How is a Business Valued in a Divorce?
Are you and/or your spouse business owners? If you so, a critical aspect of your divorce will be to determine how your business will be divided. The following discusses some of the key considerations for business valuation and division.
How Much is the Business Worth?
Valuing a business can be difficult, and will typically require a business valuation expert if a couple cannot independently agree on how the business will be divided. Unlike publicly-held companies (which can be valued by looking at the current stock price), privately-held businesses are not so easily valued. There are not many factors that must be taken into consideration in the valuation, as well as several different valuation methodologies that exist.
What Business Valuation Methodology Should Be Used for Your Company?
Four business valuation methodologies that can be used include:
- Determining the “Fair Market Value” of the Assets. This approach disregards the business as an ongoing entity, and instead focuses solely upon the value that the assets would generate if sold to an independent third party, less any liens or debts owed by the company. This approach might be appropriate if the business is to be discontinued, and if it is unlikely that there will be a buyer willing to pay more than the asset value.
- Comparing the Business with Similar Business Sales. In this approach, the sales of other similar businesses are considered. The problem with this approach is the price for similar business sales may not be publicly-known.
- Customary Industry Valuation Approaches. Some industries have very specific approaches for business valuation, such as the number of subscribers. If the business to be valued is in one of these industries, then the industry-accepted approach may be appropriate.
- The Net Income Multiple Approach. This approach values a business based upon a multiple of the current net income generated by the business. If the business has annual net income before taxes of $100,000 and the multiple for valuation purposes is 5, the business would be worth $500,000. This formula (or variations of it) are likely the most frequently used in determining business valuation.
How the Net Income Multiple Approach is Used
Understanding the Rationale
The Net Income Multiple approach assumes that business purchasers (investors) are willing to pay some multiple for a future income stream. If this income stream was guaranteed and the investor did not need to do any work to generate the cash flow, an investor might be willing to pay a very high multiple (perhaps 20 times the amount of the expected annual income, or $2 million based upon annual net income for $100,000).
However, since the net income will arise from a business (and is not guaranteed), the buyer of a business must calculate risk when determining the multiple, as well as the cost in terms of the time needed to manage the business. As a result of such risk and management time, the multiple used will be lower than if these factors did not exist (perhaps the multiple might be between 3 and 10). In this case, a business with income of $100,000 per year would be valued between $300,000 ($100,000 times 3) and $1,000,000 ($100,000 times 10).
What Factors May Impact the Appropriate Multiple to be Used?
Clearly the multiple that is used will have a significant impact on the valuation of a business. What, then, should the right multiple be?
The appropriate multiple will be subjective, and will depend upon factors such as:
- What multiples are commonly used in the industry for the business being sold?
- How long has the business been operating?
- Are there significant threats that may impact future earnings?
- Are the earnings increasing or decreasing?
- How dependent are the earnings on one or more of the founders or owners?
Are the Earnings Increasing or Decreasing?
Business profits rarely remain constant. They may increase or decrease from year-to-year and season to season. At the end of a year, there may be reason to believe that the profits for the following year will increase substantially as the results of factors such as new contract acquisition, business expansion, the development of a major product, or new employee hiring. The outlook for a business may also be negative, as the result of increasing competition or other factors.
In determining the appropriate multiple to be used, business valuation experts will want to likely consider the answers to these and other questions to understand the factors that may impact future net income and therefore the appropriate multiple to be used.
How Much is the Continued Business Success Dependent Upon the Owners?
While the continued income of any business will be dependent upon the leadership and management decisions, there is a big difference in how critical specific people will be to the continued success of a specific business.
At one extreme, professional businesses (such as those of attorneys and physicians) will be highly dependent upon the owners. Unless the owners have created substantial goodwill in their name or by including other professionals that will continue to carry on the business after the business is sold, the business may have little or no value if the professionals are no longer associated with a business. As an example, obviously a medical practice will not have any ongoing business value without a practicing physician.
At the other extreme, some businesses are perfectly capable of functioning successfully without the current owners, so long as the new owners are adept at managing a business or can hire someone who is. In this case, the customers of the business will continue purchasing the products or services from the business, even after the original owners are gone. In this example, a fast-food franchise may continue to operate smoothly when new owners take over.
Retaining a Business Valuation Expert
In both the litigation process and at trial if necessary, it is critical to retain a business valuation expert with solid credentials in seeking to make your case. Ultimately, if the valuation of a business goes to trial, it will be the opinions of the experts – and not an owner’s subjective feeling about the valuation of a business – that will determine the outcome.
A solid business valuation expert will usually have substantial experience in advising clients in determining fair valuation for the purchase or sale of a business. They may also have experience as business brokers in conducting purchases or sales of businesses directly. As an example, if the business at hand is a fast-food franchise, an expert in this area may have personally helped broker the sale of a number of fast-food franchises, and thus will be able to provide an expert opinion as to the value of the business.
A business valuation expert will also likely have experience in examining the financial statements of companies being valued, understanding the risks inherent in the ongoing operations of such a business, and determining the value of the assets (including contracts, intellectual property, and other rights) that are critical to the continued success of the business. They will also want to understand the customer relationships of a business, such as whether the business depends in large part on one or two customers (which can make a business more risky), or whether the business has hundreds (or thousands) of customers which may lower risk because of a diversified income base.
When this information is understood, a business valuation expert can then determine an appropriate multiple to be used or advise on another way in which the business valuation should be determined.
What is the Interest of the Owners in Continuing the Business?
Aside from calculating the value of the business, an important question to consider is the interest of the spouse (or spouses) in continuing to operate the business.
In many cases, one spouse may be the primary (or sole) operator of the business, and that spouse may wish to continue operating the business following the divorce. In these cases, it may be in the best interest of both spouses that the spouse who will continue in the business buy out the other spouse for an agreed-upon price.
The buyout “price” can be paid in many forms – it can be a direct cash price, it can offset other property distribution, or the price may be paid off in installments over one or more years. As with other matters involving complex property division, it may be helpful to engage a tax advisor in determining the best structure for such a buyout.
In other cases, both spouses may wish to continue to operate a business. If both spouses are agreeable to such as arrangement (which is rare), documentation can be drafted to ensure that both spouses are the legal owners of the business, and that additional agreements (such as “buy-sell agreements” or “shareholder agreements”) be drafted to protect the interest of the spouses in the event that business disputes later arise.
Lastly, there may be situations in which neither spouse wishes to operate the business after the divorce. In these cases, a business broker may be retained to sell the business, with the proceeds to be divided among the spouses as may be agreed upon or as ordered by the court. In these instances, one factor that may sometimes be difficult will be agreeing to the sales price – one spouse may be agreeable to an offer, while the other spouse may want to hold out for more money.
How I Help Divorcing Spouses When a Business is Involved
If your divorce involves a business, please contact me. I help clients identify their goals and objectives for their business, locate a highly qualified business valuation expert, and work tenaciously in seeking to obtain their desired business outcomes.