May 19, 2010

Analysis of the Active and Passive Appreciation of Closely Held Businesses

Analysis of the Active and Passive Appreciation of Closely Held Businesses
Untitled Document

In the context of a divorce action, appreciation of a closely held business is a relatively simple concept – if a business is valued at $1 million as of the Date of Marriage (“DOM”), and $2 million as of the Date of the Complaint (“DOC”), then it appreciated $1 million over the term of the marriage. This should be a straight-forward calculation, right? However, appraisers have been asked take this simple concept one step further and to determine the portion of the appreciation that is due to active efforts of the business owner and, conversely, what portion is passive in nature.

In many “equitable distribution” states, if a party to the divorce proceeding owns an interest in a closely held business as of the DOM, or an interest is gifted to the party during the marriage, then the pre-marital, or gifted, interest is “immune” from equitable distribution. However, the appreciation of the value of the interest over the term of the marriage can be subject to equitable distribution. Typically, the interest must be retroactively valued to the DOM (or to the date the business was gifted during the marriage), and again as of the DOC, with the difference constituting the increase in value subject to equitable distribution.

However, many courts now recognize two different components of appreciation: active appreciation and passive appreciation. Active appreciation is the increase in value of a business as a direct result of the effort of one or both spouses in a marriage. Passive appreciation is the increase in value brought on by such factors as the national or local economy, efforts by a third party or changes in the financial markets, with no actual effort put forth by either spouse.

The following chart illustrates the concept of active and passive appreciation:


As mentioned above, only the active portion of the appreciation is typically subject to equitable distribution, so it is necessary to determine how much of the difference in value is attributed to each type of appreciation. Oftentimes it is very difficult to distinguish the fine lines that blur between the two. The following table sets forth certain examples of causes of active and passive appreciation:

Factors Affecting Active and Passive Appreciation

Active Appreciation

Passive Appreciation

  • Change in Business Plan
    • Economic Growth
      • Increased Marketing Budget
        • Industry Growth
          • Change Product Service Offerings
            • Positive Demographic Trends
              • Increase Management Depth
                • Change in Financial Markets
                  • Diversification of Vendors/Clients
                    • Change in Interest Rates
                      • Increased use of Technology
                        • Change in Credit Policy
                          • Expansion of Geographic Area
                            • Change in M&A Market (e.g. Roll-ups)

                              This list is not meant to be exhaustive, but rather to illustrate that active appreciation is a result in a change in the Company, typically brought about by the owner, whereas passive appreciation is a result of environmental factors.

                              This is easy to write, but much more difficult to analyze. Arguments can be made for or against both active and passive appreciation. For instance, even the 100 percent owner of a company does not necessarily drive 100 percent of the active appreciation. A percentage must be figured each for the effort of the employees, the economic conditions and the value of various appreciable assets owned by the company, such as real estate. Moreover, each closely held business takes on the characteristics of its owner(s), which is why business valuation remains as much an art as a science. Much the same, the determination of active and passive appreciation is highly dependent on the facts and circumstances of each specific business and the time period over which it is measured.

                              There are several methods that have been proposed over the years for determining active and passive appreciation values. However, there is no generally accepted method to perform the calculations. Different practitioners utilize various approaches to distinguish between and measure the proportion of active and passive appreciation. However, the approaches generally incorporate the following framework:

                              1. Value the business interest as of the DOC;
                              2. Value the business interest as of the DOM (or Date of Gift “DOG”);
                              3. Calculate the change in value;
                              4. Determine passive factors that have influenced the value of the asset (changes in interest rates, growth rates of related industries, changes in foreign exchange rates, etc.);
                              5. Quantify the impact of those passive factors;
                              6. Classify the remaining value to active appreciation; and
                              7. Estimate how much of the active appreciation is due to activities of the titled spouse.

                              It is extremely important here that the same standard of value is used in each of the valuation dates, as different standards of value adhere to different guidelines and may produce significantly different indications of value. For example, a fair market value valuation for gift/estate tax purposes may result in a much different valuation than a fair value valuation. The effect of discounts which may or may not apply under fair value can have a significant impact on the calculation of appreciation.

                              Much like business valuation, no single approach or method will work for all calculations, since much of the analysis is fact sensitive and heavily dependent on the specific business and individuals involved in the matrimonial proceeding. It is imperative, therefore, that the practitioner treats each engagement uniquely and understands all of the factors that have contributed to the appreciation (or depreciation) of the subject business.

                              Kyle S. Garcia – [email protected]