David Griffin and Ronald Seigneur talk about Challenges to Valuation, Protection and Treatment Of An Owner’s (Dilutable) Interest in a Start-up.
Time and date of this session: Thursday, April 24, 1 – 2:15 pm. To register, click here.
Listen to a short interview by our Publisher, Dan Couvrette with David Griffin about this session:
Below is a summary of what the session will cover and the questions that divorce attorneys and financial experts have to address when dealing with an owner of a start-up or a rapidly expanding business. This summary was provided to us by the presenters.
We read in the media about companies such as Facebook, Twitter, Instagram and Pinterest – start-ups that at one time didn’t have any clear measurable value using traditional appraisal approaches, yet have evolved into some of the largest market cap companies that exist today.
Similar companies exist in the energy space – solar and wind companies as well as energy redistributors – and they exist in the broader tech space beyond social networking. Gaming companies, cloud-related start-ups, music and other entertainment streaming companies all exist in the space between start-up and traditionally successful. Numerous other examples can be cited. How were these companies valued prior to going to the market? What if they have not reached the stage or scale where an IPO even makes sense?
CPA’s and divorce lawyers have many shared professional interests. Areas that come to mind are taxation, forensic accounting and financial reporting. A very important area of shared interest, which can be a great source of work for a CPA’s practice, is business valuation in divorce. According to the one research study, approximately half of all current marriages are expected to end in divorce. Overall, for every 1,000 existing marriages, approximately 19 will end in divorce in this country. Translation: there are nearly one million divorces per year in the United States.
Many of the divorces that our firms handle include a closely-held or start-up business. As with any other asset, the lawyer must be able to secure a solid understanding of the value of the party’s share of the business. As a practicing matrimonial lawyer in a firm focusing on complex divorces, and as a CPA managing a firm which provides a full range of services including valuation services, it is important for each of us to cultivate relationships with our counterparts. The lawyer needs several highly-qualified CPA/business valuation experts he or she can turn to as a team is being assembled to handle complex divorce and valuation experts want access to complex and interesting cases with lawyers they know are competent and skilled. The relationships we each have built are important sources of referrals and work for both lawyer and CPA; they provide a great opportunity for networking and cross-marketing and they represent a trusted source of information and ability to brainstorm, even if there isn’t a specific engagement undertaken.
An estimate of value from an expert in itself doesn’t give great comfort. What is essential is that both valuation expert and lawyer determine in advance what process will be utilized; what standard of value is appropriate and that the conclusion reached by the valuation expert is sound and defensible. Together, the lawyer and the expert will utilize the expert’s conclusions and present them in an understandable and logical way.
It was widely reported that in many instances, the Amazon-, Facebook- and Twitter-type start-ups initially had zero revenue or were operating with massive burn rates for capital. When a valuation expert is confronted with the challenge of valuing this type of company, the assignment is fundamentally different from valuing an established company. There may be no comparables and there may not be an ability to utilize traditional methodologies such as determining a discount rate and applying it to free cash flows. Revenue forecasts are more hope than reality and in some instances, start-ups will not forecast revenue, due to the fear of dampening valuation expectations from potential angel investors. What is a valuation expert to do?
It is important to bear in mind that companies are valued in different ways for different purposes. A valuation for gift or estate tax purposes may not be the same as a valuation related to a private equity infusion. Those two purposes may differ again from valuing a company in a divorce. In some ways, the valuation of start-ups for venture capital purposes is directly related to how much money the company needs, rather than how much revenue they will eventually generate. In the divorce setting – in the preparation of a report and in a courtroom – those approaches don’t apply.
How do we advise the owners of those companies or their spouses when the most significant asset of the marriage is a company in the early stage of its development? What is the company worth? What cash can it produce for the family? How do these companies secure financing – and how does existing financing affect our analysis? Even if what had been scant revenue is now rapidly increasing, a company of this profile may not qualify for “traditional” financing or may continue to require large infusions of capital until the enterprise is sustainable. In order to secure early-stage financing, owners may seek “angel investors” or other private lenders, who in exchange for providing financing, typically negotiate to require that the owner “give away” or pledge ownership interests in the company – either as a direct transfer of stock to the lender or in the form of a convertible loan, option or warrant, in addition to recurring and preferential interest payments on a loan.
The start-up company gives the divorce lawyer his or her challenges as well. It is essential for the lawyer and the CPA to review all underlying documents, account for the treatment of startup costs and related financing, understand voting rights and restrictions on stock including conversion rights and the potential for dilution.
At times, debt is convertible to stock on a date certain or upon the occurrence of a future event, either of which can dilute the ownership interest which is the subject of valuation (and equitable distribution). Owners or high ranking employees may be paid in some combination of stock and cash, and with no consistency. What is the stock component worth? Can it be sold for the purposes of supporting the family? Should the non-owner spouse negotiate for lump sum alimony rather than wait and see?
What cash flow stream can be identified to consistently support periodic alimony? If excess revenue is projected, have a mezzanine or other lenders placed limitations on distributions or income to be paid to the owner? If the company is generating year over year increasing revenues, frequently a significant portion of those revenues must be retained in order to fund capital expenditure requirements of the company associated with the growth curve mapped out by management, angel investors and private equity investors in order for the enterprise to reach its full potential in terms of sustainable value. Can that revenue be “counted” for alimony purposes? Should it be added back for valuation purposes?
These questions all arise in the increasingly frequent cases involving a rapidly growing start-up. The session presenters will examine these questions, give real-life examples of how these issues were solved and offer insight and guidance into this interesting and challenging area of our practices.
To learn more or to register into the 2014 National Conference on Divorce, click here: https://familylawyermagazine.com//articles/divorce-conference. This exceptional conference is for ALL family lawyers and financial professionals who are interested in advancing their skills by learning from highly experienced divorce attorneys and financial experts. The conference is organzied by AICPA and AAML.
David W. Griffin is a Partner at Rutkin, Oldham & Griffin, LLC, Westport, Connecticut; Fellow of the American Academy of Matrimonial Lawyers and Ronald L. Seigneur is a Managing Partner, Seigneur Gustafson LLP. Lakewood, Colorado.
 National Center for Family & Marriage Research, Bowling Green State University, drawn from U.S. Census Bureau, American Community Survey 2011. www.bgsu.edu/content/dam/BGSU/college-of-arts-and-sciences/NCFMR/documents/FP/FP-13-14.pdf