Gain a deeper understanding of the underlying issues of “double dipping” through a business valuator’s point of view.
By Rob Metcalf, Business Valuator
In my 21 years as a business valuator in family law cases, an issue frequently arises related to the interplay between the business valuation methodologies applied and the business owner’s salary resulting in associated support obligations (I will use the term “support” to include both maintenance and child support payments in this article). Lovingly been termed the “double dip,” the short definition of this issue is counting the same income stream twice: once for division of property and the other for determination of support. Any seasoned family law attorney will take one of two positions to advocate for his or her client. This article will discuss the two options or viewpoints related to the double dip issue. While I do not intend to resolve the issue, I do hope to provide a clarifying understanding of its underlying issues.
At the heart of the issue is the application of business valuation methodologies. Because I have been valuing closely held businesses for family law purposes since 1995, I have been on both sides of this issue. Consequently, I am conversant with the underlying issues involved.
Business Valuation
The first point to bring to bear is the application of the business valuation methodologies themselves. Three approaches are used by valuators: asset, market, and income. Each one of these approaches has multiple methods associated with it.
The asset approach will look at the tangible assets of a business, adjust the assets to their fair market values, and subtract the fair market value of the business’s liabilities, either on a going concern basis or on a liquidation basis.
The second approach is the market approach. It employs market multiples from guideline public companies or guideline closely held company transactions and applies these multiples to a level of revenues and/or earnings of the subject business. Because these multiples are derived from non-normalized, operating results (normalization adjustments will be defined below), they would be applied to non-normalized revenues or earnings as appropriate.
The third approach, which I saved for last because it is the heart of the matter, is the income approach. This approach also includes a number of different methods under its banner; however, the methods are based on the same general principles. The subject business’s operating results are normalized. Normalized earnings are defined as the “economic benefits adjusted for nonrecurring, noneconomic, or other unusual items to eliminate anomalies and/or facilitate comparisons.” A multiple of normalized earnings is derived based on an assessment of the risk of achieving the normalized earnings in future periods and an assessment of the sustainable growth rate of those earnings into perpetuity.
One of the most prevalent normalization adjustments is the adjustment to owner’s compensation. In general, compensation paid to a business’s owner consists of two components: compensation for services rendered (otherwise termed “reasonable compensation”). Sometimes, the amount of compensation is determined in the course of tax planning to reduce the amount of tax that an owner will pay. The bottom line is that because owners have control over the compensation that they pay to themselves, this expense account is closely scrutinized by valuators to ascertain whether adjustments to owner’s compensation amounts are required.
The question at the heart of the double dip issue is if an adjustment to compensation to a divorcing owner is made, does this “reasonable compensation” amount become the appropriate base from which to calculate support? To state it another way, the purpose of the normalization process is to determine the cash flow available for the hypothetical purchaser(s) under the fair market value standard. The amount of cash flow available assumes a deduction of compensation including only “reasonable compensation.” The question then becomes whether the portion of compensation related to the return on investment is included in the value of an ownership interest in a business.
If the value of the business includes the investment return portion of compensation, it is then argued to be unfair to use the actual compensation level, including both portions of compensation previously discussed, in calculating support. The argument from the attorney of the owner spouse is that to do so would be to include the investment return portion in the value of the to-be-divided business interest and then use it again in the computation of support amounts. While not an attorney, it is my understanding that certain courts have adopted this view, e.g., New York in Grunfeld v. Grunfeld, 94 N.Y.2d 696 (2000).
The other side of the argument comes from attorneys representing the non-owner spouse who might state that the concept of business value is entirely separate and distinct from the support calculations. One is an issue related to property division and the other related to spousal support. Again, my understanding is that certain courts have adopted this view as well, e.g., New Jersey in Steneken v. Steneken, 873 A.2d 501 (N.J. 2005).
This view might be supported under the following hypothetical. Owner A owns 100% of a business, earning $1,000,000 per year. Owner A earns $400,000 per year and reasonable compensation is estimated at $250,000). Assuming no other normalization adjustments, normalized earnings would be $1,150,000 ($1,000,000 plus $150,000 [$400,000 less $250,000]). If an earnings multiplier of five (5) is used, the value for divorce purposes would be $5,750,000 ($1,150,000 x 5, ignoring any consideration of discounts or tax affecting).
The attorney for Non-Owner B might argue that support should be based on $400,000 of compensation. How could that argument be made? The attorney might say that Owner A does not intend to sell the business and might own the business of ten (10) years more. If this scenario proved true and the support period was only six (6) years, Owner A will continue to receive $400,000 annually through the entire support period. Would it be equitable for the trier of facts to base support on $250,000 when Owner A will receive $400,000 per year?
And what will occur when Owner A sells the business in ten (10) years? Assuming the business is operating as it was ten years prior, a valuator would make the same $150,000 normalization adjustment and the business would be valued at $5,750,000 and sell for that amount. Under this scenario, to use a support amount of $250,000 because of the double dip argument would shortchange Non-Owner B.
What is the alternative argument? Fair market value is normally used as the standard of value in divorce matters in Kansas and Missouri. It is defined as “the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller….” It, therefore, assumes a change in hands, i.e., an exchange. It may be appropriate to assume that Owner A has sold the 100% interest in the business and will no longer annually earn $400,000 as an owner, but only $250,000 as a non-owner employee.
In addition, it must be remembered that valuations are forward-looking. What I mean by that is that the valuator may use historical operating results, but only as an indication of what the operating results are expected to be in the future. Purchasers do not buy historical cash flows, but the estimated future cash flows of a business. Under the fair market value standard, purchasers are assumed to use the normalized cash flows of a business to pay the derived purchase price. One can see that the period over which normalized cash flows are used to “purchase” the non-owner spouse’s business portion will overlap with the period over which support is being paid. The compensation component considered a return of investment will serve double duty during this period of overlap.
The above analysis assumes the use of the income approach only; however, I was intentional when I previously referenced the other two approaches to estimating value, the asset and market approaches. These approaches do not require an adjustment to owner’s compensation discussed above. It has been a long-standing requirement of proper valuation practice to use as many methods as appropriate to render a credible conclusion of value. The Uniform Standards of Professional Appraisal Practice (USPAP 2014-2015 Edition) states:
“In developing an appraisal of an interest in a business enterprise or intangible asset, an appraiser must:
(a) be aware of, understand, and correctly employ those recognized approaches, methods and procedures that are necessary to produce a credible appraisal.”
The goal is to harmonize the values derived from the employed valuation methodologies, as generally it is assumed that values derived using appropriate methods ought to result in reasonably consistent values. If that is the case, what implication does that have on the double dip issue? If one method requires an adjustment to owner’s compensation and the other one does not, and yet the values confirm one another, does it favor one view of the double dip argument over the other? In my opinion, it favors the view that the adjustment to owner’s compensation only reflects the application of a valuation methodology to derive an appropriate value.
Offsetting this view is the fact that when a business sells, the purchase price must be paid in real dollars that must come from a business’s earnings. It is assumed that for the period of time over which the purchase price is paid, a working owner will only receive “reasonable compensation” and will not receive the investment return portion of compensation. The purchase price must be paid from the business’s earnings even when methods under the asset or market approach are used to determine value.
In summary, the double dip issue comes down to how one looks at the owner’s future tenure at the business. If one assumes that the owner will remain with the business and earn compensation as he or she has per the valuation analysis, the non-owner spouse might be shortchanged if the court decides to use only “reasonable compensation” for support purposes. It must be added that assuming the owner will remain with the business and retain the rewards of ownership may contemplate a value to the holder concept which valuators normally call “investment value” or value to a particular owner.
On the other hand, if one assumes a fair market value standard that posits the sale of the owner’s interest as of the valuation date, it would favor the use of “reasonable compensation” for support purposes because that would be the amount assumed earned by the owner as a non-owner employee post-valuation date.
As I stated in my opening paragraph, I did not intend to solve the double dip issue. My hope is that this article has added to your knowledge of the issues involved from one valuator’s perspective.
Rob Metcalf CPA/ABV/CFF/CGMA, CVA, CBA, ASA, MAFF is a partner at MarksNelson, a public accounting and business consulting firm. He specializes in business valuations and litigation support services as part of the MarksNelson business valuation practice. Since 1995, he has been involved in hundreds of valuations of various companies in a wide variety of industries and settings. www.marksnelsoncpa.com
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