Divorce Valuation of Business

The IRS has defined the value of a business as the price at which property would change hands between a willing buyer and a willing seller, both being informed of all relevant facts and neither compelled to buy or sell.

A business appraisal can yield different values depending upon the purpose of the appraisal. In a divorce appraisal, the valuation methods are the same as those applied to a “willing buyer” situation. However, in a divorce situation, there is no willing buyer. The business usually remains in control of the spouse who ran the business before the divorce. Therefore, certain appraisal adjustments which are necessary for a third party sale are not applicable in a divorce valuation.

A common adjustment in the sale of a business to a third party is a discount for loss of key management personnel. The rationale behind this adjustment is that the key personnel have important business contacts and knowledge special to the company in question. The loss of these people can adversely affect the company’s profitability; therefore, the selling price of the company is reduced. In a divorce valuation, the key people typically do not leave the company. In this case, no discount should be used unless both spouses work in the business and one of them leaves after the divorce.

A closely-held business often has a number of non-operating assets included in its balance sheet. Examples of these assets are vacation homes, investments in tax shelters, art, and stocks and bonds. When the business is sold, the owner typically retains these assets along with any cash and certificates of deposit. The value of a closely-held business for sale will exclude any of the assets that are to be retained by the owner.

However, in a divorce valuation, all operating, non-operating, and investment assets are included in the valuation. The divorce valuation must include all assets owned by the business because these assets are marital property and are subject to equitable distribution. The value of the business will thus be higher for divorce than for a willing buyer.

There are several other discounts which are applicable for a valuation for a sale to a third party that are not appropriate in a divorce valuation. Discounts are often taken for lack of marketability, unaudited financial statements, and product and customer diversity. Since the business is not being sold, the above discounts have no relevance on the value to the present owner.

The value of the business also includes the value of its intangible assets. The major intangible asset is, typically, good ill. Goodwill is the present value of future earnings in excess of earnings normally realized in the industry. Above-average earnings can arise from favorable customer relations, location, monopoly, and superior management.

Business profits earned after divorce include profits created by the goodwill developed during the marriage. These profits in the period soon after divorce are largely due to marital goodwill. The marital goodwill diminishes over time and the subsequent profits are then generated by goodwill developed after the divorce. The key to determining the value of the goodwill at the date of divorce is to approximate the amount of post-divorce earnings which are due to goodwill created during the marriage.

Goodwill is typically calculated by capitalizing the future excess earnings of the business at an appropriate rate. These earnings will include profits generated by post-divorce goodwill. The appraiser needs to decrease the goodwill calculated to include only profits generated by marital goodwill. While this cannot be calculated exactly, the valuator can reasonably calculate the life of marital goodwill based on the business’ history and clients. With this information, the valuator can adjust the capitalization rate to reduce the amount of goodwill. This effectively removes estimated post-divorce earnings from the goodwill value.

The valuation of goodwill is the most subjective element of value in a business. The value calculated for divorce will be different than for a willing buyer. The goodwill for a willing buyer will include all future excess earnings as opposed to future earnings related to marital goodwill in a divorce case.