Many people involved in divorce either own a business, or they have a spouse that is a business owner. The business could be a tiny, single-person business, a substantial sized enterprise, or something in between. Many businesses take the form of professional practices that provide medical, dental, legal, or accounting services. The complexity and challenges of understanding, measuring, valuing, and dividing a business makes it one of the most difficult things that divorce attorneys encounter. Improper strategy can result in a completely unfair division of business assets. This quick guide to issues only scratches the surface but can provide a good starting point for any business owner or spouse of a business owner facing a divorce.
What is a Business Worth in a Divorce?
The first and most complex question is how to value a business. The most common way is to retain a valuation specialist. The most common “expert” attorneys turn to for valuation is a forensic CPA that has experience in business valuation. But CPAs are not the only individuals trained and qualified to value businesses. There are various organizations that provide valuation training and accreditation to business valuation specialists.
Some of the organizations that certify Business Valuators are:
- National Association of Certified Valuators and Analysts
- American Institute of CPA’s
- Institute of Business Appraisers
- American Society of Appraisers
Business are either valued as an ongoing business, or based on the liquidation value. In most divorce cases the business is ongoing and the ongoing-business method is preferred. That method assumes the business will continue in existence long after the divorce. Your Ayo and Iken attorney will look at the business and work with you to determine a valuation strategy that is most in your favor.
There are three technical standards used in valuation:
Income based approach – this approach is calculated based on the net income of the business, and expected net income in the near future. For owner-operated businesses this approach is full of inaccuracies and takes a lot of guesswork. The basic idea is to subtract the owner from the equation, factor in to the financials an employee that can replace the owner, and then figure out how much cash the business can bring in during the next five years. That total is then discounted for risk, and market conditions for a final net business value.
Asset based approach – this approach is best if the business is being liquidated. The value of the assets, if sold on the open market is totaled to figure out the business value.
Market based approach – probably the most fair of all approaches, this method compares similar businesses up for sale. This approach is very similar to the method of valuing residential homes. Many valuation analysts will adjust the calculated value based on results of the other two valuation methods. The use of this approach depends on the availability of “comps” – other similar businesses for sale or recently sold on the open market. There are several databases that business valuators can use to search for comps.
Basic Issues to Consider for the Business Owner / Spouse
There is nothing that raises resentment in business owners like a group of complete strangers sifting through the business finances. Most smaller, family-owned businesses have cryptic, difficult to decipher financial records. Many times the business owner likes it that way because the business finances are intertwined with their personal finances. At best, it is always difficult for a business owner to show a true picture of their business. And of course it is against the business owner’s interest to show that true picture of the business. In any case a complete disclosure of business finances can cause large bookkeeping expenses, anxiety in employees, potential tax problems, and can absorb owner-time that is normally spent keeping the business afloat. You must consider the cost of settlement versus the cost of an intrusive examination.
Basic Issues to Consider for the Non-Business Owner / Spouse
Lets face it: attacking the business is the single most likely thing you can do to raise tension and animosity in your divorce. But then again there is a principle of fairness and many times you must do what you need to do. The problem is cost and complexity. A proper examination of a business requires not only a business valuation, but also a Forensic CPA. It can be very costly and time consuming. In cash based businesses, a proper evaluation of business finances may be close to impossible. The process of pulling out business information, examining it, and packaging testimony for the court can be drawn out and nerve wracking. Finances can run low through this lengthy process. Many non-owner spouses must weigh possible settlement scenarios versus the uphill battle of examining a business.
Possible Strategies for a Business Owner in a Divorce
Legal, but Creative Accounting – There are many legitimate techniques you can do to minimize the apparent value of the business. This strategy must be started years before the divorce. You may decide to “accelerate” expenses and “defer” income. In practical terms that could mean a several year program of upgrading your premises, or putting in place a multi-year program to enter a new area of business. The benefit from either measure will be years away. But the effect on the P & L would be to minimize income and minimize business value.
Recognize Potential Losses – Do you have a ton of aging, outdated inventory on the shelves? Most business owners are reluctant to get rid of outdated inventory because it has a theoretical value and that value makes the business look like it is worth more money. Now is the time to liquidate that inventory and write down the value.
Hire More Employees – Don’t get completely ridiculous but now is the time to bring on that extra person you wanted. If you are like most business owners, you work a long week and do without the help you need. That can put more money in your pocket but also ups the apparent value of the business. If you know divorce is in your future, dial back your work hours and hire new employees. Of course you must always consider business realities and the possibility of driving yourself under.
Possible Strategies for the Spouse of a Business Owner in a Divorce
Chart out Hiring Versus Annual Revenue – Many of your strategies involve neutralizing the strategies of your spouse. A way to ferret out excessive hiring practices is to create a chart of the number of employees versus annual gross revenue. There should be a relationship between the two trends. If not – you can be pretty sure someone is cooking the books
Get Records from Major Vendors – A sure fire way to get an x-ray of business income is to subpoena records from major vendors. A certain amount of dough equals a given amount of pizzas – and annual sales can be predicted by looking at that number. That principle extends to most types of businesses. More supplies equals more income. Another benefit of looking at that trend: you can detect a “run-up” in inventory by a spouse attempting to inflate expenses.
Work at the Business – A strategy that only works if you implement it years before the marriage. There is no better way to get an idea of what goes on in the business. Another value this strategy provides is the ability to firmly designate the business as a marital asset.
Tax Armageddon – Potential Tax Fraud in the Books
Most businesses have hidden tax-gems embedded in the books. More often than not the owner used extremely aggressive accounting tactics to avoid taxes. Both spouses should be aware that an extended battle over a business could cause a tax-Armageddon. A devastating audit from the IRS at the wrong time can destroy the potential assets of both spouses. Whatever you do, you must try not to rock the tax-boat and expose both of you to undesirable effects. Remember, you both may become liable for tax deficiencies caused by the audit. And the obvious issue – a destroyed business is one less asset to divide.
Goodwill – The part of the business considered “goodwill” is not a marital asset and will be excluded from the divisible value. Goodwill is the part of the business value that immediately disappears should the owner be “flattened in the road.” In other words, if a part of the business is directly linked to the existence of the owner – that portion may not be considered a marital asset.
Get an Attorney that Understands Business
Your attorney must be prepared to scan through records and think like a business owner. This is an extremely important principle for both sides in a divorce dispute over a family business. You must also consider the cost/value of settlement versus the cost of fighting all the way to the end. The Law Firm of Ayo and Iken has attorneys experienced in dividing businesses, and defending business owners. Attorney Howard Iken can be of special help to spouses facing this situation. He is a former adjunct professor of business, has a Masters in Business Administration, and has personally bought and sold small businesses.