Eight Landmines to Watch Out for in Divorce Valuations

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

  • Reasonable Owner’s Compensation – A business valuation usually requires the expert to make adjustments to the subject company’s income statement. This process is called “normalization.” Normalizing the company’s financial statements permits the valuation expert to compare the subject company to other businesses in the same geographic area and industry. One of the most common normalization adjustments is the owner’s compensation, which may be increased or decreased to reflect market levels. The valuator is not a vocational expert, so how can he/she give an opinion of what the business owner should be earning? Business valuation experts usually rely on published sources of survey data for the industry in which the subject business is engaged. This is one reason why it is essential to interview or depose the business owner to learn about his/her skills, duties, working hours, compensation, and perquisites. If the survey data on which the valuator relied does not match the characteristics of this particular owner, then this landmine could explode his/her opinion of value!
  • Adjusting Asset Values to Market – Another common normalization adjustment is “adjustment to book.” Tangible assets like real estate, inventories, and equipment must be adjusted to their market value if a “book value” or “excess earnings” approach is used. Again, most business experts are not appraisers, so it may be helpful to engage real estate appraisers or equipment appraisers to provide their opinions. Many business experts rely on the business owner’s opinion, which can be hazardous. Review the limiting conditions in the valuation report to see if the expert is tiptoeing between the landmines.
  • Adjusting Rent to Market – If the company pays rent to owners or other insiders, the amount of rent may be greater or lesser than market. The safest route is to hire a real estate appraiser to give an esimate of fair rental value. If the business expert relied on the owner’s opinion of market rent, it should be disclosed in the limiting conditions.
  • Specific Company Risk – Perhaps the most common method of choosing the capitalization rate in a business valuation is called the “Ibbotson build-up” method. Valuation professionals rely on the data published annually by Ibbotson Associates to calculate the risk associated with a particular business. There are generally four elements of risk which are added together (thus, a “build up”). The first three elements — the risk-free rate, equity risk premium, and size premium — are pretty cut-and-dried. The real subjectivity comes into play when an expert adds a specific company risk premium. Before going to trial, it is vitally important for the lawyer to understand specific company risk and talk to the expert about his opinion and how it was derived.
  • Rate Matching – Most lawyers don’t know that the capitalization rate is calculated differently to match various types of benefit streams: pretax cash flow, aftertax cash flow, pretax net income, after tax net income, excess earnings, projected cash flow, etc. When preparing for trial, don’t forget to ask the expert to explain how the capitalization rate matches the benefit stream.
  • Taxes and Transaction Costs – Most divorce courts have not addressed the issue of whether to “tax-affect” the earnings of a Subchapter “S” corporation. Another issue is whether to deduct taxes and transaction costs from the hypothetical proceeds that a business owner might receive upon the sale of the company. This would require the expert to allocate the sales price and perhaps even give an opinion about broker’s fees. It’s uncharted territory, so don’t forget to bring your metal detector when crossing this minefield!
  • DLOM/DLOC – Many business experts apply discounts for lack of marketability (DLOM) to their valuations of closely-held companies. They may also apply discounts for lack of control (DLOC) to minority interests (less than 50%) of a business. In recent years, the U.S. Tax Courts have aggressively challenged business valuation experts who apply discounts for estate and gift tax purposes. Intuitively, it makes sense that investors would pay less for businesses they cannot liquidate as easily as publicly-traded stocks; and the disadvantages of owning a minority interest in a company are obvious. The evidence to quantify these discounts, however, is much less obvious and bears close scrutiny.
  • Identifying 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 reserve to replace costly equipment or inventory, to secure bonding 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.

Active vs. Passive Appreciation

Minnesota’s intermediate court recently clarified the distinction between active appreciation in the value of premarital property, which is considered marital property under Minnesota law, and passive appreciation, which is separate property, in In Re Marriage of Ellingson (2007). The subject business was a custom kitchen cabinetry manufacturer and installer, which the husband began prior to the parties’ marriage. Under relevant case law in Minnesota, active appreciation is defined as increase in value resulting from marital efforts. Conversely, passive appreciation that results from inflation or market forces only is excluded from marital property.

In Ellingson, the appellate court cited to a line of Minnesota cases holding that the retained earnings of businesses over which the spouses lacked controlling interests would be presumptively excluded from marital property as passive appreciation unless there were evidence proving such earnings resulted from marital efforts. Yet, the appellate court distinguished Ellingson from that line of cases, finding that the husband’s management efforts in marketing, purchasing, human resources, location and business strategy were primarily responsible for the increase in value of the business. Also, Husband as 100% shareholder did not lack control over the retention or distribution of earnings.

The report of Husband’s business valuation expert was not admitted at trial, due to late filing. However, it is interesting to note that his expert distinguished the passive appreciation from the active appreciation by looking at the elements of risk in the capitalization rate. Since the capitalization rate contained a six percent company-specific risk premium, husband’s expert deducted that percentage from the company’s overall growth rate, concluding that the difference was equal to the passive appreciation of the company. This methodology was rejected, however, because it was not adequately explained in the expert’s report.

Pennsylvania does not distinguish between active and passive appreciation under statute or case law. This case, however, presents an interesting glimpse at how other states and experts have approached the issue.

AAML Article & What’s Really Wrong with the Excess Earnings Method?

The recent edition of the Journal of the American Academy of Matrimonial Lawyers contains an interesting article describing various approaches to personal and enterprise goodwill. There is a handy list of which states consider goodwill (both types) to be separate property, which states consider goodwill to be marital property, and which states distinguish between the two types of goodwill.

The third section of the article describes five different valuation approaches and how goodwill might be computed in each of those approaches.

In describing the valuation methods, the author praises the excess earnings method and its cousin, the Treasury method, as superior to the other methods “invented by biased experts for the purposes of . . . giving larger values to businesses.” This phrase was quoted from a leading divorce treatise by Brett R. Turner, entitled Equitable Distribution of Property.

It is a terrific book, and I keep a copy in my law firm’s library, but on this topic, I think it is wrong. The excess earnings approach and Treasury approach are generally regarded by the valuation community as theoretically weak and flawed. These were among the first methods developed by valuation experts in the 1920’s, but were left behind long ago. Unfortunately, these seem to be the most prevalent methods in divorce litigation.

In the article, the author cites one court’s criticism of the excess earnings method, in which a Maryland court complained of “double counting.” The Maryland court claimed that the excess earnings method was flawed because it regarded the owner’s future compensation both as income and as part of the value of the business. Turner, in his book, correctly noted that this criticism is unjustified. There is no double dip because the owner’s compensation is excluded from the excess earnings which are capitalized in the business valuation. To avoid the double dip in alimony and child support determinations, the court should exclude any business income that exceeds the owners’ compensation as used in the business valuation.

There is a double dip in the excess earnings method, however. The value which is calculated in most divorce cases is a going concern value, which assumes that the business will continue to operate and generate profits in perpetuity. The tangible assets of a business – its receivables, inventories, equipment, supplies – all will be consumed and replaced, over and over, in the production of an earnings stream over an infinite period of time. Nothing lasts forever. There is no residual value.

But the excess earnings approach carves out a separate value for the hard assets and adds that value to the capitalized earnings stream of a going concern business. That is a double dip.

Another problem with the excess earnings approach is the capitalization rate. The most common method of an appropriate capitalization rate, which measures the risk of certain investments
compared to other investments, is called the Ibbotson build-up method. The risk-free rate, which is generally equal to the yield on long-term government bonds, is added to an equity risk premium, a size premium, an industry risk premium, and a specific company premium. All but one of those elements is published annually in a statistical study by Ibbotson Associates.

The result of an Ibbotson build-up calculation is called an after-tax net cash flow discount rate, which is easily converted to an after-tax net cash flow capitalization rate. Several more steps are required to convert this rate into an after-tax intangible capitalization rate, which is used in the excess earnings method. The conversion from a net cash flow capitalization rate to an intangible capitalization rate involves additional levels of subjectivity, so the excess earnings approach is actually more subjective than other methods of valuation (not less subjective, as suggested by Turner).

In his discussion of the Treasury method, Turner exaggerates the level of acceptance this method enjoys outside of divorce cases. I doubt that the excess earnings method is prevalent in IRS valuations. That was once true, in the days of Prohibition when it was the only recognized method, but it is not true today. NACVA teaches that the excess earnings approach should not be used outside of divorce cases, and in those cases, only because it is widely accepted by the courts.

Perhaps it is time for us to present better valuation methods to the divorce courts and point out the flaws of the excess earnings method. I chafe when I hear divorce lawyers accuse valuation experts of tailoring their opinions to their clients’ expectations (see note 41 of the AAML article). Why should we believe they are less ethical than we?