Why the Standard of Value is Critical in Divorce Business Valuation

The standard of value in the particular jurisdiction is the single most important thing for an attorney to understand when dealing with a business valuation in a divorce.

By Shannon P. Pratt and Alina V. Niculita, Business Valuators

There is no area of law where there is as much confusion and as little consistency about the standard of value (a.k.a. definition of value) for business valuation as in the family law area. Few family law judges are specialists in finance. Most may have a case involving a business valuation once or twice a year.

The single most important thing for an attorney to understand when dealing with a business valuation in a divorce is the standard of value in the particular jurisdiction.

The standard of value describes the value being sought in terms of who the buyer and seller are, and the circumstances under which the transaction would take place. For instance, in the case of fair market value, the buyer and seller are assumed to be hypothetical and the transaction is assumed to take place under normal conditions (as opposed to under duress). In other words, the standard of value addresses the question of “value to whom?” and “under what circumstances?” (Shannon P. Pratt and Alina V. Niculita, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, Fifth Edition, 2008, p. 41.)

The Standard of Value in Divorce Business Valuation

In almost no state is the definition of value included in the statute on marital dissolution. Instead, it commonly must be gleaned by reading the case law. Often, however, this can be misleading. Prior court decisions, even within a state, can appear to interpret the standard of value differently. For instance, one court may use the term “fair market value” to refer to a specific value, but that value may incorporate elements of other types of value, such as investment value.

Some states (e.g., Florida, Hawaii, Illinois, Missouri, Pennsylvania, South Carolina, Texas, and Wisconsin) adhere quite strictly to the standard of fair market value, and the price at which property would change hands between well-informed, willing buyers and sellers on an arms’ length basis. (Shannon P. Pratt and Alina V. Niculita, The Lawyer’s Business Valuation Handbook, Second Edition, American Bar Association, 2010, p. 312.)

Some states rely on investment value (value to the owner) based on special circumstances, which may make the value to the owner higher than the value to a hypothetical buyer. In this case, unless a sale is imminent, an assumption as to a hypothetical sale is irrelevant (unlike fair market value, where there always is the assumption of a sale). Other states have different standards of value in different jurisdictions (usually counties). Additionally, in most states, family law judges have very wide discretion regarding distribution of the marital assets.

Unlike Tax Court decisions or decisions in dissenting stockholder cases, which usually describe the analytical steps that the Court relied on in reaching its decision, written decisions regarding property values in marital dissolution cases are typically short. Moreover, it is not uncommon for the judge to use the familiar term “fair market value” when, on further reading of the case, it is revealed that the expert on whom the judge relied included one or more elements that do not fit into the widely accepted definition of fair market value.

Another commonly encountered misuse of financial terminology is “capitalization of earnings method,” which, in commonly accepted business valuation terminology, is called “excess earnings method.” (Shannon P. Pratt and Roger Grabowski, Cost of Capital in Litigation – Application and Examples, John Wiley and Sons, Hoboken, N.J., 2011, p. 201.)

This is an article on definitions of value, not on methodology, but these examples indicate how difficult it is to read and interpret case law, which is the source of authority for standards of value.

The Most Common Standards of Value

The three most commonly used standards of value are:

• Fair Market Value (previously defined),
• Investment Value (sometimes called intrinsic value or value to the owner, also previously defined), and
• Fair Value, which a few states have recently adopted (e.g., New Jersey, Indiana, and Washington).

The term “fair value” is borrowed from the statutes of most states as the standard of value for dissenting and oppressed stockholder suits. Overly simplified, it means fair market value without discounts, such as discount for lack of marketability. (For an in-depth treatise on standards of value, Jay E. Fishman, Shannon P. Pratt, William Morrison, Standards of Value: Theory and Applications, John Wiley and Sons, Hoboken, N.J., 2007.)

Closely aligned with the standard of value is the question of what is included in marital assets. This question most often arises with respect to goodwill.

Goodwill is defined in the International Glossary of Business Valuation Terms as: “The intangible asset that arises as a result of name, reputation, customer loyalty, location, and similar factors not separately identified.” Goodwill is often separated into personal and enterprise goodwill. Over time, personal goodwill has come to be understood as the goodwill that attaches to one or more individuals, while enterprise goodwill is the goodwill that attached to the business regardless of any one or few individuals.

In California, for example, personal goodwill is a marital asset. But in most states that adhere closely to the standard of fair market value, personal goodwill is not a marital asset unless the spouse has an employment contract or a non-compete agreement. Therefore, in these states, the expert has to separate enterprise goodwill (the goodwill that attaches to the enterprise without the presence of the active spouse) from personal goodwill (the goodwill attributable to the presence of the active spouse). (For a thorough treatment of personal versus enterprise goodwill see, BVR’s Guide to Personal versus Enterprise Goodwill, Portland OR, Business Valuation Resources, updated annually.)

In a business valuation in connection with a divorce, it is essential that the attorney and the valuation expert agree on the applicable standard of value at the onset of the engagement, and that it be a part of the engagement letter. The attorney may also instruct the expert as to the treatment of the personal goodwill in the respective jurisdiction, asking for a value including, or excluding personal goodwill. While the attorney is responsible for the specification of the standard of value, the expert should read the relevant case law in order to pick up on any nuances implied by the interpretation of the standard of value in the particular jurisdiction.

Shannon P. Pratt, CFA, ARM, ABAR, FASA, MCBA, CM&AA, is the founder, and Alina V. Niculita, CFA, ASA, MBA, is the president of Shannon Pratt Valuations, Inc., a national business valuation firm located in Portland, OR. Dr. Pratt has more than ten books in print on various business valuation topics including valuations for marital dissolution purposes and he has testified on hundreds of occasions in various types of litigated matters including divorce cases. Ms. Niculita manages valuation engagements at Shannon Pratt Valuations, and has contributed to several business valuation books. www.shannonpratt.com.

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