Business Valuation of Assets and Debts in Divorce
Most divorces involve the division of marital assets and debts. However, the value of these assets must be determined before they can be divided. For some assets, such as a bank account, valuation is simple. The value is the account balance on a certain date that is available from the bank. For other assets, such as a small business, valuation is much more complicated. Many factors go into business valuation, and even when there is agreement as to what those factors are, experts may disagree as to the total, overall worth of a business depending on what method or means they use to determine that valuation.
A small business is often one of the most significant assets in the marriage of a divorcing couple. An error in business valuation could cost one or both spouses tens or hundreds of thousands of dollars. If an error in valuation is discovered after the entry of a divorce decree dividing assets, including a business, it is difficult if not impossible to set aside that judgment and correct any error. Business owners and their spouses should consult and work with a divorce attorney experienced and knowledgeable as to business valuations and division of business assets in a divorce. An attorney who understands the complexities of dividing a business in divorce is better able to protect your interests.
Dividing a Business in Divorce: Is the Business Non-Marital or Marital Property?
Dividing a business in divorce is complex on multiple levels, The court will need to know if a business that needs to be divided is marital property (acquired during the marriage) non-marital property (acquired prior to the marriage or by some other means making it non-marital), or both (as when one spouse owned a business prior to the marriage but invested marital assets in it).
North Dakota is an equitable division state, which means that marital property is divided in a way that is equitable under all the circumstances. Equitable does not always mean equal. In practice, however, especially in longer-term marriages, an equal 50/50 division al division of marital property is typically the starting point
All property, whether separate/non-marital or marital, is included in the total value of the marital estate. All property, whether separate/non-marital or marital, must be valued and accounted for. Only after all property is valued and accounted for, whether separate/non-marital or marital, is it determined which spouse is awarded which asset or what percentage of each asset goes to each spouse. The source of non-marital property is a consideration in deciding which spouse it will be awarded to. In other words, whether a business is marital property, separate property, or a bit of both isn’t determinative, but is an important consideration for the court.
When provided for in organizational documents, one spouse operates or works at a business during the marriage but not the other, or to otherwise avoid having to liquidate, disband, or sell the business, courts or the parties can fashion a property division that avoids that undesirable result—i.e., one spouse is awarded the business in the divorce, and the other spouse receives the equitable equivalent amount of other assets. If both spouses have owned and operated the business together, it is unlikely they would want to continue in that vein after the divorce, and it is also not typically a workable solution or outcome. In such instances, one spouse may need to buy the other out. Either way, an accurate business valuation is critical.
The Importance of Business Valuation in Divorce
The process of obtaining a business valuation can be costly and time-consuming. Spouses may be tempted to agree on a value for the business and move on without the help of business valuation experts. That can produce savings in the short run, but lead to disaster in the long run, which an example will illustrate.
Ian and Lydia, both 35, have been married for ten years. Ian is a retail manager earning $75,000 annually. Lydia and her business partner are software developers. They started a company after Lydia’s marriage from which Lydia draws an annual salary of $35,000. Ian and Lydia decide to divorce and are on good terms.
When listing her financial assets in the divorce, Lydia identifies her interest in the business as being worth $80,000. Ian accepts the value Lydia gives for the business, and even thinks it may be a bit high. Six months after the divorce, Lydia and her business partner sell the software company for $2.5 million dollars, of which Lydia takes half. Had Ian insisted on having the business professionally valued, he might have learned that multiple potential buyers were interested in the company prior to the divorce, and that it was likely worth much more than Lydia asserted.
At that point, Ian’s options are to try to have the divorce settlement agreement set aside for fraud or to simply walk away. His attorney advises him that trying to have the settlement set aside will result in a long, expensive legal battle with an uncertain result. Ian chooses not to take legal action.
Methods of Business Valuation in Divorce
There are three approaches often used for business valuation: the asset approach, the market approach, and the income approach. Which makes the most sense depends in part on the type of business involved.
The asset approach to business valuation appears straightforward at first glance. The value of the business is equal to the value of the business’s assets, less the business’s liabilities. This is often a worthwhile approach for a small business whose assets and debts are easy to determine. Assets include tangible assets such as equipment and inventory that can actually be touched. Intangible assets include things like accounts receivable, goodwill, patents, and licenses. If there are unrecorded assets and liabilities that are not taken into account, or if it is difficult to arrive at a firm value for assets, the asset approach could be inaccurate.
The market approach to business valuation compares a business to similar businesses which have been sold recently. If a divorcing couple owns a franchise of a national pizza chain, business valuation experts might consider what similar franchises in the area have sold for in the recent past. Unsurprisingly, the market approach works best when the type of business being valued is not unique, so there are true comparables.
The most common approach to business valuation in divorce is the income approach. It is more complicated than either the asset approach or the market approach. The income approach relies on historical data and formulas to calculate the business’s future income and profits and to determine how much the business is worth. In short, the income approach seeks to determine the current value of a business’s future earnings. The accuracy of the formula depends heavily on the accuracy of the inputs, such as growth rate and required rate of return.
Often, especially where a business is the primary asset in the marriage, it is wise to have a business valuation expert to determine which valuation method is appropriate and apply it. The spouses may agree to choose an expert from a short list generated by their attorneys and accept that expert’s valuation. If the business is expected to have a high value or there are reasons different appraisal approaches or appraisers could reach dramatically differing conclusions, each spouse may each retain their own business valuation expert who can testify on their behalf in the event of a trial.
The best time to protect your business from divorce is when you start the business and/or before you marry, or at least before you are faced with divorce. If it is too late to act proactively, the next best measure to protect your interests is to work with a law firm that understands not only divorce, but business, and has access to business valuation experts who can support your position. Whether you are a business owner, the spouse of a business owner, or both, we invite you to contact Fremstad Law to schedule a consultation.