Eight Landmines to Watch Out for in Divorce Valuations
Whether attacking or defending your expert’s business valuation in a divorce trial, it is important to know and avoid the eight landmines that can blow up your case:
- Reasonable Owner’s Compensation – A business valuation usually requires the expert to make adjustments to the subject company’s income statement. This process is called “normalization.” Normalizing the company’s financial statements permits the valuation expert to compare the subject company to other businesses in the same geographic area and industry. One of the most common normalization adjustments is the owner’s compensation, which may be increased or decreased to reflect market levels. The valuator is not a vocational expert, so how can he/she give an opinion of what the business owner should be earning? Business valuation experts usually rely on published sources of survey data for the industry in which the subject business is engaged. This is one reason why it is essential to interview or depose the business owner to learn about his/her skills, duties, working hours, compensation, and perquisites. If the survey data on which the valuator relied does not match the characteristics of this particular owner, then this landmine could explode his/her opinion of value!
- Adjusting Asset Values to Market – Another common normalization adjustment is “adjustment to book.” Tangible assets like real estate, inventories, and equipment must be adjusted to their market value if a “book value” or “excess earnings” approach is used. Again, most business experts are not appraisers, so it may be helpful to engage real estate appraisers or equipment appraisers to provide their opinions. Many business experts rely on the business owner’s opinion, which can be hazardous. Review the limiting conditions in the valuation report to see if the expert is tiptoeing between the landmines.
- Adjusting Rent to Market – If the company pays rent to owners or other insiders, the amount of rent may be greater or lesser than market. The safest route is to hire a real estate appraiser to give an esimate of fair rental value. If the business expert relied on the owner’s opinion of market rent, it should be disclosed in the limiting conditions.
- Specific Company Risk – Perhaps the most common method of choosing the capitalization rate in a business valuation is called the “Ibbotson build-up” method. Valuation professionals rely on the data published annually by Ibbotson Associates to calculate the risk associated with a particular business. There are generally four elements of risk which are added together (thus, a “build up”). The first three elements — the risk-free rate, equity risk premium, and size premium — are pretty cut-and-dried. The real subjectivity comes into play when an expert adds a specific company risk premium. Before going to trial, it is vitally important for the lawyer to understand specific company risk and talk to the expert about his opinion and how it was derived.
- Rate Matching – Most lawyers don’t know that the capitalization rate is calculated differently to match various types of benefit streams: pretax cash flow, aftertax cash flow, pretax net income, after tax net income, excess earnings, projected cash flow, etc. When preparing for trial, don’t forget to ask the expert to explain how the capitalization rate matches the benefit stream.
- Taxes and Transaction Costs – Most divorce courts have not addressed the issue of whether to “tax-affect” the earnings of a Subchapter “S” corporation. Another issue is whether to deduct taxes and transaction costs from the hypothetical proceeds that a business owner might receive upon the sale of the company. This would require the expert to allocate the sales price and perhaps even give an opinion about broker’s fees. It’s uncharted territory, so don’t forget to bring your metal detector when crossing this minefield!
- DLOM/DLOC – Many business experts apply discounts for lack of marketability (DLOM) to their valuations of closely-held companies. They may also apply discounts for lack of control (DLOC) to minority interests (less than 50%) of a business. In recent years, the U.S. Tax Courts have aggressively challenged business valuation experts who apply discounts for estate and gift tax purposes. Intuitively, it makes sense that investors would pay less for businesses they cannot liquidate as easily as publicly-traded stocks; and the disadvantages of owning a minority interest in a company are obvious. The evidence to quantify these discounts, however, is much less obvious and bears close scrutiny.
- Identifying Non-operating Assets – Some companies maintain investment portfolios or own property that is not used in the operation of the business. On the other hand, some businesses require capital reserve to replace costly equipment or inventory, to secure bonding or financing, or for other reasons. Non-operating assets generally increase the value of a business because the business expert will isolate those assets and add them to the capitalized earnings of the remaining assets.