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Determining the Marital Value of a Small Business

Sunday, 10 June 2007 13:00

One of the purposes of a divorce case is to divide the assets and debts acquired by the parties during the marriage.  In order to make an equitable distribution it is necessary to determine the value of the marital assets and debts.  This task can be difficult in even the simplest case.  When the parties own a small business, however, the task is even more difficult.  Often, the parties will have to hire an expert to appraise the value of the business. 

If the parties cannot agree on whom to hire they may each end up hiring their own expert and a judge may ultimately have to decide the value of the business.

This article will discuss some of the methods used in valuing small businesses as well as several issues for a small business owner to keep in mind if he or she is going through a divorce.  Of course, each case is unique and this article is not intended to replace specific advice in your case. If you or your spouse own a small business and divorce appears to be imminent you should consult with a domestic relations attorney in your area to discuss your case.

It is usually fairly easy to determine the value of publicly traded corporations.  There are markets for the stocks of those companies and a quick check of those markets tells you the value of a share in the company.  Family owned businesses, often referred to as “closely-held” businesses, pose a much greater challenge because there is no established market for the sale of those companies.  In the case of a publicly traded company we would determine the fair market value of the company by looking up the market price for a share of stock and multiplying that value by the number of shares in question.  For small business the test for determining the fair market value is to determine the price at which the business would change hands between a willing buyer and a willing seller if neither was under any compulsion to complete the transaction and if both had reasonable knowledge of the relevant facts.  (See I.R.S. Revenue Ruling 59-60 and I.R.C. Reg. §20,2031-1(b)).  In other words, the business valuator tries to determine what the business could be sold for if there was a willing buyer and seller.

One method sometimes used to estimate the value of a closely held business is to use the “book value” of the company.  This is a simple assets minus liabilities calculation using the values of assets debts as stated on the company’s books.  Often this calculation can be inaccurate, however.  Most businesses depreciate assets over a number of years (typically seven) so the book value of those assets may differ significantly from the actual value.  For example, an accounting firm could invest in new, expensive oak furniture.  After seven years the book value of the furniture might be zero because the firm depreciated the furniture on its tax returns.  However, the furniture might have significant actual value and the firm could probably sell it for cash despite the lack of book value.

A second method which is often used for business valuations is an “earnings approach”.  There are several different earnings that can be taken into account depending on the type of business involved.  The evaluator might look at a projection for future earnings.  In a divorce case this method might be inappropriate because the value of the company is based on the post-divorce efforts of the business owner.  The evaluator might look at the debt-free cash flow (i.e. the business cash flow after making any debt payments).  The evaluator might multiple the company’s gross or net revenue times a fixed factor to determine the value (i.e. the company is valued at five times the current annual gross revenue).  The evaluation is most often based on a “capitalization” of the company’s earnings.   This technique assumes the investor would expect to recover his or her investment in a certain number of years, usually four to six.  Based on the company’s current earnings the evaluator determines what price the buyer would pay in order to meet this expectation.  For example, if buyers of a particular type of business usually expect to recover their investment within five years, and the company to be valued has net annual earnings of $50,000, the buyer would be willing to pay up to $250,000 for the business.
 
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