Business Valuations

The Law Firm of Isabel M. Millard, PC believe that the divorce process requires a multidisciplinary approach. We work with a range of other professionals.

VALUING YOUR FAMILY BUSINESS

The most valuable assets owned by a family are often the family’s residence and the business owned by the husband and/or wife. By law, the business must be valued for divorce purposes. However, unlike the home, there is no ready market to determine the value of that business.

The spouse operating the business may tell tales that the business is unexpectedly souring and the golden days of prosperity are behind. This mantra is more commonly referred to as Sudden Income Deficiency Syndrome.

Against this backdrop, the operating spouse may try to convince you that the value of the business is whatever value is indicated on the balance sheet of the business. A balance sheet only reports the assets and liabilities of a company as of the date of purchase of the asset (net of depreciation) or current amounts the business owes to its creditors. In addition, the earnings that these assets generate do not increase the value of these assets.

This method is not a good indicator of value for companies that sell consulting, medical, dental and legal services, among others. For example, imagine that your spouse owns a professional recruiting firm that places sales representatives. The assets of the company consist of four computers, a computer network and office equipment (desk, chairs and phone system). Total out of pocket investment $40,000. This modest investment generates $1 million in annual revenue and your spouse earns $250,000. If the value of the business was based on the balance sheet, it would only be valued at $40,000 (assuming no liabilities) for divorce purposes.

A business valuation doesn’t begin or end with the balance sheet. Estimating or arriving at a value for a company (or a fractional ownership interest in a company) begins with a detailed analysis of the company. In order to determine the value of the business, the valuator must learn about the strengths and weaknesses that the spouse operating the business already understands. It is only then that the value of the business can be determined.

Businesses can be valued by other methods that are based on current or future income generating capabilities of the business. One such method uses normalized historical earnings (i.e. earnings expected to continue into the future adjusted for items such as excess owners compensation and personal expenses charged to the business) to derive a value for the business. The normalized earnings are converted into an indication of value for the company using a capitalization rate that incorporates the risks associated with the business in generating its future earnings. Capitalization rates vary among particular types of businesses and from time to time.

The capitalization rate can be presented as a percentage or a multiple. A capitalization rate of 25 percent is a four times multiple. Therefore, the more uncertain the business’ income stream, the higher the capitalization rate is (and the lower the multiple) which serves to lower the value of the business.

If the normalized earnings stream of the hypothetical recruiting firm is $250,000 and the capitalization rate is 25 percent, the value of the business is $1 million ($250,000 x 4) and n