What to Consider When Divorcing Parties Have Ownership Interests in Privately Held Companies
Previously published in the Cleveland Metropolitan Bar Journal
By Sean Saari, CPA, ABV, CVA, MBA, Partner, Advisory Services
Remember the excitement and mystery you felt when receiving a gift-wrapped present as a child? You probably had an idea of what was inside based on what you had begged your parents for or how heavy the box felt, but you still needed to tear through the wrapping paper to find out for sure (although sometimes you could shake the package to get a better idea). Your guess may have been spot on or way off. The box you thought might have held that shiny new toy you wanted might have just concealed a sweater. Or the present that felt like it was just a few pairs of socks could have actually turned out to be that baseball jersey you had been hoping to get. You learned that the look and feel of a gift-wrapped present can be deceiving – you need to open it up to confirm or deny your expectations.
There are many similarities between guessing the contents of a gift and determining the value of a privately held business in a divorce. When assessing a business’s value, sometimes “judging the book by its cover” can lead to a reasonable expectation of value, while others remind us that looks can be deceiving. Unlike a portfolio of publicly traded securities, the value of an ownership interest in a privately held business is not readily ascertainable. Therefore, while each party involved in the divorce process (clients, attorneys, etc.) has their expectation of a privately held company’s value based on how it looks and feels, one invariably needs to “open it up” and dig into the financial details to determine its actual value. The differences in expectations that the parties may have, which are sometimes driven even further apart by the intense emotions accompanying the divorce process, can make the valuation of a privately held ownership interest a significant hurdle to clear before reaching a resolution.
Family law attorneys navigating cases that involve divorcing clients with ownership interests in privately held entities should keep the following concepts and issues in mind.
Why is Business Valuation Relevant in Family Law?
When couples going through a divorce hold an ownership interest in a privately held business, one spouse typically retains the ownership interest. An equivalent value comprising other marital assets is allocated to the other spouse as a part of the property division. This creates a natural source of tension as the spouse retaining the ownership interest is incentivized to seek a low value while the other spouse seeks a high value. Yet, it is very common that neither party has an accurate or realistic idea of the company’s true fair market. Considering that an ownership interest in a privately held company is often a couple’s most valuable asset, valuation issues can take center stage in these divorces, with significant dollars at stake.
Do I Need to Hire a Valuation Expert?
When an ownership interest in a privately held business is identified as a marital asset, counsel must decide whether it is necessary to hire a valuation expert. From a valuator’s perspective, the answer to this question is almost always yes. In evaluating the necessity for such expertise, it is also fair to consider the following factors in making this case-specific determination:
- What is the potential value of the business and is it material to the marital estate?
- Do the parties have similar expectations of the business’s value?
- Is there any concern that the spouse involved with the business may not provide accurate financial information or run personal expenses through it?
- What is the quality and availability of the business’s financial information?
- Does the spouse not involved with the business have a solid understanding of its operations and financial position?
- Have any recent transactions or valuations indicated the value of the ownership interest?
- Does the company have a buy-sell agreement in place?
- What is the valuation experience of counsel on both sides of the case?
- Will opposing counsel hire a valuation expert?
If the decision is made to hire a valuation expert, a few additional factors should be considered:
- Does it make sense to hire a joint expert? (This typically produces a quicker resolution, gives the expert direct access to both parties to consider their input and concerns, and results in lower overall expenses)
- Is the valuation expert credentialed in valuation? (Simply being a CPA does not qualify someone as a valuation expert)
- By what date will the valuation need to be complete? (Preparing a proper valuation analysis often takes a number of weeks)
- Has the expert prepared valuations for litigated cases in the past, and do they have experience testifying?
Critical Valuation Concepts
Attorneys are not expected to be valuation experts, but they should be familiar with the following valuation concepts:
The valuation date is important because the value of a company fluctuates over time (just as the prices of publicly-traded stocks change regularly). More significantly, governing valuation standards generally preclude a valuation expert from considering any facts that were not known or knowable as of the valuation date.
Each of the following valuation approaches are required to be considered (although not necessarily applied or relied upon) in a valuator’s conclusion of value:
- Asset Approach – Focusing on the assets and liabilities of the business;
- Income Approach – Using cash flow and risk/required return to determine value; and
- Market Approach – Considering valuation multiples indicated by comparable public companies or the sale of similar businesses.
Normalizing adjustments are made to a company’s historical and/or projected financial statements to better reflect economic reality and account for non-recurring or non-operating income and expense items. A company that reported losses historically may be very profitable on a normalized basis (or vice versa). A common normalizing adjustment involves adjusting officer/owner compensation to fair market value if there is overcompensation (or under compensation) relative to fair market value, which may result from tax planning, temporary cash flow shortfalls, or other factors.
When valuing ownership interests in privately held companies, discounts for lack of control and marketability may be applicable. These discounts take into account the detriment to the value associated with (a) not having control of the company (when valuing a non-controlling ownership interest) and (b) the lack of a ready market for the sale of ownership interests in privately held companies.
Separate vs. Marital Assets
When an ownership interest is acquired with marital funds, it is common that the entire value of that interest is included as a marital asset. When an ownership interest was brought into the marriage by one spouse or was acquired with separate funds during the marriage, however, it may be necessary to value the company on multiple dates (often the date of marriage and the current date) to determine the appreciation in the ownership interest that may be includable in the marital estate.
Common Valuation Misconceptions to Avoid
There are a handful of common valuation misconceptions that family law attorneys should keep in mind when dealing with cases that involve business valuation:
- Just because a company is (a) privately held; or (b) not for sale does not mean that an ownership interest in that entity has no value. Discounts for lack of control and lack of marketability can take into account the detriment to value associated with holding an ownership interest in a privately held company.
- The value of a non-controlling ownership interest in a company is rarely equal to its pro-rata share of the company’s overall equity value. The application of discounts for lack of control and marketability, the extent of which is facts and circumstance specific, can result in a significantly lower value for a non-controlling (minority) ownership interest.
- The value of a business is not typically reflected in a company’s financial statements or tax returns (including K-1s). These documents serve as a starting point, but additional valuation analysis and adjustments are almost always necessary in determining value.
- The book value of a company is rarely the same as its fair market value. Book value and fair market value will be the same only by coincidence.
- Just because a company was valued in the past does not mean that value is still relevant today. Valuations can become stale over time as changes in the company, industry, and economy cause value to fluctuate.
Family law attorneys must navigate many complicated issues, and no two engagements are the same. When an ownership interest in a privately held business is present in a divorce, it adds another layer of complexity. It is essential that family law attorneys develop a plan for addressing valuation issues early in the engagement so that the guesswork related to business value is minimized and client expectations are appropriately managed.