by Diana L. Powell, J.D.
As published in v.2 2008 Collaborator
Often collaborative divorces involve parties who own all or part of a business. Collaborative divorce offers opportunities for solutions and processes not currently available in a litigated divorce process in Colorado. Here’s an in-depth look at business valuation during divorce.
Preserving Business Value During Divorce.
The parties can agree at an early collaborative session to present a solid front to other stakeholders in the business, whether they be partners, employees, vendors or customers. In addition, while deadlock in the divorce can frequently result in a business deadlock that ruins the business, parties to a collaborative divorce can work through business deadlocks in the collaborative process, or choose a business coach to mediate or be the tie-breaker for business deadlock during the divorce. In contrast, the divorce court has little ability, as a practical matter, to contain the conflict or manage the deadlock, prior to permanent orders many, many months hence.
Ascertaining Business Value
Under Colorado law, the value of a business during a divorce is the value of the business in the hands of the business owner spouse. Ordinarily, determination of business value during divorce is done by the handful of business valuation experts in Colorado who specialize in divorce valuations. Some of these experts are more comfortable being “party” experts, and render opinions that adopt a perspective most favorable to one party. More and more, however, courts appoint joint experts who are expected to take a balanced approach to business valuation. Business valuation is not accounting, although business valuation uses accounting products and tools, such as statements of assets and liabilities (balance sheets) and statements of operations (“p&l” or statement of profits and losses). In a collaborative divorce, the business valuation expert can support collaborative solutions for the case. Given the cost of valuations, it is often determined by the parties that the business valuation expert and his/her report will be available to the parties in subsequent litigation, should the collaborative process fail. It is important to consider the possible future use of the expert if the matter turns to litigation in determining the use a collaborative team can make of the valuation expert.
There are three main categories of valuation approaches: (1) asset approach; (2) market approach and (3) income approach. Within each category, there are multiple sub-categories. In valuing a particular business, the expert will commonly consider a variety of approaches, and then either settle on one as most appropriate for the business, or perhaps average the results of two or more approaches in reaching a business valuation. The asset approach can encompass a net asset value or a liquidation value. The market approach can be predicated on prior transactions, adjustments from guideline public company values, adjustments from guideline M&A transaction values, or based on direct market data. Within the income approach are encompassed both capitalization of income and discounted cash flow approaches. The excess earning method combines elements of the asset and income approaches.
To determine the value of a business, the accounting statements and/or tax returns for a business must be “normalized” and “adjusted” to make them useful to the business valuation expert. Common adjustments are that: (a) depreciated assets will occur on the adjusted balance sheet at their market value, which is neither their historic cost nor their depreciated value; (b) non-operating assets (think Vail condo) will be taken out of the asset value of the business—though they will appear elsewhere on the marital balance sheet; (c) accounts receivable on the balance sheet will be discounted to reflect the risk they are uncollectible; (d) costs paid for lifestyle expenses of the owner and owner’s family will be treated as owner compensation, rather than as a business expense; and (e) depreciation and amortization expenses will be removed from the statement of operations. In addition, revenue resulting from non-recurring events (sales of assets and similar items) will be adjusted downward, as will expenses resulting from nonrecurring events (settlement of lawsuits and similar items).
The “Multiplier,” “Discount Rate” or “Capitalization Rate
While laymen often confuse the discount and capitalization rate, these terms relate to very different concepts for the business valuation expert. The “Discount Rate” is usually comprised of the rate of return in the market for “risk free” investments (think T-Bills), plus a premium for the risks of large-cap publicly traded companies, plus a premium for the risk associated with an investment in smaller public companies, plus a premium for the risks associated with this particular company. That last premium, for the risks of this company, is determined subjectively by the business valuation expert, based on his/her professional judgment and experience.
The “Double Dip”
Divorcing business owners in Colorado face what is referred to as a “double dip,” in which the same stream of income is used to support the value of the business and as the basis for determination of maintenance. Moreover, the payout for the business value is neither deductible nor determined on a tax adjusted basis. The combination of these two hazards can leave the business owner with orders with which the owner cannot comply, or a very limited future. For example, if a business owner earns $200,000 in annual gross income, on which he must pay $60,000 in taxes, from which he must pay $60,000 in equalization payments and $45,000 in spousal maintenance (with a $15,000 tax benefit from the maintenance) and $12,000 in child support, the business owner who expended the effort to earn $200,000 has only $38,000 (including $15,000 in tax benefits on maintenance) on which to support the business owner’s lifestyle, including any unexpected financial requirements of the business. After orders like those, unless there were substantial accumulated marital assets with which to offset the business value, many business owners cannot keep up. This desperate situation is also appreciated by the non-owner spouse as a risk to the future relationships the parties are trying to build through a collaborative resolution of the divorce.
Opportunities in Collaborative Settlement
Collaborative divorce settlements give both spouses the opportunity to avoid rigid legal definitions and restrictive case law, but the parties must be fully informed by their collaborative counsel of the likely outcome of a litigated case. While collaborative divorce teams have the freedom to address the double dip, and treat the business valuation as part of the solution, rather than a fact, the collaborative divorce team must always remember that innovative solutions must be supported by knowledgeable and informed parties. Nevertheless, collaborative divorce teams are increasingly using risk sharing, earn-outs, spin-offs, splitting of transaction proceeds and sliding scale maintenance for collaborative resolution of cases involving business assets. The best use of a business valuation expert in the collaborative process is to assist the team in brainstorming such collaborative solutions, to make the process “win-win” for both parties.