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In many divorces one or both spouse may own a business or an interest in a business. Sometimes, that business may be the largest asset in the case. This article will discuss how such a business is valued and how that value may be allocated between two spouses who are dissolving their marriage.
A “business” can be almost any endeavor that allows its owner to generate income. It may be something as simple as you selling a product or service from your home to something as complex as a multi-billion dollar operation with several locations and which might not only sell a product or service but which also may own substantial assets including real estate and inventory.
In the divorce world the most common type of business will be a self-employed person who operates a business. It may be a professional practice (doctor, lawyer, accountant, etc.) or it may be a “closely held” business owned by one or two owners or family members. To have “value” a business need not be a big operation or generate large revenues.
A business may be a “sole proprietor” meaning there is no business entity such as a corporation or partnership. These sole proprietorships are often by definition small operations but they may generate significant revenues, such as a successful insurance broker or real estate salesperson.
A business operated by a business entity is often described by a confusing alphabet soup of choices. It may be a “C” Corporation or an “S” Corporation. It may be an LPC, a PC, an LLLC or an LLP or an LLLP and so on. If there is a business entity there may be several or even dozens or hundreds of owners.
What will be valued in a dissolution case is the ownership interest of one or both parties in such a business. If it is a sole proprietorship the interest is 100%. If there are no other owners or partners in a business corporation or partnership the interest again is 100%. If there are other owners or partners then the percentage of ownership will be determined by examining the books and tax returns of the business and the parties. So, if a business has 5 owners with equal shares each owner has a 20% interest. However, it is not unusual that each owner may have a different ownership interest depending on the amount of the owner’s investment of funds or time in the business. One owner may own a majority of the business and other owners may hold a minority interest. These factors can play a role in the value of the interest as will be seen later in this article.
Under Colorado law, property acquired during the course of a marriage is marital property unless there is some written agreement to exclude it (such as a prenuptial agreement). The value of marital property is divided between spouses in a fair and equitable manner. In most cases the spouses agree on how the property will be divided. If the spouses cannot agree, a judge will determine what the fair and equitable division should be. In most cases, a “fair and equitable division” is 50% of the equity value. However, depending on the facts of the case a fair division may be more or less than 50%.
For example, Sam and Susan marry in 2005. In 2007 Sam leaves his job as a mechanic for an auto dealership to start up his own auto repair business. The business does well. In 2016 the parties file for divorce and the business has an equity value of $60,000. [“Equity value” means the fair market value of the business less any debt owed by the business.] That equity value will be divided between Sam and Susan. Either one could buy out the other. How such a buy-out would be handled is subject to negotiation by the parties or may be determined by the judge if there is no agreement.
Property that is acquired before the marriage is separate property and is the property of the owner. However, any increase in value for the property that occurs during the marriage is considered marital property and as such that value can be divided.
For example, Sam starts his auto repair business in 2005. The parties marry in 2010 and the business continues to operate. The parties file for divorce in 2016 and the business is still operating. In this case, the business has a separate property value that belongs solely to Sam and a marital property value that can be allocated between Sam and Susan. The value of the business on the date of the marriage is the separate property value. The increase in that value from the date of the marriage to the date of the divorce is marital and can be divided. If the equity value of the business on the date of the marriage was $50,000 and on the date of the divorce it is worth $76,000, there is an increase in equity value of $26,000. Sam’s interest will be $63,000 ($50,000 premarital value + half the marital increase of $26,000). Unless there is an agreement for Susan to buy Sam out, Sam would the owe Susan $13,000. This is because the business itself is Sam’s separate property and he will retain the ownership. How Sam will pay Susan for her interest is subject to negotiation by the parties or may be determined by the judge if there is no agreement.
Colorado law provides that in the absence of an agreement by the parties, the trial judge will determine the value of the business based on the evidence presented at the time of the divorce. Often the judge will hear expert testimony from a business valuation expert or from an expert from each side. Expert testimony tends to carry a great deal of weight in making such decisions. If the experts cannot agree, the judge has the discretion to decide what evidence is the most persuasive and most credible.
Colorado law also recognizes that a business may have good will value. This good will value is best described as the value of the business to the owner based on such things as brand recognition or reputation in the field, length of time in business, customer base, customer relationships, employee relationships, ability to generate revenue, nature of any competition, patents or proprietary business secrets and stability of management. Good will may be institutional good will for a large business (McDonald’s hamburger franchises) or individual good will for a smaller business (the long-time and well respected local dentist.) Colorado does not distinguish between institutional and individual good will when valuing a business.
Colorado law recognizes that there may be several valid ways in which to value a business. No single approach is deemed “best” in all cases. If the parties cannot agree, it is up to the trial judge to decide what evidence of value is the most credible and the most persuasive. The most common approaches for valuing a business are discussed in the next section.
Value Per the Owner: Colorado law allows the owner of property to testify about the value of the property owned. This can apply to any property such as a car, a piece of art, a bank account, a home, an investment or even a business.
So, if a party to a divorce case owns part or all of a business that person can testify as to what he or she thinks the business is worth. The concern the Court might have with this is how did the owner arrive at the value and how reliable is that opinion of value.
It is understandable that not every business has great value and not every couple may be able to afford to hire a business valuation expert. The business might be a small business that provides a service, has no other employees, is operated from the home and generates just enough income to pay the bills of the business and maybe a small income to the owner. In this type of case, the owner might rely on tax returns and bank statements to show what the business made, how much it paid out in expenses and what was left over for income. The value of this business might be minimal.
It is up to the parties in the case to present evidence to the judge concerning the value of any asset. If they agree on a value the judge likely will accept that agreement unless the circumstances in the case raise some questions in the mind of the judge. If there is no agreement on value and no expert opinion is obtained, the burden of proving the value of a business falls on each party to demonstrate what they think the value is and how they arrived at that value. As noted above, reliance on the financial records of the business such as tax returns and bank account statements may be helpful to show value. If the business owns inventory or other hard assets, some evidence of value for those assets will also be helpful.
For example, Sam and Susan might own several rental homes. They might have a small corporation set up that holds title to the homes and which has a bank account to receive rental income and pay the bills related to the homes such as mortgages and utilities. The business might file a tax return or the income generated might “pass through” to them on their individual form 1040 tax return. Those records and some evidence of value for the homes themselves (real estate appraisals, tax assessor’s records of market value, etc.) will be helpful in showing how Sam arrives at his opinion of value for the business. If Susan disagrees with that value she has the burden of showing the court information that supports her opinion of value. Susan might have more recent or more thorough appraisals or a better record of how much the expenses and income were or she may know of other facts that might affect the value, i.e., one of the homes has an asbestos problem that will have to be mitigated as great expense.
If the business is successful and generates significant income for one or both of the parties it is risky to base the value on just the opinion of the owner. In such cases it may be wise to hire an expert to value the business.
Value Per Expert Opinion: Colorado law also recognizes that the opinion of a qualified expert is evidence of value. The expert must be qualified to offer an opinion and thus must have the education, training and experience necessary to offer such an opinion. Experts who have certifications in business valuations are often certified public accountants or similar financial professionals.
The most common approaches to valuing a business are:
Each approach has its own uses and sometimes there may be a combination of approaches used to determine value. The specific details of how the expert will use these methods is beyond the scope of this article but suffice it to say that most cases will use the income approach and or the market approach or some combination of the two.
For example, Sam and Susan’s rental properties number in the dozens and the business generates over $500,000 in annual income for them after all the bills are paid. The properties range from small homes in less affluent neighborhoods to large homes in the most affluent neighborhoods. Sam has been the hands on manager of the business and it is his full time job. Sam intends to keep it and run it. Susan has no interest in owning or running the business but wants her fair share of its value as part of their divorce. They agree to hire an expert to value the business. The expert will review all the financial records and will analyze the income it generates. The expert will also ask for recent appraisals of the real estate. The expert may consult data bases to determine if any businesses similar to Sam and Susan’s have been sold on the open market in the last 5-10 years and compare those sales to the value the expert may eventually come up with. So, in this case the expert might use all three approaches: valuing the real estate assets; valuing the business based on any similar sales on the open market; and value based on the income it generates.
How Many Experts Will Be Involved: It is more efficient and cost effective if the parties can agree on one so called “neutral” expert to value a business. That expert may need help from other experts depending on the type of business, i.e., for Sam and Susan’s business above the expert will likely need help from a qualified real estate appraiser.
However, Colorado law allows each side to retain their own expert if that is what they wish to do. If the experts have similar opinions then the case may settle on one value.
If the experts have very different opinions then the case may not settle and the judge will hear the evidence and determine what opinion he or she finds the most reasonable and credible. For example, Sam’s expert offers an opinion that the company and its assets have a value of $4,200,000. Susan’s expert offers an opinion that he value is $5,500,000. The judge will hear the case and render his or her findings on value. The judge has the authority and discretion to resolve contested facts and to decide credibility and how much weight to give each opinion.
Valuing a business in a divorce case is usually not a simple process. The selection of a business valuation expert can be a very important decision for a couple who are going through a dissolution of marriage. The business may be the most valuable asset they own and it may provide them with most if not all of their livelihood. The expert should be well qualified and have experience valuing similar businesses. Hiring an expert who is “neutral” can save expense and avoid the concern that the expert will inflate or deflate the value based on who the expert is working for. Using the CPA who does the work for the company and the parties is not always a good choice since that professional have a conflict of interest or have greater loyalty to one of the parties. Consulting with a family law lawyer who has experience with business valuations and how they are done is well advised when faced with making this kind of decision.
The lawyers and staff at Johnson Kush, P.C., understand that good legal representation requires a comprehensive understanding and application of the law to the facts and circumstances of each case.
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