Our discussion today will cover some of the specific concerns in the performance of valuation engagements for the purpose of an equitable distribution in a divorce. The first consideration is what level of service the valuation analyst should perform. Under the American Institute of Certified Public Accountants (AICPA) Statement on Standards for Valuation Services (VS Section 100 or SSVS), valuation analysis can perform 2 levels of services, which are a valuation or a calculation of value. In performing a valuation, the valuation analyst considers and applies valuation approaches and valuation methods as described under the SSVS. The valuation analyst then utilizes professional judgment to select the most appropriate approaches and methods under those approaches to estimate the value of the business. The determined value is reported as a conclusion of value.
Conversely, in performing a calculation of value, the valuation analyst and the client agree on the approaches, valuation methods, and/or valuation procedures to be utilized as part of the calculation engagement. The valuation analyst will calculate the value of the business under the agreed-upon approaches and methods to arrive at a value for the business that is reported as a calculated value. A calculation of value report will include the following statement: “a calculation engagement does not include all of the procedures required for a valuation engagement, and had a valuation engagement been performed, the results may have been different.”
Therefore, when it comes to selecting the appropriate level of service for a valuation engagement in the divorce setting, most valuation analysts will require the client to agree to a valuation engagement rather than a calculation of value engagement. The main reason for this requirement is that many valuation analysts question whether a calculation engagement meets the expert standard of an “opinion expressed with a reasonable degree of certainty.”
However, there are a couple of instances where a calculation of value may be appropriate in the divorce setting. The first is in situations where the parties are in settlement negotiations, and it is believed that the case may be settled and not proceed to trial. In this case, a calculation may be used for settlement purposes as it tends to be a cheaper alternative, as certain approaches, methods, and/or procedures are not performed, reducing the time spent by the valuation analyst. In addition, the valuation analyst can discuss the operations with the business owner and advise which approach and method would most likely be the most appropriate to value the business, and utilize only this approach and method in the calculation. A second potential scenario where a calculation of value may be appropriate is in a situation where the parties are trying to limit expenses and they can agree to utilize one valuation analyst and agree to the most appropriate method for valuing the business.
Another factor in divorce valuation is what the appropriate Standard of Value is. The Standard of Value in divorce cases is established either by state law or case decisions. The typically Standard of Value in valuation is “Fair Market Value” which is defined in SSVS as “the price, expressed in terms of cash equivalent, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.” State law or case decisions may establish a significantly different standard. For example, in Virginia, the standard of value established by case decisions is intrinsic value. The case law defines intrinsic value as the value to the parties involved in the divorce. As a result, this standard of value can affect such decisions as what adjustments are made and what discounts are taken in the valuation engagement.
The valuation analyst must also consider the method of accounting to be used. Often in divorce valuation, the entity being valued is privately held by one or a small number of individuals. As a result, these entities may not need nor engage accountants to prepare audited, reviewed or compiled financial statements. As a result, the valuation analyst will obtain the financial information from the entity’s tax returns. Tax law generally allows the liberal use of the cash method of accounting for small businesses. However, in valuation for divorce, the accrual method of accounting is typically more appropriate to determine the value. If the valuation analyst utilizes the asset method, a cash basis balance sheet will not include accounts receivable, inventory, and accounts payable, which may significantly impact the value. If the valuation analyst is utilizing the income method, it might be easier for the business owner to manipulate income over a short period of time by the timing of when income is received and deposited, and when expenses are paid. Finally, the accrual method of accounting is used by most businesses when reporting transactions to transactional databases. As a result, if the valuation analyst is using a market method, the accrual method of accounting will produce multiples that are more comparable to the comparable transactions.
In divorce valuation, consideration must be given to normalizing entries. Normalizing entries can be necessary due to poor company accounting records, inappropriate inclusion of non-business expenses, to adjust to the accrual method of accounting, or to adjust from historical values to fair market values. While not comprehensive, the following is a discussion of some of the more common normalizing adjustments in divorce valuations.
On the balance sheet, the valuation analyst will generally consider whether an adjustment needs to be made to the Loans to Shareholders. In the divorce setting, these amounts can often be disguised dividends as they have been paid to the owner who may have no intention of ever repaying the loans. Loans to related parties will also need to be similarly examined, as they may be legitimate loans to assist the related party with low cash flow, or they may be disguised dividends that are just using a different entity to get the cash to the owner.
On the income statement, the valuation analyst will consider whether adjustments need to be made to officer compensation. It is not uncommon in small businesses for the owner/officer of the company to base his/her compensation on something other than market value. This may be done to obtain the most favorable tax benefits of the company, or it may be based on the cash flows of the company. A normalizing adjustment is made to adjust the owner/officer compensation to the market value for what a non-owning individual would require performing the same tasks as the owner/officer.
On a similar note, related party compensation must also be examined, as it is not uncommon in many small businesses for family members to receive compensation from the business for performing tasks that may not be compensated at market value. Their compensation may be either more or less than market value, depending on the relationship with the owner and the owner’s profit goal. In some instances, we have even seen compensation being paid to relatives who were not performing services for the Company.
A third area to look at is rent when paid to a related party. It is not uncommon for a rental rate for real estate used in the business but owned by the owner or a related entity to be established at a point in time and not adjusted over the years. It is also common for rents to be established based on the lessor’s required debt payments or based on the cash flow of the Company. This normalizing entry is made to adjust the rent to the fair rental value for the property being leased.
Adjustments may be considered for personal expenses paid by the business on behalf of the owner. These expenses may be difficult for the valuation analyst to determine without the assistance of the business owner or non-owning spouse, as they may look very similar to normal operating expenses. Some expenses that we have seen over the years include personal vehicles, personal cell phones, utilities for residences and personal meals, entertainment, and trips. The personal expenses may be determined through a separate forensic engagement, which is typically only recommended if significant personal expenses are involved, as the forensic engagement can be expensive. Another method is through the assistance from the owner/spouse to provide information about the nature and amount of personal expenses, but this method runs the risk of the trier of fact ruling against you. Finally, in some instances it might not be worth the time and expense for the valuation analyst to make the cash of excluding the personal expenses, especially when they represent a minimal amount.
The valuation analyst may also consider unreported assets, liabilities, and/or income. As with personal expenses, it may be difficult for the valuation analyst to locate these items without a separate forensic engagement or assistance from the client. However, in some instances, there may be indications of unreported assets, liabilities, or income based on the reported information in the financial statements. For example, the presence of interest or dividend income on the income statement but no investment account in the assets may indicate that there is an unreported asset. Another example is that the expense of gas and vehicle repairs in the expenses but no vehicle on the books, might be an indication of an asset (car or truck) not being reported or a personal expense (gas and vehicle repairs for a personal vehicle) A final example may be a decline in income after the date of separation which may indicate that the business owner is not reporting all of the income (which may be more common in a cash intensive business) or may indicate that billing by the Company is lagging.
The valuation method selection can also be affected by divorce considerations. A common valuation method under the income approach is the discounted cash flow method. This method takes into account future cash flows from the business and discounts them back to their present value. Some jurisdictions consider this method to be highly speculative, and therefore, other methods may be considered more appropriate in the valuation context. One such income method is the capitalization of cash flows method, which capitalizes the historical cash flows into the future. This method is often more accepted in divorce settings as it relies on the historical earnings of the Company. However, when the capitalization of earnings method is utilized, the weighting of the prior year’s earnings must be given consideration. Some years may not be indicative of future earnings due to changes in business operations. The weighting can also vary based on trends in the earnings over the years. Furthermore, some judges may also prefer to see the capitalization of excess earnings method utilized, as this method contains both a value for the net assets of the business, along with an earnings component for the intangible value of the business.
In a typical valuation, discounts are often applied to the value derived under the methods utilized. However, depending on the state law and case decisions, these discounts may or may not be applied. For example, in Virginia, under the intrinsic value standard, minority interest discounts are not applied. Likewise, discounts for the lack of marketability are also not applied unless the business will be sold as part of the divorce proceeding.
In the divorce setting, goodwill, an intangible value, may or may not be considered a separate asset. Once again, this will depend upon state law or case decisions. Generally, goodwill can be divided into two categories. The first is Professional, also referred to as personal, goodwill. Professional goodwill is defined as the intangible value attributed to the individual’s reputation, skill, and relationships. The second is Practice, also referred to as Enterprise, Goodwill. Practice Goodwill is defined as the intangible value attributed to a business, which includes such value related to client lists, business reputation, customer loyalty, location, and efficient systems. Certain types of businesses are more likely to have significant amounts of Professional Goodwill. These types of entities include (1) Professional service firms such as doctors, lawyers, and accountants, where the clients are loyal to the individual practitioner’s expertise and relationships. (2) Specialized Consulting where the business owner has a specialized degree or experience and reputation that is in high demand. (3) Small owner-operator businesses, in particular ones that may only have a few larger customers who utilize the business based on the owner/customer relationship. (4) Contractors and tradespeople where there is a highly skilled artisan or the contractor who is the face of the business. Other types of businesses may have little to no Professional Goodwill. These types of business include (1) retail, where product, price, and location are most important to the customers. (2) Franchises such as fast-food restaurants, gyms, etc., where the value is in the franchise’s name rather than any value being provided by the owner.