ACHIEVING THE BEST RESULTS IN BUSINESS VALUATION CASES THROUGH PROACTIVE LAWYERING
Business valuation issues arise at a variety of points during marital dissolution cases, including property division, decisions whether and/or at what price to buy or sell community business interests, and strategic or investment decisions concerning businesses in which the community has an interest. For most legal purposes, the value of a business (or a fractional interest in a business) is treated as an issue of fact. Because business valuation is a complex discipline, beyond the presumed ability of a judge, business valuation issues are driven by expert opinions unless the value is readily ascertainable, such as through a public market in its securities.
Because the value of a business is an issue of fact, valuation may be resolved through negotiation between the parties, joint delegation of the issue to an expert (or panel of experts), valuation by a court-appointed Evidence Code section 730 expert, or litigation with a “battle of experts.” When the value of a business is not agreed upon by the parties, and becomes a matter of expert opinion, the law does not specify the precise method that an expert must follow to arrive at a valuation. Business valuation or “appraisal” has its own professional standards. The 2015 decision of the California Court of Appeal (First Appellate District), In re Marriage of Honer, 236 Cal. App. 4th 687 (2015), held that a trial court’s valuation of a business for purposes of property division is reviewed under the substantial evidence standard. So long as the trial court’s fact-findings are supported by substantial evidence, a reviewing court will not substitute its judgment for the trial court’s factual determination of value.
Due to the complexity of business valuation, family law practitioners often delegate the entire task to an expert. Many valuation experts are highly skilled at litigation support and are pleased to complete the valuation, draft witness examinations, and prepare relevant graphics. This article shows how a more proactive and collaborative approach between family lawyers and valuation experts can enhance the valuation’s accuracy and improve client results.
At the front end of the business valuation process, several “macro” issues arise—many of which involve legal determinations such as what is being valued, the valuation date, what valuation standard will apply (which, in turn, affects the expert’s methodology in the valuation), who will perform the valuation, what and when attorney/party client input is permitted, and how a valuation may be challenged. These ground rules typically are not determined by the expert; they are determined by the parties and the court through negotiation or litigation. This article shows how family law attorneys can help shape these structural rules, then work within the valuation process to provide proper and influential input to the expert.
What is Being Valued?
“What” is being valued can have a significant impact on the valuation methodology and the ultimate determination of value. The types of business interests that are valued in family law cases include the entire business, a partial interest in the business (such as a 25% ownership interest), particular assets or divisions of the business, an income stream from certain operations, derivatives (such as stock options), “carried interests,” and particular business liabilities.
The importance of defining up-front what is being valued is illustrated by the following example:
Case 1: Value 100% of the business and divide it in half;
Case 2: Value a 50% interest in the business; and
Case 3: Value 50% of the business’s assets less 50% of its liabilities.
In Case 1, a valuation of 100% of the business will consider the fact that a 100% owner has total control of the business—how to run it, when to sell it, how to raise money, and so on. Control of a business is almost always worth something, and a control block (whether 100% or 51% or some other appropriate measure) generally will receive a higher valuation. In a case in which the marital community owns 100% of a business, or other controlling stake, the party who seeks a higher valuation often will argue that 100% of the value should be cut in half.
In Case 2, the owner of 50% (or less) often is in a precarious position—that owner may lack control, may have no discretion how to operate or finance the business, may be faced with deadlocks on key issues (often the case with 50%-50% owners), may be subject to capital calls (mandatory investments), and may be trapped in an illiquid investment with no power. If the community owns a non-controlling interest in a private company, a party who prefers a lower valuation generally seeks to ensure that what is being valued is not simply 100% of the business (which will be multiplied by the percentage owned by the community, then divided in half). That party generally will want to advocate for the “minority interest” to be valued as such, and for the valuation expert to apply discounts and other negative factors to reflect the vulnerability.
Case 3 arises when the business is worth little more than the value of its assets minus its liabilities. This situation typically arises in businesses that hold other assets (such as an LLC created exclusively to hold a piece of real estate with no significant business operations) and in smaller professional firms whose values derive from the ongoing labor of the owners and employees. In the former situation, the “business” may be so closely identified with its assets that it is reasonable and cost-effective simply to value the assets rather than the business. In the latter situation, it is often appropriate to focus on the ability of relevant owners or employees to generate a stream of personal income—it may be “the business” has little or no independent value.
“What” is being valued may have complexity far beyond the three examples described above. Let’s say the marital community owns 51% of a business—but a dozen employees in the company have handwritten, “unlawyered” documents titled “Option Promises,” under which 25% of the company “will vest and be exercisable at 5 cents/share if the president dies or becomes disabled.” Further, assume there are no plans to sell the company, and the owner-president is only thirty-nine years old—but, due to genetics, the owner-president has a 50% chance of contracting Huntington’s disease by age forty-five. His death or disability could trigger vesting and potential exercise of the “options” and a possible loss of community control of the business (depending on who owns the other 49%). What is being valued now is not just “the business” or the “community interest in the business”; the valuation must consider the possible contingent rights of the employees and their impact on the community block’s value.
From the earliest stages in a dispute, a family lawyer should identify issues concerning what is being valued to ensure that the scope of the valuation expert’s work is accurately defined.
The Valuation Date
The valuation date is the date “as of which” a business is valued. Under Family Code section 2552, the trial court generally is required to “value the assets and liabilities as near as practicable to the time of trial.” Upon notice and for good cause, the trial court may set an alternate valuation date “at a date after separation and before trial to accomplish an equal division of the community estate of the parties in an equitable manner.” FC § 2552(b). In the recent Honer case, the Court of Appeal confirmed that in the selection of a valuation date, the trial court’s judgment is reviewed under the highly deferential “abuse of discretion” standard. Under the abuse of discretion standard, the trial court’s selection of a valuation date will be reversed only if the court’s decision “exceeded the bounds of reason” or “no judge would reasonably make the same order in the same circumstances.” In re Marriage of Honer, 236 Cal. App. 4th 687, 693-94 (2015).
The selection of an appropriate valuation date is predominantly a legal issue—with sufficient information, a business valuation expert can value a business as of just about any date. The trial court may take information from an expert into consideration in setting the precise valuation date (e.g., the expert may recommend that the valuation be done as of the end of the most recent calendar year), but the major decision whether to require a trial date valuation, a separation date valuation, or something in between, is driven largely by legal and equitable factors. In determining what valuation date to seek, unless it is obvious, family law counsel should work with a valuation expert to determine what date is most helpful to a particular client.
In advocating for a particular business valuation date, family law attorneys should consider the following:
- The default or presumptive valuation date (i.e., close to trial, or with respect to certain businesses such as small professional practices, the separation date under case law);
- The practicalities of a particular date, in terms of making information available to the expert. Business valuation experts often prefer to work with “final” year-end numbers that have been adjusted by the business’s accountants to be comparable to past year data. Valuation experts always prefer to value a business at the end of a quarter, perhaps the last quarter before trial, rather than on the exact trial date;
- Whether there are remedial factors that can be argued to support a more favorable valuation date than the legally presumed date. For example, whether a party improperly delayed the sale of an asset that declined in value during the delay period; and
- If a valuation date is likely to be significantly in advance of the trial date, whether it is possible to obtain an “update” report from the valuation expert so that the court may have access at trial to information that may affect its perception of valuation opinions.
The Valuation Purpose, Standard, and Methodology
The purpose or intended use of a valuation is linked to the valuation standard and methodology that an expert will use. Common purposes of valuations in family law cases include valuation for asset division (who gets what asset, and at what value, in an equal division of community property), the price paid by the acquirer-spouse in a negotiated or court-ordered interspousal buyout transaction, tax-related issues (e.g., whether gift, estate, or capital gains tax ultimately will be due on an asset), and determination of the impact of a business “buy-sell” provision.
The purpose of a valuation affects the valuation standard and methodology, which in turn affects the ultimate value determination. For example, a corporate buy-sell agreement may prescribe a specific business valuation method to be used (sometimes based on “book value” or a specified standard); the Internal Revenue Service in some cases requires specific factors to be considered; and family law has an overriding goal to achieve an equal division of the community property. Valuation opinions virtually always disclaim the reliability of a valuation for purposes beyond what was commissioned in the engagement. Family law attorneys should ensure that, if a valuation, or any part of it, is required for multiple purposes, the expert understands all needs before the valuation work has progressed so far that the expert cannot effectively adjust the methodology to allow the valuation to be used as required by the case. An example of such “multiple purposes” is when the compensation analysis in a business valuation will be used to determine both the value of a business and the compensation that would be available to one or both spouses for purposes of establishing long-term spousal support.
The valuation “standard” defines what “value” means in a specific valuation. The Honer case illustrates that the selection of a valuation standard for a particular case may involve both legal and expert considerations and input. In Honer, husband’s expert performed a valuation that he labeled a “marital value” analysis in which he valued the business based on “the economic value of the business to the spouse retaining it.” Honer, 236 Cal. App. 4th at 697-99. Wife argued that the trial court was bound by a “fair market value” standard in which valuation would be determined based solely upon the value that would be received by the community in a hypothetical sale of the business to a third-party. The Court of Appeal held that the trial court was not so narrowly restricted and that the expert’s use of a marital value standard, in a case in which the court had ordered a spousal buyout and not a sale, was permitted. We note the courts in Honer observed that the business’s “fair market value” and the “marital value” were not significantly different, and the marital value standard applied by husband’s expert incorporated methodologies that would be used in a fair market value analysis.
The following list familiarizes family lawyers with several of the most common valuation standards:
- Fair Market Value: The price at which a business or asset would likely sell in a transaction between parties who are not related and not under unusual pressure to make a deal.
- Fair Value: Fair value has different definitions depending on the purpose and jurisdiction, but generally contemplates a concept of overall fairness considering the parties’ relationship and circumstances of the transaction. A common situation is in the valuation of dissenter’s rights in a corporate merger transaction. The “fair market value” of the dissenter’s interest might be low because the dissenter lacks control. It may be unfair, however, to discount the dissenter’s shares for a lack of control or marketability when all non-dissenters will obtain the merger price and become liquid. Therefore, the fair value of the dissenter’s shares for this purpose may be based upon the value of the entity without applying discounts.
- Investment Value: The amount that would be paid by an investor to acquire a particular interest in a business, considering all important attributes of the interest such as illiquidity, lack of control, and lack of a market to dispose of the interest. This measure is especially appropriate for businesses that are extremely unlikely to be bought and sold, but which may deliver a valuable stream of benefits to an investor.
- Book Value: The value of the business or its assets and liabilities as reflected on the balance sheet (or similar list of business assets and liabilities). Since many assets are carried on business books at their adjusted basis (original purchase price less depreciation), the book value often does not reflect the current value of appreciated assets and may be much lower than the market value of the business. Likewise, a business with large liabilities that are not reflected on the books may be overvalued based on book value. Book value will generally not include any estimate of the current value of the business’s intangible assets (e.g., intellectual property).
- Liquidation, Salvage, Fire Sale: The value that assets will yield if sold-off separately and not as part of an ongoing business. The notion of a “fire sale” adds an element of urgency—the seller has little bargaining power and may have to take the best offer in a small time period possibly from a buyer who is aware of its advantage.
- “Marital Value”: The value of a business or asset to the spouse that acquires another spouse’s interest, with all of its long and short-term benefits and risks (described in Honer).
- Custom Valuation Standards: A contractual or statutory provision that adopts a valuation standard for a particular purpose or transaction, often by adjusting one of the usual standards (e.g., a contractual requirement that a business be valued “at 115% of book value, as determined by the company’s CPA,” or requiring that “no discounts be applied for illiquidity, minority, lack of marketability, taxation, or otherwise”).
Counsel should take steps to ensure that the engagement letter or court order that appoints an expert sufficiently specifies both the purpose and to some extent the applicable standard for valuation. By defining these items up-front, counsel can reduce ambiguity in the final product and distinguish valuations done for other purposes that may be urged on the court.
Who Will Do The Valuation?
The process of deciding who will perform a business valuation is heavily dependent on lawyering and often a judicial decision. Part of the process is macro-structural—will each side retain and use its own experts, will the court appoint an expert, or both? Once that is resolved, the identity of the expert(s) will depend on the nature of the business, and will require exploration of a variety of factors such as the expert’s qualifications and experience with a particular type of business, location, availability to testify at trial, cost, and availability to perform the work on the anticipated case timetable. For some businesses, the valuation process will require multiple experts who may need to coordinate. For example, if a major asset of the business is a piece of intellectual property that has not yet produced any income (such as newly granted patent rights), one expert may value the operating business and another may value the patents.
In selecting an expert who might be required to testify at trial, family law attorneys often need to balance specialization in the type of business involved in the case against experience with family law cases. It is helpful to have a valuation expert who is respected by family law judges, and who can comfortably address issues that are unique to family law. That expert may have less experience with a particular type of business than, for example, an expert who specializes in valuing businesses for mergers and acquisitions in a narrowly defined industry segment. These considerations must be weighed on a case-by-case basis. No matter what, if an expert who is unfamiliar with family law is brought into a family law case, that expert must be assimilated into family law. If a compelling valuation expert has little or no family law experience, the family law lawyer should educate the expert on relevant family law principles and seek to avoid that expert drifting into areas with which he or she is unfamiliar (risking an analytical error).
If the valuation is contested in a “battle of experts,” presentation skills and testifying experience may be important qualifications. If a valuation expert will be neutral, such as an Evidence Code section 730 expert, the expert’s relationship with the court and parties takes on greater importance—i.e., is there concern that the expert will favor one party over the other or that the court will accept the expert’s valuation even if one side can identify tangible defects in the analysis? In most localities, a small number of experts handle most family business valuations. With these experts, it is important to ascertain what the expert opined in similar cases.
On an issue of any magnitude, a business valuation expert generally should meet these criteria:
- Experience. The expert should have experience in the general type of business or asset involved in the case. It is not essential that a business valuation expert have valued an extremely similar business (e.g., “an investment advisory firm that specializes in foreign stocks and bonds”). The expert should have experience in valuing the type of business (e.g., a financial services business). If the expert will value a particular asset, such as stock options or intellectual property rights, the expert should have experience with that asset class.
- Qualifications. The expert should have relevant professional designations, certifications, and involvement in organizations with rigorous professional standards and continuing education requirements, especially if the opposing expert is likely to have such qualifications.
- Testifying Skill. A testifying expert should be capable of presenting valuation results under examination by a court and lawyers. If the expert has extensive non-judicial presentation experience, that experience may be sufficient if the expert will not be cross-examined. In a highly contentious situation, an expert’s cross-examination skills (both as a witness and as a consultant for cross-examination of the other side’s expert) are extremely important and some qualification-superiority is often sacrificed for these skills.
- Acceptable Cost. An expert should be selected whose rates and out-of-pocket costs are appropriate for the case. Business valuations can be extremely expensive—often exceeding $25,000 or even $100,000. There is wide variation in the cost of business valuations, both in the professional’s hourly rate and billing practices. An expert who must travel far to complete the work may be significantly more costly due to the travel time and costs. The retaining attorney should have a clear understanding with the expert how travel time and costs will be billed, and what other resources will be used by the expert and charged to the party who retains the expert (e.g., junior analysts and others at the expert’s firm). While some experts are uncomfortable with a budget, due to the uncertain effort to be expended on a project (especially when the parties have many disputes), most valuation experts are able to quote a price range, subject to updating if parameters change.
If it is necessary to find a hyper-specialized expert, a good source for a referral is another expert. Professionals generally have ways to identify the leaders in allied fields of study, often by calling a professional contact in the field, consulting proprietary databases for articles, and contacts with professional organizations in which specialist groups may exist. In general, non-experts are in a poor position to evaluate the qualifications of an expert. It is helpful to use an existing working relationship with an expert to identify other experts (the same way an attorney is often asked to refer-out clients who have matters in another field of law).
The Main Valuation Methodologies
Valuation experts use a variety of approaches and methods to value a business. While a family lawyer need not be an expert in these approaches and methods, it is critical to understand basically what the expert is doing and the points at which a lawyer can add value to the process.
- “Asset” Approach: This approach treats the business as an assemblage of tangible assets, individually valued, rather than as a cohesive, income-producing whole. This approach is appropriate when the value of the business derives primarily from the market value of discrete tangible assets such as real property, marketable securities, or collectibles, etc. The Asset Approach generally is not effective in capturing the business’s intangible asset value (e.g., goodwill) if any exists. Methods used by valuation experts under the Asset Approach include:
- Net Book Value Method – Relies on the unadjusted accounting values for assets and liabilities reflected on the business’s balance sheet.
Adjusted Book Value Method – All of the business’s assets and liabilities (both recorded and unrecorded) are adjusted to their fair market value.
- Cost Method – The value is determined by estimating the costs to replace/create all the business’s assets.
- Orderly Liquidation – Values the business based upon the estimated net proceeds of liquidating its assets over a reasonable period of time with the objective of maximizing the proceeds. This method is appropriate if the business is not considered a going concern.
- “Income” Approach: In contrast to the Asset Approach, the Income Approach considers both tangible and intangible assets (e.g., goodwill) of the business as a cohesive, income-producing whole. The two methods within the Income Approach are:
- Capitalized Earnings Method – A single period of earnings considered representative of the business’s sustainable future income is converted to value through division by a “capitalization rate” (a numerical factor that is intended to aggregate the investment risks and benefits of a business going-forward, considering a variety of macro-economic, industry, and company-specific factors).
- Discounted Future Earnings (or Discounted Future Cash Flow) – The value of the business is arrived at by discounting the business’s estimated future earnings to present value using a “discount rate” (a numerical factor that adjusts the value of a stream of future payments/cash flows by a factor which reflects that payments received in the future have less value than cash received today and also the investment risks and benefits of a business going-forward, considering a variety of macro-economic, industry, and company-specific factors).
- “Market” Approach: Values a business based on actual (“market”) transactions for the purchase/sale of interests in “comparable” businesses. The two methods within the Market Approach are:
- Guideline Public Company Method – The value of a private company is derived from one or more trading multiples (e.g., price at which the company stock is traded by investors in relation to its revenues, earnings, or other financial metrics) of a representative group of comparable publicly traded companies.
- Guideline Private Company Method – The value of a private company is derived from the terms on which a representative group of private companies was (usually) sold.
- “Hybrid” Approaches/Methods: There also exist hybrid approaches and methods that do not strictly adhere to the approaches and methods described above and which combine elements of several. The “Excess Earnings Method,” for example, is a hybrid that combines elements of both the asset and income approaches.
Valuations often include more than one of these methodologies, with the output of each method being assigned a “weight” in the final valuation. Because the methods may yield significantly different outputs—in some cases a 75% difference or more—it is important to understand not only why a valuation expert selected a particular methodology, but also its weight. An expert should be able to explain the weighting analysis clearly to the lawyers and the court.
Where the Family Law Lawyer Comes In: Improving the Process
The family law lawyer’s role is driven by what analysis the valuation expert will pursue and what litigant input is permitted by the process. While the lawyer’s input into the expert’s analysis is limited by the expert’s need to apply professional standards and protect credibility, party and counsel input is often negotiable and helpful, and can make a significant difference in the final outcome of the analysis. Several of the most common valuation analyses are “multiple-driven,” meaning that the business value will be a multiple of some metric (such as revenues, profits, a certain kind of sales, or other metric). Therefore, when a litigant can correct an input, the change in the output value may be a multiple of the correction. In some cases a party’s input can affect the multiple itself, because the multiple often derives from the valuation expert’s assessment of where the business fits in its markets, its competition and other information.
By way of example, if a party shows the valuation expert that expenses of the business are overstated (perhaps because personal expenses are being “run through the company”), a proper valuation analysis will likely disregard those expenses—increasing profits and increasing the value. Likewise, if a party shows that revenues are being understated, the valuation expert may use higher revenue/profit numbers—which also would increase the value. Similarly, if a party can show the valuation expert that the business tends to grow more slowly than others in its industry (perhaps due to a unique clientele), the valuation expert may project smaller future cash flow and profits, which will result in a lower business valuation. The “garbage-in, garbage-out” nature of the valuation process creates a role for vigilant counsel to play in the valuation process by helping shape the major inputs into the analysis.
Of course, counsel and the parties can only play a useful role in a valuation if the process allows such input. A spouse who is intimately involved in the business will likely play a role in the process (not as a litigant, but as a manager on whom the valuation expert will depend for information). The business out-spouse may need to fight to give input—and that effort is often worthwhile. An especially valuable role may be played by an out-spouse who knows about the business, especially an out-spouse who actively participated in the business for many years.
The time to protect the client’s ability to participate in the valuation process is when the process is established. The following list describes the main valuation processes that are used:
- The Evidence Code Section 730 Approach: California Evidence Code section 730 permits a court to designate a neutral expert who will report back to the court with a recommendation that the court will adopt, reject, or modify. It is a common belief that the recommendations of section 730 experts are highly influential on a court. Many courts have standard appointment forms for Evidence Code section 730 experts. In other cases, the parties draft a stipulation or the court establishes the ground rules concerning compensation of the expert, scope of the analysis (often including the valuation date, the standard and other guidelines), and how the expert’s report will be delivered. The order should be reviewed and the parties’ ability to have input should be negotiated. Note that under Evidence Code sections 732 and 733, the appointment of a court expert does not preclude the parties from challenging the expert report or presenting party-appointed expert testimony. Even if there is no plan to oppose the conclusions of a section 730 expert, it may be helpful in an important valuation issue to have one’s own expert assist in developing input for the section 730 expert, examination of the expert, or objections to the report and recommendations of the expert.
- “Free-For-All” Approach: Sometimes a court will grant the parties virtually unlimited rights to contact the experts. This approach can make all parties feel that the expert has considered their information, which is especially helpful when there is an in-spouse (business manager spouse) and an out-spouse (spouse who is outside the business at the time of valuation). The main issues in a free-for-all approach are cost (Who will pay for extra work that the expert does at the parties’ request?) and transparency (What level of disclosure to the other side is required when one party communicates information to the expert?). All of these elements can be negotiated, or, if an agreement is not reached, ordered by the judge in the case.
- Comments/Adjustments to a Draft: Most parties, experts and judges prefer that an expert issue a draft report for comment before a final report is issued. The draft allows parties to comment informally on the report before a final report is issued and to correct all types of errors. When a free-for-all approach is not used, at a minimum the parties in business valuations should request comment rights on a draft.
- Counter-Opinions and Litigated Valuations: The most effective way to oppose an expert’s opinion, whether it is from a section 730 expert or another party’s designated expert, is to propose one’s own expert. It is critical to ensure that the expert has sufficient access to underlying information to generate and defend a report. When there is an in-spouse and out-spouse, an order from the court may be helpful to ensure that all parties’ experts have equal access to business records and employees.
Using Litigation Tools to Build a Record on Specific Valuation Inputs
We now will describe the more common valuation inputs, and how a family law lawyer can use common litigation tools, especially discovery procedures, to develop a factual record on the inputs.
Sales and Revenue Recognition
Much of the analysis of business valuation ties in some way to the revenues of the business, whether standing alone as a metric of business performance or as a component of a profit calculation. Business revenue recognition is subject to manipulation, even when accounting supposedly is done under “Generally Accepted Accounting Principles” (GAAP)—such as manipulation through accelerated or delayed billing, deferred transactions, “channel stuffing” (transfers of inventory to false buyers), and manipulation of work-in-process calculations to accelerate or delay revenue recognition. In almost all business valuations, a reduction of revenue will have a negative impact on valuation—often an exaggerated impact due to the role of multiples in business valuation. For example if a business is valued at 2.5X sales, a $200,000 understatement of sales will understate the value of the business by $200,000 x 2.5=$500,000.
When one party has an incentive to devalue the business, the family law lawyer (often working with an out-spouse who once worked in the business) can play a critical role in determining whether the business’s financial statements are being manipulated. An inquiry that should be done in most cases when reduced revenue manipulation is suspected will look into whether the business’s revenue recognition activities deviated from historical practice, industry practice, and/or a consistent application of the requirements of GAAP during a relevant valuation period.
In a business valuation, expenses are the flip side of revenue: excessive expenses or an acceleration or other upward manipulation of expenses can have a negative impact on business value. The reason for this impact is that profits decrease as expenses increase—and a less profitable business is less valuable. A valuation expert will routinely seek to identify “Owner Discretionary Expenses” (ODEs) that are not a normal part of operating the business, such as the payment of personal or household expenses by the business or keeping non-employee family members on the payroll. Another area for inquiry is business “reserves” (e.g., reserve for inventory obsolescence) that are accounted for as expenses. Excessive reserves may reduce apparent profitability of the business. A sudden change in reserve practices may be a red flag for expense manipulation by the managers of the business.
An out-spouse who worked in the business at some point, or who does family bookkeeping, may have intimate knowledge of what ODEs the business pays for and what reserve levels are customary. In such cases, the family lawyer should work with an out-spouse client to ensure that personal ODEs and excessive reserves are properly added-back into revenue and profits. In many cases, the issue is not just whether an expense is “business or personal”—an expense may have both business and personal components, which need to be parsed to avoid valuation inaccuracies.
Perhaps the most commonly disputed expense item in a privately owned business is owner-officer compensation. While a valuation expert may feel competent to make some determination of reasonable compensation, a family law lawyer often is able to bring more resources to the compensation discussion and find significant overcompensation or undercompensation—either of which warrants an adjustment of the compensation expense (which affects profits/value). A family law lawyer whose client prefers a lower valuation can work to show that the current compensation paid to an owner is unreasonably low and argue that the fair market value of the business is lower because the replacement cost of the owner’s services is higher than the present owner’s compensation. A family law lawyer whose client prefers a higher valuation can show that the compensation paid to a current owner is unreasonably high and argue that the fair market value of the business is higher because the replacement cost of the present owner’s services is lower than the present owner’s compensation. The use of discovery to determine how an owner’s job function is the same or different from the jobs of executives in similar businesses can have a major impact on reasonable compensation.
Many business valuations are based upon a multiple of “earnings”—i.e., the profits of a business. Profits are often expressed as “EBITDA” (Earnings Before Interest, Taxes, Depreciation, and Amortization) or “EBIT” (the same except it includes depreciation and amortization). EBITDA and EBIT are often viewed as a better basis on which to determine the value of a business—because interest and taxes, and typically depreciation and amortization, often relate more to how the company is capitalized and managed by its current owners than a new owner’s predicted costs. Using EBIT and EBITDA to calculate profits, a prospective new owner can make its own calculation of the “IT” or “ITDA” factors. A valuation using EBITDA multiples generates an estimate of a company’s “invested capital” (which includes equity and debt). To arrive at the value of the subject company’s equity, the value estimated using EBITDA multiples is then reduced by the balance of the business’s existing debt.
The profits of a business relate directly to revenues and expenses, so any defects in the revenue and expense accounting will affect profits. When a business is being valued on profits rather than revenues or sales, the multiple that is used to achieve the valuation (i.e., the factor that is multiplied against the profits to determine the value of the business) is often larger than a revenues multiple. For example, a business may be valued at 2X revenue and 6X EBITDA. Therefore, any factor that affects the profit computation (including revenues, expenses and the inclusion or exclusion of any item in the profit calculation) should be understood by the family law lawyer and potentially be the subject of further disclosure and investigation.
Industry Classification and Comps
Much of the valuation process depends on the valuation expert applying accepted metrics for the same type of business as the business being valued. Extensive books and databases provide valuation experts with industry-specific valuation factors, including appropriate multiples, capitalization rate inputs, and metrics. As such, the valuation depends heavily on how the business is classified. In cases where a business has multiple segments, or does not fall clearly within a single classification, judgment calls must be made as to how to classify a business. Businesses that have both traditional segments (e.g., product manufacturing) and new or nontraditional segments (e.g., cloud computing services) can present complex classification challenges. When the classification issue is identified, the family law lawyer working with a valuation expert can use investigation and discovery to generate data for the expert.
For example, an in-spouse who desires a low valuation may explore the traditional aspects of a business model to argue for a low multiple on grounds that the business is “not very exciting” in terms of future growth. From typical financial statements, that may appear to be the case because all of the business’s current revenues come from the traditional business. The opposing family law lawyer may be able to show that the business is on the verge of entering into a new segment that should generate a significant amount of growth. The in-spouse’s initial claim may be that such a new line of business should be discounted as a speculative pipe dream. Is that what the internal projections say? Is that what an employee or contractor was told when he or she was hired by the company specifically to develop that new segment? Probing these areas is greatly assisted by discovery tools (especially e-discovery) and in general can go far beyond the amount of investigation and “case-building” that a valuation expert will do alone. Unless given a specific investigative task, the valuation expert is largely dependent on the good faith of the business’s current management for business information.
Beyond industry classification, there is the issue of “comparable” businesses, competitors, and transactions in the market. All of these issues arise in most business valuations. If a lawyer represents the out-spouse, that lawyer should assume the in-spouse is in a better position to influence the expert on the issue of business classification, comparable transactions, and the competitive landscape. The out-spouse’s lawyer must fight for a seat at the “comps” table. People who have been involved in a business are often better than experts at distinguishing comps—with unique insight into who is an actual competitor of a particular business. If necessary, the lawyer for the out-spouse should consider hiring a person with operating experience in the same segment to help gain equal footing with the in-spouse in terms of classifying the business.
Market and Growth Expectations
A similar dynamic is at play with other input—especially expectations for how much the business will grow. The difference between whether a business will grow 1% or 3% is a 200% difference. Accordingly, when an in-spouse claims that the business is “stagnant” or “declining,” that difference will translate into reduced future revenue and profit projections, and a dramatically reduced valuation. Especially if the business is in a robust segment, the out-spouse should explore any factors that would tend to affect the market and the growth rate.
Business risks include both general types of economic risks that affect all businesses or an industry, and company-specific risks such as too much debt on the balance sheet, too few different customers, input and supply chain risk (e.g., a component is supplied from an unstable country), and key person risk. Business owners may try to enhance general and company-specific risks. If a lawyer represents a spouse who wants a lower valuation, that lawyer can develop a record to overcome skepticism about company-specific risks. For representation of a party who seeks a higher valuation, develop a record to overcome claims that company-specific risks are severe. This may require discovery to explore each of the alleged risks, and to undermine exaggerated claims (or at least put them in context so that the risks are not unfairly driving the valuation).
Here is a simple example on customer concentration risk. The in-spouse claims 45% of the business revenues are from a single customer that is “rumored to be a takeover target.” If the customer is taken over, that revenue supposedly will evaporate because all potential acquirers “do the work in-house.” On one hand, this risk may be very true and real. On the other hand, the risk may be speculative and hard to verify. The in-spouse’s attorney can seek to substantiate the rumors as much as possible, as well as the fact that all potential acquirers of the customer perform the work in-house. The out-spouse can seek to show that the rumors are unlikely to be true, that the acquisition is not imminent and that with sufficient advance planning the business can absorb the loss of this customer and obtain future growth in other ways.
The investigation of company-specific risks is not only useful for purposes of completing the valuation—this work also may affect how a buyout or other transaction is structured. A fuller understanding of company-specific risks can help make a buyout deal. For example, even if it is shown that a business may lose 45% of its value if a rumored customer acquisition occurs, that does not mean the in-spouse should be allowed to buy the business at a price that presumes the business will be lost. It is possible to negotiate a transaction in which buyout payments are reduced if the rumored customer acquisition occurs with dire consequences.
It is critical to address business valuation issues early in a marital case and to understand the basic process. Family law practitioners should use their “litigation superpowers,” especially broad civil discovery tools and the ability to obtain key procedural orders, to assist the development of information that will be material to an expert business valuation. A valuation expert cannot require people to testify under oath, nor compel the production of information by parties and non-parties. Therefore, identify and investigate areas rife for manipulation in the key valuation inputs. Recognize that the normal valuation process does not contemplate that the valuation expert will do a significant amount of investigation or verification. Use specific information about the business to help get an accurate valuation and to structure a fair deal.