An experienced appraiser can bring sanity to a divorce matter when a business valuation is required, and eliminate a faulty conclusion resulting from an erroneous “one size fits all” application.
By Erin D. Hollis, Accredited Senior Appraiser
A “small business” is defined as an independent business having fewer than 500 employees. According to a 2015 U.S. Small Business Administration Office of Advocacy report, there are 30.2 million small businesses in the United States. This is up from 27.9 million small businesses in 2010. A recent study by the CDC/NCHS National Vital Statistics System reveals that about 3 of every 10 people in the U.S. get divorced or have an annulled marriage. That’s a lot of businesses that are the focus of divorce matters involving business owners.
For many married business owners, the business is both the most valuable and most illiquid asset in the marital estate. As such, it is reasonable to assume that if owners divorce the business asset may spark substantial controversy and conflict between the separating parties. When working with divorcing owners, attorneys may want to engage a valuation expert to assess the business’ value. It is highly recommended an experienced and credentialed expert be engaged. A credible and reliable valuation is based on technical know-how, an experienced understanding of the specific industry and best practices.
Three Approaches to Valuation: Income, Market, and Asset
There are three approaches to valuation – the income, market, and asset approaches – and within these approaches, there are various corresponding methodologies. Contrary to some opinions, there is no “one size fits all” application. In fact, it is understood among valuation professionals there are preferred methodologies for valuing certain types of companies, which are based in large part on the capital structure and financial operations of the business in conjunction with the consideration of the purpose of the appraisal.
The Income Approach to Valuation
The income approach is the most commonly used approach for valuing a business. It is based upon the economic principle of expectation and assumes the value of the business is the present value of the economic income expected to be generated. The expected returns are discounted or capitalized at an appropriate rate of return to reflect investor sentiment and the inherent risks of the business. A business’ value is based either on future cash flows or historical earnings, and methods under this approach include the Discounted Cash Flow Method, also known as the “DCF Method”, and the Capitalization of Earnings Method.
The DCF Method is most widely used when valuing a typical, growing business operation. This method identifies the total value of a business as the present value of its anticipated future earnings in a specified period. The present value of anticipated future cash flows is then discounted at an appropriate present worth factor. This method is often utilized when valuing companies for sale, acquisition, or to acquire capital infusion. It is also employed when valuing a company that is projected to experience significant growth or has a finite life. Basically, any business can be valued utilizing this method as it examines how the business will financially operate over a defined period – five years going forward, for example. Service businesses, contractors, wholesale or retail operations, and manufacturers may be reasonably evaluated utilizing this method.
The Capitalization of Earnings Method is used widely when valuing very small, closely-held businesses, and in some cases, depending on the purpose of the valuation, mid-to-larger sized entities. The premise of this method assumes a company’s historical results are expected to continue with a relatively stable growth rate into the future. In many cases, particularly in the case of a small closely-held business, plans for expansion and growth do not exist or are not formally documented. Typically, with small, mature companies, the future mimics history, and shareholder expectations are not as focused on future financial performance or return on investment as they are on day-to-day operations. For example, start-ups, companies that anticipate growth based on a business plan, and companies that are in a transitional phase may all warrant a forward-looking valuation analysis. This indicates an application of the DCF Method. Conversely, a historical performance analysis may be required for purposes of taxation, such as estate and gift taxation.
There is also another method, which is based more on judgment call than technical application, called the Capitalization of Excess Earnings Method. This method was a creation of the Internal Revenue Service and developed to value distilleries put out of business during 1920s Prohibition. Its application is sometimes used to calculate the intangible value that tangible assets generate for a closely-held business. Although not widely accepted as an appropriate methodology in the business valuation industry due to the fact it relies heavily on the judgment of the appraiser and less on sound calculations, it may be reasonable to use in some circumstances where, for example, a business is heavily invested in equipment, such as a smaller sized transportation company. This method also has been cited in marital dissolution state case law; however, its reliability is profoundly suspect due to the unsubstantiated calculations of the rate of return on both the tangible and intangible assets.
The Market Approach to Valuation
The market approach is based on the principle of substitution. Methods under the market approach include the Guideline Publicly-Traded Company Method and the Guideline Transaction Method. The fundamental basis of the market approach is predicated on the theory that the fair market value of a closely-held company can be estimated based on the price investors are paying for stock of similar, publicly-traded or privately-held companies. This is done using ratios that relate the stock prices of the public companies to their earnings, cash flows, or other measures. By analyzing the financial statements of analogous companies and then comparing their performances with those of a subject company, the appraiser can judge what price ratios are appropriate to use in estimating the market value of the entity.
For example, an examination of market multiples may give a perspective on the types of buyers, demand, and rates of return for a given entity in a given industry. Keep in mind, however, that multiples are specific to that transaction and point in time and are not always appropriate to apply to every company due to a multitude of company-specific risk factors, including management, clientele, market share, and financial condition. As such, a market approach methodology may be best applied as a sanity check to other values derived from other methods, such as a method under the income approach.
The Asset Approach to Valuation
An asset approach methodology may be applied when the benefits of operating a business do not outweigh the value that could be derived through the orderly liquidation of assets. Methods under this approach assume a controlling premise of value and include the Net Asset Value Method and the Adjusted Net Book Value Method. It should be noted that an asset approach method is typically utilized to value the entire enterprise value, versus a non-controlling ownership interest – or a pro rata ownership of less than 51%. This is because only a controlling ownership can dictate a business’ capital structure or the sale of business assets, among other controlling shareholder characteristics.
The Net Asset Value Method is calculated as the business’ assets minus existing liabilities. This simplistic approach is used most commonly when valuing securities of businesses involved the development and sale of real estate, investment holding companies, and certain natural resource companies. This method assumes the book values of the assets on the company’s balance sheet are equivalent to their fair market values. However, the Adjusted Net Book Value Method involves adjusting the book value of the assets and liabilities to their current fair market values. The value derived from this method assumes there is no expectation of intangible value or commercially transferable goodwill. The Adjusted Net Book Value Method may be also applied when valuing an investment or real estate entity, when all business income is attributable to personal goodwill of the owner or key person, or when the value of the net tangible assets exceeds that of the company’s value as a going concern. Companies that are not profitable and have no expectation of becoming profitable, or companies that are winding down, may also be better valued utilizing an asset approach methodology.
By excluding an asset approach in a valuation analysis, the appraiser assumes that an investor would evaluate the company based upon its earnings and cash-generating potential, rather than through an appraisal of the underlying tangible assets, which would not reflect the intangible value or economic obsolescence inherent in the company.
The type of business and its financial condition, the particular industry, and the purpose for the appraisal all dictate the appropriate methodology to be applied for the valuation analysis. Utilizing methods under one or more of the three valuation approaches allows for a comparison of information as a sanity check to confirm the integrity of the final value concluded. An experienced appraiser can bring sanity to the divorce matter when a business valuation is warranted, and eliminate a conclusion that may result from an erroneous “one size fits all” application.
 2015 Statistics of US Businesses (SUSB) and US Census Bureau. www.sba.gov/sites/default/files/advocacy/2018-Small-Business-Profiles-US.pdf
 Provisional number of divorces and annulments and rate: United States, 2000-2016, Source: Center for Disease Control/National Center for Health Statistics National Vital Statistics System. www.cdc.gov/nchs/data/dvs/national_marriage_divorce_rates_00-16.pdf
Erin D. Hollis (ASA, CDBV) is Director of Financial Valuation at Marshall & Stevens Inc. She has experience in valuation services in both the United States and Canada for various valuation purposes, including estate planning, succession planning, shareholder buy-outs/buy-ins, family limited partnerships, ESOPs, family business disputes, marital dissolution, and distressed business valuations. A qualified expert witness, Erin has testified in matters involving corporate litigation and family law matters. www.marshall-stevens.com
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