Divorce – Eight landmines to avoid in business valuations

Whether attacking or defending your expert’s business valuation in a divorce trial, it’s important to know and avoid the eight landmines that can blow up your case:

1. Reasonable compensation of the owner – The valuation of a company generally requires the expert to make adjustments to the income statement of the company in question. This process is called “normalization”. Standardizing the company’s financial statements allows the valuation expert to compare the company in question with other companies in the same geographic area and industry. One of the most common normalization adjustments is owner compensation, which can be increased or decreased to reflect market levels. The appraiser is not a vocational expert, so how can he or she give an opinion of what the business owner should be earning? Business valuation experts generally rely on published sources of survey data for the industry in which the business in question is engaged. This is one of the reasons why it is essential to interview or file with the business owner to learn about their skills, duties, hours of work, compensation, and perks. If the survey data relied upon by the appraiser does not match the characteristics of this particular owner, then this landmine could exploit his opinion of value!
2. Adjustment of asset values ​​to market – Another common normalization setting is “fit to book”. Tangible assets, such as real estate, inventory, and equipment, must be marked to market value if a “book value” or “excess earnings” approach is used. Again, most business experts are not appraisers, so it can be helpful to hire real estate appraisers or team appraisers to provide their opinions. Many business experts trust the opinion of the business owner, which can be dangerous. Review the limiting conditions in the appraisal report to see if the expert is tiptoeing around the landmines.
3. Market Rent Adjustment – If the company pays rents to owners or other insiders, the rent amount may be higher or lower than the market price. The safest route is to hire a real estate appraiser to give an estimate of fair rental value. If the business expert relied on the owner’s opinion of market rent, it must be disclosed under the limiting conditions.
4. Company-specific risk – Perhaps the most common method for choosing the capitalization rate in valuing a company is called the “Ibbotson accumulation” method. Valuation professionals rely on data published annually by Ibbotson Associates to calculate the risk associated with a particular business. In general, there are four elements of risk that add up (hence a “stack”). The first three elements, the risk-free rate, the equity risk premium, and the size premium, are fairly straightforward. Real subjectivity comes into play when an expert adds a company-specific risk premium. Before going to trial, it is vitally important that the lawyer understand the specific risk of the business and talk to the expert about his opinion and how it was obtained.
5. Rate matching – Most lawyers don’t know that the capitalization rate is calculated differently to match various types of benefit streams: pre-tax cash flow, after-tax cash flow, pre-tax net income, net income after taxes, excess earnings, projected cash flow, etc. When preparing for trial, don’t forget to ask the expert to explain how the cap rate matches the flow of benefits.
6. Taxes and transaction costs – Most divorce courts have not addressed the question of whether to “tax” the earnings of a Subchapter “S” corporation. Another issue is whether taxes and transaction costs should be deducted from the hypothetical income a business owner might receive from the sale of the business. This would require the expert to assign the selling price and perhaps even give an opinion on the broker’s fees. It’s uncharted territory, so don’t forget to bring your metal detector when you cross this minefield!
7. DLOM/DLOC – Many business experts apply non-marketability (DLOM) discounts to their closed company valuations. They may also apply discounts for lack of control (DLOC) to minority interests (less than 50%) of a company. In recent years, the US Tax Courts have vigorously challenged business valuation experts who apply discounts for estate and gift tax purposes. Intuitively, it makes sense for investors to pay less for companies they can’t liquidate as easily as publicly traded stocks; And the downsides of owning a minority stake in a company are obvious. The evidence to quantify these discounts, however, is much less obvious and deserves close examination.
8. Identification of 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 reserves to replace expensive equipment or inventory, to secure bonds 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.