Thursday, May 17, 2012
In Pennsylvania and New Jersey, a business owned by either or both of the spouses will be considered property subject to equitable distribution in a divorce. But how do we divide an asset you cannot simply split down the middle? Dividing a bank account can be relatively easy. Here is the balance - you get half and I get half. A business tends to be an entirely different story. Unless the plan is to sell the business outright and simply divide the proceeds, the parties must determine the value to be assigned to the business. If the business began prior to the marriage, then only the increase in value which accrued during the marriage will be subjected to valuation and division.
When the spouses cannot agree on a value, which disagreement is unfortunately common during a divorce, either or both parties and sometimes the court can retain an individual, who is experienced in business valuations, to establish a number. We also call this professional a forensic accountant or appraiser. Notably, the evaluator ideally will be experienced in the particular field of assigning business valuations for purposes of divorce, which is an extremely specialized skill. Although almost all business evaluators tend to be accountants and even certified public accountants, not every accountant is a business evaluator. Additionally, valuing a business for a divorce involves a different analysis than other types of valuations, such as those for an estate, insurance quote or sale. Accordingly, you should be careful about taking advice and opinions from those not familiar with the intricacies of valuations in the context of a divorce.
As with most property that must be valued in a divorce, the spouse who wants to retain the property in the divorce would like a lower value assigned to the asset, while the spouse who wants to be compensated for their marital share seeks a higher value. Therefore, one party has the incentive to establish a low value, while the other party has the incentive to establish a high value. By way of example, the spouse keeping the business may say it is worth $100,000.00 and in an equal division would pay the other spouse half, or $50,000.00. However, the receiving spouse says, “No, wait a minute, I think it is worth $1,000,000.00 and you owe me $500,000.00.” An experienced business evaluator should be able to set those individual interests and biases aside to come up with an objective analysis and a fair number.
Sometimes, the parties can agree on an evaluator and jointly retain the expert and live or die by his or her opinion. However, sometimes with a significant amount of money a stake, each party his or her own expert, who then establishes competing evaluations and makes a case favorable to his or her client. In extremely high conflict or technical cases, the court sometimes appoints an evaluator to provide objective analysis. The cost of the evaluator is part of the divorce process and is typically shared by the parties, sometimes equally and other times in proportion to their respective assets or incomes.
Typically, your attorney can provide you with names of evaluators who are familiar to the local courts and also to the particular type of business that you need evaluated. For example, some evaluators specialize in construction firms and know the intricacies and the specifics of that field. Other evaluators may have a particular expertise in another area. The more experienced the evaluator is, the more credible his or her findings will be. Therefore, he or she will be more persuasive to the court. Additionally, evaluators, like other experts, tend to develop reputations within the courts and legal community, which could add or take away from their opinions.
A business evaluation can take some time, as it begins with the discovery phase when the evaluator obtains and reviews documents, including tax returns, financial statements, business plans and other written information regarding the overall structure of the business. In many instances, the documents will not be enough to present a full and accurate picture, and the evaluator will visit the business and interview the owners and/or key employees. Discuss with your financial, business and/or legal teams whether or not your attorney (business and/or divorce) should be present during these information gathering sessions. Sometimes, more questions must be asked in the form of depositions, wherein the opposing attorney will examine certain individuals, under oath, to gain and clarify information.
The documents needed to perform a business evaluation, if printed out, can sometimes fill a conference room or even a building! The various financial statements, ledgers, tax returns and supporting documents are usually gathered for the previous five (5) years. Depending on the level of organization of the business, this information gathering phase can be absolutely excruciating. Additionally, it is an additional burden on a business to gather and copy the requested information, both in terms of finances and manpower. Many businesses require confidentiality agreements before releasing the information to protect information from their competitors or clients.
Once all the documents and information are gathered, the evaluator begins examining the health of the business, the trends over the past few years, the income and expenses and the equity and/or debt. Sometimes, the evaluator must adjust some of the figures to account for atypical events, a process called “normalization.” In order to produce a fair and neutral value, sometimes the idiosyncrasies of a business must be neutralized. For example, a small business owner may pay themselves a $150,000.00 salary for a job that would normally command a salary of only $100,000.00 in the open market. In order to avoid having that inflated salary artificially depress the value of the business because the salary expenses are higher than they should be, the evaluator must then normalize that number.
With the information, the evaluator then comes up with a ratio known as the capitalization rate. The lower the capitalization rate is, the higher the value of the business. Basically, the capitalization rate determines the current value of the expected returns of a business based on information from a particular time period. Occasionally, any of these numbers can become an extreme point of contention between experts, which results in a vast difference in opinions on the value, that, if not resolved, will likely have to be sorted out by a judge.
In addition to the value of the business, an evaluator must determine whether an individual’s ownership interest in the business should be discounted. For example, when someone owns 40% of a business, he or she may not own 40% of the actual value of the business, because his or her percentage share, for value purposes, must be discounted for his or her lack of overall control of the business. If you, as an owner, cannot make decisions on your own, then your share may not be worth what you think. Additionally, some shares of a business are simply not marketable, especially in small, closely-held companies. Therefore, even though that share of a business does have some value, it may be extremely discounted due to its non-marketability. What good will it be to you to own 40% of a business that you cannot sell or turn into another type of asset? Your value for purposes of divorce will be adjusted accordingly. The rate of the discount, however, can be a bone of contention between warring spouses.
A business evaluation, like any establishment of value, takes a snapshot in time and therefore poses some risks. What if you value your business today, pay your spouse a handsome sum for his or her marital share and are later sued, lose your biggest client or go bankrupt, making your once profitable business worthless? Now you own a failed business that you essentially bought from your spouse. Of course, no one can predict every potential contingency. However, a detail oriented and professional business evaluator may be able to point out red flags to help guide you in establishing a valuation that poses the least risk.
The business evaluation process will often be time-consuming and expensive. If your divorce involves a business, whether it is your own, your spouse’s, or jointly owned with your spouse or another, you should consult with an attorney to develop a divorce plan and determine a ballpark figure for the value of the business, so that you can plan a cost-effective strategy for valuing that business for purposes of equitable distribution. Careful planning will assist you in making cost-effective decisions.