Divorce is difficult enough, and the added stress of dealing with the division of a marital assets can make it more so. When those assets include a family business, things can get even more contentious, usually because of disagreements around what the business is worth. Understanding the basic approaches to business valuation can help.
Picture this: John and Jane, a married couple, currently own a retail operation called “Psyche Out,” a store that sells creative novelty items reminiscent of the 1960s and 70s. Among specialty offerings such as life-like Halloween masks of ex-presidents and 1960s political activists, the store also buys authenticated 1960s memorabilia which it resells at a significant mark-up. Recent purchases demonstrate the lucrative nature of this aspect of their business: A stained bar napkin allegedly signed by Jim Morrison was recently resold for over $10,000, while a soiled and gritty lock of Janis Joplin’s hair, which was said to have been torn out at the roots and contains both the blood and saliva of former Doors producer Paul Rothchild, went for over $14,000. In addition to these two areas of revenue, the store also features a large space for patrons to hang out, snack, listen to music and “freak freely,” as John says. Purchases from this portion of the business represent roughly 25% of total revenue.
John and Jane, who were married atop the Digger Free Store in the Haight “sometime in ’69,” according to John, opened the store in the late 1980s, once “Jerry Garcia started selling $75 neckties,” admits John. “Hey, I realized that money–and people over 30–weren’t so bad after all.” Jane agrees, but admits she cannot possibly trust “anyone over 100.”
In recent years, however, the two have drifted apart. “The money went to his head,” says Jane, who estimates annual sales for the store at roughly $775,000. John disagrees, and states that he has merely begun to rethink his entire life’s purpose, and is starting to believe that Psyche Out isn’t big enough for him anymore. He wants to branch out, and create video games, CDs and other forms of media to “spread the word and pass the karma” along to younger generations. He also points toward the ever-growing online sales platform, which John helped create and which continues to grow the store’s revenues. Jane, on the other hand, wants to move back to Northern California and live in her ex-housemate’s garage so she can “live lean, live clean” again and make art out of her cat’s shedded fur. They two have decided to divorce.
While the childless couple have no custody issues, since they are self-proclaimed “children of our Mother Earth,” they don’t have to deal with that aspect of a dissolution. What’s much stickier is the division of their assets. Both entered the marriage with little more than the clothes on their back and a headband said to have been thrown into the audience by Melanie at the Human Be-In held at Golden Gate Park in ’67. The assets they accumulated since opening Psyche Out, however, have been substantial.
The couple is not arguing about how to divide the bulk of their since-acquired possessions: they both agree they should each be entitled to their own personal affects and property. The main point of contention is the business. While both agree that the business should be sold off and the proceeds should be divided equally between them, they fail to agree on how the business should be valued.
John, who has recently become enamored with capitalism, asserts that the business should be valued based on pure market value. As he burned his last copy of “Das Kapital,” John said, “This place is a gold mine. Let’s see what we can get for it on the open market. Free the people!” Jane, on the other hand, still holds dear all of the items and collectibles that the store holds as inventory. She believes the best way to value the store as a marital asset is to add up the market value of all of the store’s tangible assets and use that as a basis for the value to be divided. “We only have what we have…what the store is worth is up to the next person who is lucky enough to buy it,” she says. “Who am I to put a value on future profitability? Here, kitty-kitty…” The couple finds themselves in a stubborn deadlock over this one issue.
If this sounds far out, it isn’t (well, at least when it comes to the division-of-marital-property part). When it comes to divorce, different approaches to value often lead to dissimilar valuation conclusions and as a result, the parties end up having to convince a judge, mediator or arbitrator which method of valuation best leads to a fair and appropriate division of the asset. And since hardly anyone enters either a marriage or a business venture expecting the worst (divorce/splitting the business), few parties have a pre-executed agreement specifying the valuation method agreeable to all or both parties should something go wrong.
It’s a situation all-too common, and can make an already difficult experience far worse. What’s more, it’s rare when two business valuation experts arrive at the same exact conclusion of value; This is largely because many subjective judgments must be made in order to arrive at a business valuation conclusion, whatever the method used.
It’s for these reasons that a basic understanding of the primary methods of business valuation can help clients decide which is best for their particular situation, and, if an agreement now (while things are going well) may be in order.
The Basic Approaches to Value
There a three basic approaches to value any asset, business or business interest: 1) asset approach; 2) income approach and 3) market-value approach. Each approach has inherent strengths and weaknesses in terms of providing an objectively accurate, or reliable, valuation for a business. In addition, depending on the type of business being valued, one approach may well be preferable than either of the other two. Absent an existing agreement between the parties specifying a particular valuation method in the event of dissolution, it is each party’s responsibility to convince the court that the method s/he is endorsing is best suited to provide a reliable valuation for the type of business at hand.
Here is a rundown of the three methods:
The Asset Approach — Determines a value of a business or business interest by determining the value of the business’s assets less liabilities. Generally, this approach operates by establishing a general value for the business’s tangible and intangible assets in light of any remaining or outstanding liabilities. Sounds simple? Think again. While this approach can work well for businesses that sell actual tangible items (think “widgets”), complications can arise even when valuing tangible assets. Do you rely on the “book value” for an asset or does the asset require an appraisal? What if you need the expertise of several kinds of appraisers? Inventory is typically valued at cost, another tangible asset that is not usually valued at “book value.” And what about unrecorded assets and liabilities, such as goodwill or intellectual property? As we can see, the asset approach – while it seems simple — can be wrought with complications. As such, this approach typically works best for very small businesses or for a professional practice with little goodwill or name recognition beyond a small marketplace.
The Income Approach — Here, the business’s value is determined by converting anticipated economic benefits into a present-value single amount. This approach is most frequently used to value an interest in a privately held business. There are many methods that employ the income approach, including the capitalized cash flow method, discounted cash flow method and excess cash flow method, to name a few. While these methods are distinct, each requires the determination of a future benefit “stream” and a rate of return/risk that the projected future economic benefit will actually come to fruition.
Typically, the process of concluding a future benefit stream involves collection and review of historical financial data, among other things. Then, the valuation expert will “normalize” that data to present a “normal” operating picture, from which s/he will then project future earnings. This may sound easy, but it isn’t. For one, it cannot be assumed that all expenses and costs will remain constant and steady over the long term. Next, business owners don’t always make rational, or market-friendly decisions when spending company money. For example, in most privately held businesses, it’s not unusual for the controlling shareholder to be compensated in excess of market rates. As such, this process of “normalizing” the business’s operating picture will include determining fair (closer to market value) comp for that shareholder, and then scaling back shareholder comp in order to add back excess compensation to cash flow. This is one of the many subjective decisions a valuation expert will face when applying an income-based approach to valuation.
The Market Approach — This is the approach Jane seems to be endorsing. A market approach to valuation involves determining a value for a business or business interest using one or more methods that compare the business to similar businesses that are similarly situated. Sometimes this approach includes “pieces” of the other methods, such as heavily factoring in financial data, tax returns, and on-site inventory, for example. And, in order to aim for a reliable, or even reasonably accurate valuation for Psyche Out, Jane and John would have to find a retail operation that sold similar goods, in a somewhat similar market (suburband? metro area?) and which was recently sold. In essence, this “leave it up to the people” approach relies on a premise and assumption that if a nearby similar business was recently sold for $1 million, that’s what ours must be worth too. Problem is, if your business is one-of-a-kind unique (like Psyche Out), it may be nearly impossible to find a reasonable comparison.
For a specialty operation like theirs, John and Jane may be best relying on one of the other two approaches for a more accurate valuation. The market approach tends to work best for real estate, where property, buildings or land can be at least remotely comparable to the same type of properties in a nearby location. If John and Jane owned the land upon which Psyche Out sits, they could employ this approach for the real estate aspect of this marital asset. Since they own only the business itself, not the property, they are probably best avoiding this valuation approach and looking to either the asset or income approach, or a combination thereof.
The multitude of variables inherent in business valuation – especially during a divorce – calls for expert guidance and assistance. Should every party to a business venture have an operating agreement or buy-sell agreement in place? Certainly. If you don’t, and division of the business as a marital asset is looking imminent, it’s always best to get help. Trusting the court to decide–much less understand–the intricacies of your family business is at best risky. If your family law attorney is not well versed in business law, or in business ownership, insist that s/he enlist the help of “of counsel” to assist in the division of this portion of the marital estate. What’s more, get the assistance of a qualified business valuation expert. S/he will recommend the best method to value your business most accurately. If you don’t, you could find yourself asking a district court judge to determine what a lock of Janis’s hair is really worth. Is that really what you had in mind for an asset you spent years helping to build?
NOTE: As always, this article is not intended to be construed as legal advice. No two businesses or divorces are the same. Contact an attorney skilled in either division of assets in divorce, business valuation or preferably, both, before making any decisions. Reading this article does not create an attorney-client relationship. This article is intended for general information only.