Often one of the more complicated yet vital parts of a divorce is valuing a closely owned business. A business has value, and that value will have to be taken into consideration by the trial court in dividing up the community estate. Just like any other asset, a business is to valued as the amount a willing buyer (who is under no compulsion to buy) would pay a willing seller (who is under no compulsion to sell).
Valuing a business can be a complicated matter, and it will often require the work with an expert certified in business valuation. Generally speaking, the expert will use one of three approaches to valuating a business:
- Market Approach
- Asset Approach
- Income Approach
The market approach simply looks at what a company has sold for on the market. There is rarely information available for the expert to rely on the market approach.
Generally speaking, the asset approach is accomplished by looking at the assets owned by the business, and it can often be accomplished by looking at the business’ balance sheet. The expert would simply add the value of the assets (accounts receivable, cash on hand, equipment, etc.) and subtract the liabilities (accounts payable, credit cards, lines of credit owed, etc.) to come up with the value. The asset approach does not take into consideration that the business is an ongoing concern.
The income approach values the business as an ongoing concern and takes into account the intangible asset of goodwill (see below discussion on goodwill). In other words, this approach values the business as if it will continue to make money, thus increasing the value of the business. Generally speaking, the expert will look at historical income data for the business and project income into the future. The expert will then apply a capitalization rate on that projected income to determine the value of the business before discounts and before backing out personal goodwill.
In using the income approach, the expert will often apply discounts to the value of the business. The most common discounts are marketability discounts and lack-of-control discounts. A marketability discount takes into account how long it may take to sell the business. The longer it potentially would take to sell a business, the greater the discount. A lack-of-control discount takes into account ownership of the business. If one does not have a majority interest in a business (and therefore cannot control the decisions of the company), that interest is worth less than if the owner has a majority interest of the business. The lack of control discount takes these factors into account.
Goodwill can be a confusing and complicated process of business valuation. There are two types of goodwill: personal and enterprise goodwill.
Enterprise goodwill is defined by the International Glossary of Business Valuation Terms, as “[t]hat intangible asset arising as a result of name, reputation, customer loyalty, location, products and similar factors not separately identified.” As an example, think of Rolex. Rolex is worth much more than just its stock, real estate, and capital. The name Rolex means something; it has value. That name is Rolex’s enterprise goodwill and is no different than a closely held business. The name, reputation, and structure have value.
Personal goodwill is the value of the business attributable to the individual owner of the company. The Pattern Jury Charge defines personal goodwill as “the goodwill attributable to an individual’s skill, abilities, and reputation.” For example, a world-renowned chef may make plenty of income through their catering business. Still, that success is attributed to the chef and their culinary skills, not to the general reputation of their catering company.
In Texas, personal goodwill is not taken into consideration in the overall value of a business. In a divorce in Texas, a business is valued as if the seller intends to open up a new business across the street to compete with the company they just sold. How much would you pay for that business? You wouldn’t pay much to run a chef’s catering company without the chef, but you would spend quite a bit to run a Rolex retailer.
When the expert uses the income approach, he or she will most likely apply a personal goodwill discount to the overall valuation. The discount amount is a judgment call by the expert and can often lead to wide variations in value if experts disagree on the amount.
Very few courts will require that the parties continue in the business together, so one spouse typically buys out the other by awarding community property to that spouse and/or with cash payments over time. It is, therefore, critical that the valuation is accurate because it directly determines how much one spouse must pay the other. Unless the business is traded on the stock market, valuations can be very complicated. Often, each side will hire a forensic expert to determine the value of the business.
Courts faced with determining the value of a business may consider both valuations and assign a value to be somewhere between the two numbers given by opposing sides, or they may adopt the value of one over the other.
Sometimes the court will order the sale of the business or the liquidation of retained earnings since that may be the only way to pay out one side or the other. Additionally, cash payments used to buy one spouse out of the business need to be secured against something (typically the business or real property), which requires drafting complicated documents to protect both parties.