What Must You Know About a Business Valuation in Divorce Cases?

Here are 6 essential truths about business valuations in a divorce case that every business owner must know

What is the business valuation process in divorce cases? Can it be fair?

Say the words, "business valuation" in a divorce case and add the words "forensic accountant" and the business owner's eyes may become wide. Just the thought of an accountant hired by their spouse or ordered by the court to crawl through the business' financials is enough to cause anger and visions of money thrown away.

It is not much different for the other spouse. He or she may fear the business owner lying about income, writing off personal expenses through the business and attempting to undervalue the business.

Fear is not helpful. What you want to achieve is on the other side of fear. You have to use your head during a divorce. It is not doom and gloom. Let us show you why you do not need to fear the business valuation process in your divorce case.

  1. Most of what you read below is a simplified version of the business valuation process.
  2. We stayed away from the legal jargon and nuances that significantly complicate business valuations during a divorce.

Here are the topics we will cover in this article.

  1. Why you should expect a valuation if your divorce case involves a business
  2. Different ways to value a business
  3. Why profitability is important to the business valuation
  4. The relevance of goodwill
  5. How to determine a business' assets
  6. Who conducts the business valuation in the divorce case

If your divorce case includes a business, expect a valuation

Business valuations in divorce cases are almost unavoidable in California when one or both spouses are business owners.

The common perception is business valuations in divorces get unnecessarily expensive. That is true if the spouses or their lawyers allow it to go on too long.

  1. Does it have to be that way?
  2. Can this process be efficient?
  3. Can the business owner not spend an outrageous amount of money or liquidate community property accounts to pay for the thing?

The non-business owner also has concerns.

  1. Can this business valuation process go forward more fairly for the non-business owner spouse?
  2. Can that spouse avoid the business owner spouse from artificially lowering the value of the business?
  3. Can he or she avoid unreasonable and costly delays?

Fortunately, the valuation process can be efficient and fair in a divorce.

A business has a value

Every business has value. Small or large, there is no exception.

Some simplify this "value" process by stating that value is what a buyer who is not in a hurry to buy will pay for the business and what a seller who is not in a hurry to sell will accept for the company. That is a simple way to look at it. In reality, it is more complicated than that.

What are the different ways to value a business during a divorce?

Business valuators usually take one or a combination of the following approaches when they value a business.

  • Income-based approach
  • Asset-based approach
  • Market-based approach

We are not going to go into what each of these approaches means in this article. We start using words like "capitalization," "discounted cash flow," "net asset" versus "fair market" value and this article may become a treatise on business valuations.

We intend to write comprehensive articles (which are easy to understand) that discuss each approach.

Here is what we want you to know. Every approach takes some or all of the following into consideration:

  • A business' profitability, the starting point of which is reviewing the profit and loss statement.
  • The goodwill of a business, and
  • A business' tangible and intangible assets

What is the business' profitability for valuation purposes?

Profit is the money that remains when you subtract business expenses from business revenue.

What about business expenses that are personal expenses?

Many self-employed business owners deduct business expenses that are not, by IRS standards, deductible. The expense may be partially deductible or not deductible at all.

When measuring profitability, these nondeductible expenses may be "add-backs," and the business valuator may remove them from the expense column. The add-back increases the business' profitability. It also often increases the business owner's income as a result.

Learn more about how spouses may lie on an income and expense declaration form during a divorce.

What is goodwill in a business valuation?

Here is a visual of some of the factors a forensic accountant may take into consideration when he or she values goodwill.

Graphic that lists the different factors a forensic CPA may look at to determine goodwill of a business

What are business assets?

For a business that sells "goods" of some type, assets may include its personal property. That is usually its inventory and equipment. It depends on the company and industry.

For a professional service business, you usually do not see inventory and items like computers, desks, etc. rarely have significant value. Such companies rely heavily on their goodwill.

How is a business that owns real property valued in a divorce case?

A business that owns real property has that property as an asset.

  1. It is normal for a business that owns real estate to hold that property in a separate entity, such as an LLC, which stands for a limited liability company.
  2. That LLC becomes an independent business valued during the divorce.
  3. If the business has real estate but not in a separate entity, that real estate becomes an asset of the actual company.

A business' assets for valuation purposes are not always tangible

The business may have intangible assets such as one common example, intellectual property.

Does the business own any of the following?

  • Copyright
  • Trademark
  • Patent

All of these have value and are part of the business valuation process during the divorce case.

Who conducts the business valuation during the divorce?

The spouses have several options available to them.

  • The first option, which is the most dangerous, is to try and figure it out on their own.
  • The second option is to hire a joint forensic accountant who will value the business.
  • The third option is for each spouse to hire his and her separate forensic accountant.

1. Trying to figure out the business' value on your own

Doing this is in our opinion, without exception, a bad idea. The spouses will either undervalue or overvalue the company unless they have actual business valuation experience and can conduct the same or similar to diligence as a forensic accountant and business valuators.

2. Hiring a joint forensic accountant for the business valuation during the divorce

A joint forensic accountant is one who both spouses trust to provide a proper valuation and on whom both spouses rely in negotiations that may lead to a settlement. A joint forensic accountant, like any forensic accountant, does not provide legal advice.

Spouses who hire a joint forensic accountant can also utilize a separate forensic accountant to review the joint accountant's work.

The only potential benefit of hiring a joint forensic accountant is cost

You may think it common sense that a mutually selected forensic accountant will cost less. You may be right, but you also may be wrong.

Just because spouses jointly agree to use one forensic accountant does not mean they can predict an agreement on that accountant's business valuation number.

  1. What happens if one spouse disagrees? The spouse may hire his or her forensic accountant to review the joint accountant's work.
  2. What happens if both spouses disagree? That means each spouse hires a forensic accountant and now they paid three forensic accountants to conduct the business valuation.

There are different ways to agree on a joint forensic accountant for the business valuation

  • The spouses can agree informally.
  • The spouses can sign a contract with the joint forensic but not make it into a court order.
  • The spouses can appoint the forensic as the court's expert.

The last one means there is a court order for the appointment of the forensic and the forensic becomes the court's expert on the business valuation during the divorce case.

Each one of these comes with some benefit and risk. It is beyond the scope of this article to discuss the benefits and risks, as they are highly customized and dependent on the case. Your consultation with your divorce lawyer becomes essential.

3. Each spouse can hire his and her forensic accountant for a business valuation

This is not as contentious as it may sound. The forensic accountants do not go to battle against each other. Instead, they each obtain the same information and determine the value of the business.

  1. Business valuations are both a science and an art, and therefore reasonable minds can sometimes disagree.
  2. Forensic accountants should communicate to build a bridge toward a compromise.

In those situations where the forensic accountants both have reasonable arguments in support of their valuation, the spouses, lawyers, and accountants can cooperate and determine if they can reach a compromise.

If one forensic accountant is overreaching and therefore unreasonable, court involvement may be inevitable

  1. There is nothing wrong with litigation of these issues if the facts and the amount in dispute justify it.
  2. Each spouse may want their day in divorce court regarding the business valuation.

Nobody sane wishes for a contested divorce. A contested divorce results from disagreements. Disagreements are sometimes reasonable and sometimes unreasonable. If the spouses have reasonable disagreements that involve significant money, it may be best for the court to make the ultimate decision. That way, each spouse can state he or she received their day in court and, despite reasonable efforts, were unable to compromise.

Does your divorce involve a business valuation?

Our family law firm represents husbands and wives in each of the seven California counties. Our family law firm works closely with respected forensic accountants. We have experience with divorces that involve a business. Contact us for an affordable strategy session.

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