Business Valuations in a Divorce
When a spouse in a divorce owns a business, that business is a marital asset which is divided at divorce as part of the marital estate. And that means determining the value of the business. But unlike publicly traded companies, where the stock price can be readily ascertained, a closely-held company usually requires a divorce business valuation to ascertain its value.
There are three primary ways to value a business in a divorce:
- Income Approach, also commonly known as the “excess earnings method”, whereby the “excess earnings” are capitalized over a period of time to determine the business value.
- Market Approach, whereby the business is compared to other comparable businesses which have been sold on the open market. This approach is not as common, as there is often insufficient sales data.
- Asset Approach, which is basically taking the liquidation value if the business were stripped and its assets sold. This is rarely used, because if the business assets were worth more than the business as an ongoing concern, most rational owners would have already broken it up and sold the assets.
In a recent unpublished decision, the Colorado Court of Appeals reinforced the appropriateness of using the income approach for a professional practice. In Kim, the husband started a surgical business during the marriage, and paid himself $720,000 annually, plus substantial benefits including 401(k) contributions, cash balance contributions and vehicle expenses.
Shortly before the dissolution hearing, the husband notified the wife that he intended to sell his surgical practice to his partner for $40,000, and move to Cambodia to perform surgery for a $36,000/yr stipend, as opposed to the $720,000/yr plus generous perks he was then-earning (we address the alimony aspect of the decision in a companion blog post today, and suffice it to say, the trial court found it would not be a good faith career choice for a successful 50 y.o. surgeon to take a 95% reduction in income to “retire” to Cambodia).
The parties had three different business appraisers whose divorce business valuations ranged from a low of $337,000 (the husband’s expert) to $1.79m and $2.24m (the wife’s two experts). After a contested hearing, the family law judge valued the business at $1.76m for purposes of the marital estate.
The husband appealed, and the appellate court affirmed the business appraisal.
Income Approach for Divorce Business Valuation
The husband argued that since he was planning on selling the business, it was not appropriate to use the income approach, because his plan to sell the business eliminated the probability of future earnings, as well as the determination of goodwill. The Court of Appeals first explained the capitalized earnings method, and why the income approach was appropriate:
“The valuation method used is a factual question for the district court. The excess earnings approach is a generally accepted method for determining the present value of a spouse’s interest in a business. It capitalizes the amount by which the spouse’s historical earnings exceed that which a professional with similar education, experience, and capabilities earned during that period. It represents the value of the tangible assets and goodwill of the spouse’s interest on the dissolution date.”Kim, ¶ 10 (Cleaned Up).
Goodwill in a Divorce Business Valuation
Note the court’s reference to goodwill being part of the excess earnings method. Discussing other cases, the Court summarized what goodwill means:
“Goodwill is a property or an asset that supplements the earning capacity of another asset, business, or profession, and, therefore, it not the earning capacity itself. It is generally regarded as the summation of all the special advantages, not otherwise identifiable, related to a going concern. It includes such items as a good name, capable staff and personnel, high credit standing, reputation for superior products and services, and favorable location.”Kim, ¶ 11 (Cleaned Up).
Selling a business diminishes its goodwill, but does not completely destroy it:
“Discontinuation of a business or profession may greatly diminish the value of the goodwill but does not destroy its existence. Rather, a professional who has established a reputation for skill and expertise can expect his patrons to return to him, to speak well of him, and upon selling his practice, can expect that many will accept the buyer and will utilize the buyer’s professional expertise.”Kim, ¶ 12 (Cleaned Up).
Both of the wife’s business valuation experts testified to its goodwill, with one placing a value of over $1.2m on the goodwill alone. Even the husband’s partner who was planning on buying the business indicated that the business was attractive due to being already established with employees – i.e. it had goodwill! And this goodwill made the income approach appropriate for the divorce business valuation:
“Husband created goodwill in the practice’s reputation, location, referrals, and staff, and not just in his ability to earn future income. That goodwill did not diminish simply because husband decided to sell the practice. It would be inequitable to wife, who contributed to the marriage, to ignore the value of that goodwill as a marital asset. Accordingly, because of the existence of goodwill, the court did not err in using the excess earnings method.”Kim, ¶ 14 (Cleaned Up).
Reasonable Compensation in a Business Appraisal
As indicated above, the income approach considers how much the business owner is earning compared to his reasonable compensation – and those “excess earnings” are directly attributable to the business, and therefore form the basis of a business valuation. By way of a simplistic example, if you take a small business with no real assets and the owner makes $200K/yr (counting not just salary, but earnings, and “addbacks” for perks which diminish living needs), but the reasonable compensation for someone with the owner’s skills and experience would be $120K/yr, she is earning an extra $80,000/yr by virtue of owning the business.
Those excess earnings are then “capitalized” over a period of years, so that $80K excess may result in several hundred thousand dollars of actual business value.
In Kim, the court determined his reasonable compensation to be $533K/yr, which was based upon one of the wife’s experts who utilized the 75th percentile for the husband’s income. All three experts utilized the Medical Group Management Association (MGMA) survey to determine his compensation, which considers “what one practitioner earns as compared to another practitioner with the same qualifications and years of experience who works the same number of hours in the same general area.” ¶ 16. The median income is typically used except in rare circumstances.
By contrast, the husband’s expert argued that the court should use the 87th percentile, which would result in reasonable compensation of $660K, or $127K more than the wife’s expert. The court rejected this testimony, finding that the wife’s expert was more thorough, and included substantial benefits he paid to himself which the husband’s expert ignored.
There was also a dispute over the value of the business’s accounts receivable, but the trial court there also sided with the wife’s expert.
There was nothing groundbreaking about the Kim decision, which is probably why it was not selected for publication. But it is helpful because it presents succinctly and simply some difficult business appraisal concepts.
The takeaway? A divorce business valuation is all about the income – or “excess earnings”. Trial courts are not likely to adopt divorce business valuations where the appraiser lowballed the value by inflating reasonable compensation, or ignoring perks. The husband’s attempt to lowball the value with a sweetheart deal to his business partner, and then head to Cambodia, probably did not endear him to the judge.
This decision was not surprising – at Graham.Law, we have litigated numerous cases where there are competing business valuations, and a more thorough evaluation generally is more persuasive to judges.
Award-Winning Divorce Business Valuation Attorneys in Colorado Springs
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