Iowa Rejects Rule of Thumb Business Valuation in Divorce

A recent decision of the Iowa Court of Appeals illustrates the perils of reliance upon industry rules of thumb to value a business in matrimonial litigation. In Marriage of Hagar (11/24/2010), husband and wife purchased a dry cleaning business from a trust established by husband’s parents as part of a business succession plan. Husband and wife agreed to a $300,000 purchase price that was determined by the companies’ accountant. The trust took a promissory note for the purchase price. The opinion does not describe the technique by which the accountant estimated the company’s value, but there were adjustments to normalize the excess rent and excess interest paid by the dry cleaning business to the real estate company (which the parents’ trust continued to own).

Over the years, the dry cleaning business struggled. The payment terms were modified to maximize the seller/parents’ tax benefit and to accommodate the buyers’ inability to pay the notes. For instance, the dry cleaning business began to make quarterly distributions to pay the notes in lieu of salaries for husband and wife. When husband and wife separated, the distributions ceased entirely. The promissory note from husband and wife to the trust was reduced from $300,000 to $160,000 over the course of the marriage.

In the equitable distribution trial, the company’s accountant estimated the current value of the operating company based on industry rules of thumb. He testified that the range of values was between $71,000 and (-$120,000). He further testified that his range of values was not based upon his professional judgment, but simply an application of industry rules of thumb.

The trial court misconstrued the accountant’s testimony, finding that the business was worth the mid-point between $120,000 and $71,000. On appeal, the Court of Appeals held that a better measure of value was the equity created by the buyers’ paydown of the note: $140,000. The appellate court held that rules of thumb are too unreliable in cases where insider/family transactions might skew the data used in the calculation. An actual transaction, such as the husband and wife’s purchase of the business less than ten years prior to the trial, was deemed more reliable.