In Parts 1 and 2 of this series, we discussed the importance of hiring an expert and the documents needed to prepare the marital balance sheet and analyzing support and need in a Lifestyle Analysis.
In this piece, we discuss the documents needed for performing a business valuation, the core competency of Mercer Capital.
There are many unique considerations and complexities to business valuation in divorce, often requiring more documentation and analyses. This includes personal goodwill, owner/operator compensation for valuation and income division purposes, formula clauses in Buy-Sell Agreements, and active vs passive, among others.
As appraisers, we provide business valuations for divorce as well as many other purposes. Regardless of the industry, there are certain documents we request in every engagement:
Sometimes some of these documents/items do not exist at the subject Company, which will not necessarily prevent us from performing our work, but the more information we receive the better.
When valuing businesses, or really any stream of cash flows, valuation comes down to three variables: expected cash flow, risk, and growth. All else equal, investors want larger cash flows, that are growing faster, and that are less risky than alternative streams of cash flows. Financial documents show historical earnings and trends, which serve as a basis for expected future cash flows. Other information requested like top customers, suppliers, and competition show both capacity for growth and risks associated with the earnings the company has recently generated. A business valuation involves both qualitative and quantitative information and analyses.
In divorce, there are additional considerations when valuing a business. A common battleground for experts is personal goodwill, which is not a divisible asset in divorce in many states. For example, if a business is worth $5 million, but it is determined that $3 million of the value is attributable to personal goodwill, the value of the business for marital balance sheet purposes might be $2 million.
There is no one-size-fits-all methodology or approach to allocating personal vs. enterprise goodwill. It will depend on the industry, history of the company, and relative contributions of the divorcing party as well as contributions of all other employees, among other factors. From a theoretical perspective, personal goodwill should show the difference in value of the business with and without the contributions from the divorcing party. Documents to help determine personal goodwill may include:
The availability of documents will vary greatly. These complex analyses can be both a quantitative and qualitative analysis, and it will depend on the facts and circumstances what documents will be relevant.
Like personal vs enterprise goodwill, an active vs passive analysis determines whether the appreciation of an asset or investment during a marriage is considered marital property. States differ in their treatment, and this analysis may be necessary for a business owned by a divorcing party prior to the marriage, which has appreciated during the marriage. However, it can also be necessary on investments in passively held retirement accounts. We will delve more into this in Part 4 regarding documents needed based on the nature of the investment.
In all business valuations, an assessment of the reasonableness of management compensation needs to be considered relative to market rates. It is common for business owners to not pay themselves exactly in line with market rates, or perhaps the owner compensation structure includes base rates and profit sharing. We see compensation structures in many different forms and fashions, and above/below market comp is not necessarily nefarious.
In the end, the money ends up in the owner/operator’s pocket, whether as W-2 earnings or distributions from company profits. In business valuation, particularly in divorce, it is more important to make a judgment on how much of the profits should be allocated to the owner’s labor (wages) and how much to their investment in the business (return on investment). In divorce, the business owner’s market wages may be utilized in determining alimony whereas the return on the investment in the business is capitalized into the present value of the business, which is placed on the marital balance sheet.
We consult available industry benchmarks to help determine reasonable compensation, but information about compensation for other key members of management and available industry-specific data is helpful in making these determinations.
It is important to consider the purpose of the valuation, as this can influence the valuation conclusion. For example, some Buy-Sell Agreements provide for how a business is to be valued upon the death of a shareholder. However, this may not be relevant to the valuation in a divorce context for a few reasons:
A financial expert can help focus the scope of a divorce case, saving time and money throughout the process, particularly if brought in early to the process with ample time to assist with the various stages of the case. We help engagements be as efficient as possible, hoping to reduce the need to update our analysis, which can drag out the process and lead to higher costs for clients.
For more information or to discuss your matter with us, please don’t hesitate to contact us.
Essential Financial Documents to Gather During Divorce Series
