)||(75,000)|
|Capitalized Excess Earnings (225,000 divided by 25%)||900,000|
Seems simple. And because of its implied simplicity, the Capitalization of Excess Earnings method is sometimes referred to as the formula approach (see IRS Revenue Ruling 68-609). However, it is not simple. There are all kinds of challenges with using this method.
What are Net Tangible Assets? Net of what? So the first entry to the formula requires a valuation of the tangible assets, either through appraisal, financial records, or both.
Normalized Earnings also its challenges. Many business valuations for divorce do not factor the owner’s compensation or personal fringe benefits being paid by the company. And, the word normalized also creates a headache- what if the business is growing rapidly or has uneven incomes? The capitalization of earnings relies on consistent income or at least consistent growth- if there is acceleration (or deceleration) or large variations, capitalization cannot work and perhaps a discounted future earnings methodology is preferred.
What rate of return should be used for the earnings attributed to tangible assets? Do we group them together such as a blended rate, or parse out each asset individually?
Lastly what capitalization rate should be applied to the excess earnings? More subjectivity. In practice the more risk involved with the future income, the higher the “cap” rate. If the risk is low and the future income can be relied upon without much detriment, then the capitalization rate is lower. While the IRS Revenue Ruling 68-609 suggests a 15% to 20% rate, most divorce business valuations will use a rate that is prudent to the business being analyzed.
Here’s another aside- IRS Revenue Ruling 68-609 was an update to a 1920 Appeals and Review Memorandum (ARM), ARM 34. The U.S. Treasury cited the Excess Earnings method to be used in calculating reparations to breweries during Prohibition. It might not make you feel better, but the valuation technique for your small business in divorce proceedings can find origins in the beer industry. Fun!
Business Valuation Professional
There are thick books and long conferences on the subject of business valuations. While most divorce attorneys believe they can accurately divide marital assets between houses, cars and retirement accounts, thankfully most lawyers leave divorce business valuations to the experts.
Jason Watson is the Managing Partner of the Watson CPA Group, and provides small business consultation and valuation for divorcing couples. He is also a Certified Divorce Financial Analyst, and assists divorce lawyers in the financial aspects of marital property and separation agreements.