Valuing a Business in Divorce: Insights from Business Valuation Advisors

In any divorce proceeding, two critical financial questions inevitably arise: "What are the assets and debts of the marital estate?" and "What is the income available for support?" These questions are often straightforward when both spouses earn their income through traditional employment. However, when a business or multiple businesses are owned within the marital estate, the complexity increases significantly. The value of the business becomes a challenging issue, and the income derived from it often requires extensive discovery and analysis. This is where the expertise of Business Valuation Advisors becomes indispensable.

Understanding Business Valuation in Divorce

Many divorcing couples are surprised to learn that a business they own, even if it's a small operation with no employees generating self-employment income, must be valued to determine an equitable asset split. Any goodwill value associated with the business is subject to this division. Business valuation in divorce is crucial because it impacts both of the primary financial issues—assets and income. The business itself is an asset that must be equitably divided, and it is often the primary source of income for the family, which forms the basis for marital and child support.

Given these dual roles, it is typically most efficient for family court attorneys to retain the same expert to address both issues. This ensures consistency in the valuation process and helps avoid potential conflicts in the assessment of income and asset values.

The Income Approach to Business Valuation

The most common method used to value a business in the context of divorce is the income approach. After paying for all business expenses and taxes, this method involves capitalizing on the free cash flow the business generates. There are two primary ways to do this: by capitalizing income or by determining "excess income" and capitalizing the portion associated with intangible assets.

Under either method, it's essential to include the market value of services provided to the business by the divorcing spouse as part of the business expenses. If profit distributions are considered part of the business owner's compensation, an adjustment is necessary to reflect the operating cash flow available from the business before any profit distributions. This adjusted cash flow is then used to determine the business's value.

This adjustment is where the interaction between income and asset value becomes critical. The challenge in divorce cases is that alongside the issue of valuing the business is the question of determining spousal and/or child support. It is crucial to avoid using the same income to both value the business and determine support—commonly known as double-dipping, which is generally considered unfair.

The Issue of Double-Dipping

Double-dipping occurs when the same stream of income is used both to value a business and to calculate support payments. This practice is widely regarded as unfair because it effectively counts the same income twice, leading to inflated support obligations or distorted business valuations.

Understanding the separation of cash flows between those generated by the business and those produced through the personal efforts of the owner is key to achieving a fair outcome in a marital dissolution. Failing to recognize this distinction, or not engaging an expert who does, can result in unjust and inaccurate results.

Challenges in Valuing Closely-Held Businesses

In closely-held businesses, it is common to see reported profits at or near zero due to powerful tax and cash flow motivations to minimize taxable income. This is often achieved through strategies such as bonuses, perks, and personal expenses that are run through the business. As a result, the role of the valuation expert becomes critical in identifying the total compensation of the owner, which serves a dual purpose in divorce proceedings.

Once the total compensation is determined, the expert will allocate it between "reasonable compensation" for the services provided to the business and profit distribution. The profit distribution is then used to value the business, while the compensation forms the basis for support calculations.

Illustrative Example

Consider a scenario where a husband draws $500,000 annually from the business, leaving a reported profit of zero. The appraiser's task is to determine whether the services provided to the business are fairly valued at $500,000. In many cases, the appraiser might conclude that only a portion of this compensation reflects the value of the services provided, with the remainder being deemed as profit distribution.

For instance, if reasonable compensation is determined to be $200,000, the business’s value would be based on an annual net income of $300,000. Support calculations would then be based on annual compensation of $200,000. This approach avoids the unfair result that would occur if the entire $500,000 were used for both support and business valuation.

If the appropriate capitalization rate for the business is 25%, the business would be valued at $1,200,000 ($300,000 ÷ 25%), with income available for support set at $200,000. However, if reasonable compensation were deemed to be only $75,000, the business value would increase to $1,700,000, and the income available for support would be $75,000.

Role of Valuation Experts in Divorce Negotiations

The role of valuation experts in divorce negotiations extends beyond merely providing a business’s value. These experts are instrumental in helping attorneys and their clients understand what is likely to be the court’s conclusion. If the case proceeds to negotiation, the valuation expert can assist in calculating the impact of various allocation scenarios on each party. This support is crucial in reaching a fair and equitable settlement.

Expectations and the Knowledge Gap

One of the primary drivers of litigation in divorce cases involving a closely-held business is the gap in expectations between the "in-spouse" (the spouse involved in the business) and the "out-spouse" (the spouse not involved in the business). This gap often stems from a lack of understanding that income can only be used once, as well as differences in knowledge about the business’s operations.

The in-spouse typically asserts that all revenue has been reported and all expenses are legitimate business expenses, while the out-spouse may suspect that some revenue has not been reported (especially in cash businesses) and that personal expenses have been deducted as business expenses for tax purposes. This is another reason why many family law practitioners prefer to use a single expert for both income and business valuation. A unified approach to discovery is more efficient and ensures that all relevant information is considered.

Conclusion

In divorce cases involving a business, the interplay between business valuation and income determination is complex and requires careful analysis. Engaging an experienced valuation expert is essential to ensuring that these issues are addressed accurately and fairly. At Business Valuation Advisors, we specialize in providing the expertise needed to navigate these complexities and achieve equitable outcomes for all parties involved. Whether you're facing a divorce or need assistance with any business valuation matter, we’re here to help you understand the process and secure a fair result.

By retaining the right experts early in the process, you can avoid the pitfalls of double-dipping, ensure that business valuations are accurate, and achieve a fair division of assets and income. Contact us today to learn more about how we can assist with your specific needs.