DIVORCE VALUATIONS FOR BUSINESS & REAL ESTATE
Divorce appraisals, assets including business & real estate disputes involve many decisions,
including "Who gets what"?
In a divorce there are generally two options regarding disposition of the property - it can be sold and the proceeds divided, or one party can "buy out" the other. In either case, one or both parties should order a divorce appraisals as of the date of separation. Preparing an appraisal for divorce settlement requires a valuation expert that can support a defensible opinion in court. Just like choosing a doctor, attorney at law, accountant, CPA, or estate planning professional it is wise to review the qualifications of a divorce appraiser when the divorce involves any kind of businesses, residential, industrial or commercial real estate.
It is strongly recommended by
most professionals in a divorce that before any settlement agreement is finalized, the parties seek consultation with a tax attorney or tax professional to review the tax consequences.
If you are divorced or separated from your spouse and have business or real property, it is important to obtain an appraisal that is acceptable to both the IRS and a defensible appraisal that can also be used by your attorney in a settlement proceeding, mediation, or arbitration matter. In both of these instances, selection of a qualified appraiser is very important.
IRS guidelines state that
a real estate appraiser or business appraiser (the principal of Alpha Appraisal Consulting Group is qualified to do both, business & real estate) must be qualified under Treasury Regulations Section 1.170A-13(c)(5). In addition, you should find an experienced divorce appraisal expert and one that is familiar with IRS Business Valuation Guidelines and IRS Real Property Valuation Guidelines.
For example, Treasury Regulation Section 20.2031-1(b) requires the appraiser to follow certain guide lines when preparing a qualified appraisal for federal and state tax filing.
We also know how to handle the sensitive needs of divorce situation. It is equally important that you select a business/real estate appraiser who has the experience and knowledge necessary to prepare appraisal reports according to IRS Valuation Guidelines.
Divorce attorneys and accountants handling a divorce rely on a experts in business valuation or real estate valuation when calculating property & business values for estates, estate tax return filing, divorces, marital disputes, bankruptcy, or partnership dissolutions.
As business and real estate appraisers we understand divorce parties needs and we are used to dealing with all parties involved. We can prepare business valuation, residential home, commercial income property, and industrial real estate reports throughout the State of Washington that are in compliance with the Uniform Standards Of Professional Appraisal Practice (USPAP).
If you are a family law divorce attorney handling division of property or business, your needs often times include hiring an appraiser to establish "Fair Market Value" (FMV) and to provide expert testimony for appraisal purposes. Many times the divorce date differs from the date you order the appraisal. In those situations, we are familiar with the procedures and requirements necessary to perform a forensic retrospective appraisal with an effective date and "Fair Market Value" (FMV) opinion matching the date of separation.
The ethics provision within the Uniform Standards of Professional Appraisal Practice (USPAP) binds us with confidentiality, ensuring the fullest degree of discretion.
AVOIDING PITFALLS OF BUSINESS VALUATIONS FOR DIVORCE
I: USE OF A VALUATION METHOD NOT ACCEPTED BY THE COURTS
A. Market Value Method
A common error in the valuation of businesses - particularly with appraisers who are unfamiliar with the practice of family law - is the application of the market value method to privately-held companies. Using the market value method, the appraiser simply applies to the business being valued the price-earnings ratio of a comparable public company.
For example, if the business being valued is a cosmetic company, and publicly-held cosmetic companies are selling for twenty times earnings, then the subject cosmetic business would be valued by multiplying by twenty its annual earnings. If the current market price of a publicly-held cosmetic company were $50 per share, and there were ten million shares of stock outstanding, then the market value of the company would be $500 million. If the marketplace currently expects that the company will have annual earnings of $100 million dollars, then the price-earnings ratio would be 500 to 100, or 5 to 1. Using this approach, the privately-held cosmetics company with $2 million in earnings would be valued at $10 million, by using the price-earnings ratio of 5 to 1, or five times annual earnings.
Two cases, In Re Marriage of Lotz (1981) 120 Cal.App.3d 379, 174 Cal. Rptr. 618, and In Re Marriage of Hewitson (1983) 142 CaI.App.3d 874, 191 CaI.Rptr. 392, have held that relying solely on the price-earnings ratio of publicly-traded corporations to value privately-held companies is error. These cases have reasoned that one cannot compare the stock of a business owned by a single shareholder, responsible to no one, that cannot be easily sold, to a company that is publicly-held and easily sold. Furthermore, an owner of a private company may eliminate most of the corporate profits by paying himself a large salary; a public company will not arbitrarily eliminate profits by paying out large salaries.
B. Discounted Future Earnings Method
Another valuation method that is occasionally used is the "discounted future earnings method." This method equates the value of a company to the present discounted value of the company's expected future earnings. The evaluator, for example, may determine that the company will earn $2 million in the two years following valuation, $2.5 million in the next two years, and $3 million for each year thereafter. The present discounted value of those millions, after adding in the residual value of the business at the end of the cash flow stream, constitutes the business' value.
This approach, while acceptable as a valuation method for certain businesses, should not be used in valuing a professional practice. As the court in Marriage of Fortier (1973) 34 CaI.App.3d 384, 109 CaI.Rptr. 915, held: "Since the philosophy of the community property systemis that a community interest can be acquired only during the time of the marriage, it would then be inconsistent with that philosophy to assign to any community interest the value of post-marital efforts of either spouse." In Re Marriage of King (1983) 150 Cal.App.3d 304, 197 Cal. Rptr. 716, similarly rejected a valuation where the appraisal was "replete with references to post-separation efforts of husband."
II. USE OF VALUATION METHODS THAT DO NOT INCLUDE ALL OF THE ASSETS OF THE BUSINESS
There are certain accepted formulas and rules of thumb often used in valuing a small business. An appraiser relying on a particular formula or rule of thumb should keep in mind that many formulas addressing the valuation of small businesses do not necessarily consider all of the assets of the business. For example, one formula used to value a retail auto parts business produces an indicated value for the fixed assets, the lease and the "intangibles" of the business, but it omits from the valuation the company's cash in hand, accounts receivable, prepaid expenses and all of its liabilities. Another method produces an indicated value for the company's lease and intangibles, but omits from the valuation the fixed and current assets of the company and the business' liabilities.
Similarly, the calculation of goodwill may be so complicated that it becomes the exclusive focus of attention. In one recent trial court case, an appraiser ended up using goodwill alone as the value of the business, inadvertently omitting consideration of all other assets and liabilities.
III. APPLICATION OF VALUE MULTIPLES TO THE WRONG INCOME STREAM
Certain valuation methods use income multiples to determine goodwill. In one industry, for example, goodwill may be a multiple of the company's earnings. To properly figure goodwill, however, an appraiser will need to determine whether goodwill in that industry is based on after-tax or pre-tax earnings. The difference may be significant. Imagine, for example, that a company's pre-tax earnings are $100,000 and the after-tax earnings are $70,000.
The difference in the goodwill value, at five times earnings, will be $150,000 - the difference between $500,000 and $350,000 - a thirty percent error.
Similarly, in applying valuation methods that use a multiple of gross revenue, one should guard against the inadvertent use of a multiple of net income, or the use of income where cash flow instead is required.
IV. OMISSION OF MINORITY DISCOUNTS
Imagine two identical businesses, with the same sales and profits, except that Company A is owned by a single stockholder, whereas Company B is owned equally by five shareholders. A valuation of both businesses concludes that each company is worth $25 million. The stock of Company A's sole stockholder is accordingly worth $25 million. Presumably, the stock of Company B's five equal shareholders is also each worth $5 million.
The valuation assigned to Company B's shareholders' stock is wrong. The value of each of Company B's shareholders' stock must be discounted because each stockholder has only a minority interest in the company. The Company B shareholder cannot dictate company policy (unlike the sole stockholder of Company A) and he cannot control profits (as can Company A's stockholder). To illustrate this, assume that the sole stockholder of Company A sold his shares to a new owner on the express condition that the new owner could not change sales policies, production methods, personnel or purchasing practices. The new buyer would technically own Company A, but he would have no real control over it.
Presumably, he would pay much less for the stock than if he were able to run the company however he chose. The new owner is simply a passive investor; if he had true control over the company, he would be an active owner. A passive investor will pay less because he has no control over his investment.
V. FAILURE TO CONSIDER UNIQUE EVENTS
In calculating goodwill, a common practice is to average the more recent years' income and expenses to arrive at an average net income, which then forms the basis for a goodwill calculation. In calculating goodwill, it is usually appropriate to eliminate all atypical income and expense for the company, because the purpose of the valuation is to determine the value of the business without the effect of unusual events which might cause temporary fluctuations in the market for the goods or services.
A prospective buyer, for example, would probably ignore unusual occurrences such as earthquakes, floods and fire in determining business value. The buyer will want to know the value of the business under normal circumstances.
The appraiser must therefore eliminate the effects of unusual, non-recurring income or losses from the company's financial statements. For example, the costs of non-recurring litigation should be "normalized" by the appraiser, as should the financial effects of an earthquake. The appraiser should determine if anything unusual has happened during the years being considered, and the necessary adjustments should be made.
VI. FAILURE TO ADJUST GOODWILL TO RISK FACTORS
Goodwill is usually found where a business both generates and appears likely to continue generating income which exceeds the norm for that type of business. One commonly-used goodwill calculation incorporates at least two steps - a determination of the business' excess income and an assessment of whether the excess income is likely to continue. An appraiser may be valuing an accounting or legal practice using methods that are perfectly appropriate to the valuation of those practices, but the result will be flawed if those practices are unusual in nature.
For example, a law practice may be highly specialized with a unique referral source. A law firm focused primarily on asbestos litigation, for example, which was at one time a lucrative area of practice, typifies the problem. The likelihood of continued future earning at previous levels in such a firm would be much different from the earnings of a law firm with a wide area of practice which is not dependent on a single or atypical referral source.
A manufacturer may be very successful, and his product may be similar to others in the industry, but the success may be dependent on a patent that is about to expire. A retail store may be very successful, but the neighborhood may be full of people who work at the nearby General Motors plant, which has just announced it is about to close. A local hardware store may be thriving, but a hardware chain may be building a massive store nearby.
Furthermore, using the prior example, it is not even necessary that the General Motors plant announce a closing to affect the valuation of the retail store. Even if no such announcement were made, one must at least consider that the success of the retail business may depend on the General Motor plant's continued operation. The risk factor for the retail business must consider the risk factor of that General Motors plant.
VII. OMISSION OF CERTAIN ASSETS OR LIABILITIES
Certain assets and liabilities are easily overlooked because of their nature. One such asset is "work in progress." Work in progress is a form of accounts receivable for services rendered, for which no invoices have yet been issued. For certain businesses, work in progress can form a substantial portion of the accounts receivable. For example, a construction company typically bills only when a significant part of the job is completed. The value of those unbilled services needs to be reflected as an asset of the business.
Another asset to be considered is the value of a lease. A below-market lease may be a considerable asset and should likewise be reflected in assessing the business' value.
VIII. BUY-SELL AGREEMENTS
A buy-sell agreement may form part of a firm's partnership agreement, governing the terms of a partner's buy-out if the partner leaves or dies or a new partner wants in. A buy-sell agreement may also be used to determine the value for the transfer of shares in a stockholders agreement. In family law valuations, depending on the circumstances, it is sometimes appropriate to use buy-sell agreements.
In the valuation of professional practices, for example, the courts have held that a buy-sell agreement may be considered, but will not be determinative. Marriage of Slater (1979) 100 CaI.App.3d 241, 160 CaI.Rptr. 686. A recent case, Marriage of Nichols (1994) 27 CaI.App.4th 661,33 CaI.Rptr.2d 13, concluded that it was not an abuse of discretion for the trial court to value the husband's shareholder interest in his law firm based on the formula set forth in his firm's stock purchase agreement.
The Nichols stock purchase agreement excluded the value of accounts receivable and work in progress although in Marriage of Lopez (1974) 38 Cal.App.3d 93, 113 Cal. Rptr. 237, the court held that these should be included in valuing a law practice interest. The court in Nichols, supra, found that the stock purchase agreement, which the firm had consistently adhered to with every shareholder who had retired or left, was an appropriate valuation method in this particular case.
The Nichols court recognized that the law firm at issue was a large firm where the shareholder did not share in the firm's earnings, but was compensated as an employee based upon his own productivity and length of service to the firm. In assessing whether a buy-sell agreement should be determinative, the Nichols Court set forth the following criteria:
- The proximity of the date of the buy-sell agreement to the date of separation to ensure that the agreement was not entered into in contemplation of marital dissolution;
- The existence of an independent motive for entering into the buy-sell agreement, such as the firm's desire to protect all partners from the possible effects of a partnership dissolution; and
- The similarity of the value resulting from the agreement's purchase price formula to the value produced by other approaches.
Mrs. Nichols was, however, awarded an interest in her husband's professional goodwill. The court reasoned that the stock purchase agreement did not determine the lawyer's goodwill, and that Mr. Nichols had personal goodwill whether he remained with the firm or not. In effect, the court said, goodwill cannot be eliminated merely by a recital in a buy-sell agreement. "It is a community asset because husband's experience, reputation and skill, which enabled him to command this high income, were developed while he was married to wife. It directly creates excess income for husband whether he stays with his firm or strikes out on his own" Marriage of Fenton (1982) 134 CaI.App.3d 451,463, 184 CaI.Rptr. 597.
Because Nichols upheld a buy-sell agreement as to accounts receivable and work in progress, but not as to goodwill, it appears that trial courts will have to examine carefully, on a case-by-case basis, the facts behind individual buy-sell agreements.
CONCLUSION
Business appraisals require close attention both to theoretical and practical considerations. Attorneys and clients typically want a speedy, low-cost appraisal, but that approach invites errors such as the ones described above. In appraising businesses in family law actions, the appraiser should keep in mind these possible errors and avoid such pitfalls.
Divorce Resource Links:
Divorce Manual : A Client Handbook - This publication produced by the American Academy of Matrimonial Lawyers covers the divorce process, reconciliation, counseling, selecting a divorce lawyer, estate planning considerations, and the lawyer-client relationship.