As tough as it is, calculating the worth of a privately-owned business is a necessity of divorce for many couples. During the business valuation process, one important fact must dominate your thinking: all value is subjective. You should also recognize the big difference between value and price: value is what something is worth, and price is what someone will pay for it.

All business value derives from three things:

1. What the business owns (typically its assets)

2. What the business earns (this means "real" earnings)

3. What makes the business special (its risk and desirability)

You can find all you will ever need (or want) to know about business valuation in the dozens of books available in bookstores and from professional organizations such as the Institute of Business Appraisers.

Rules of the Game

Making the investment to learn the rules is an important first step in the valuation process. But the rules are dry. What you need to know is how the rules can be influenced, how the game really works. Insiders and experienced professionals give you an advantage in making the system work for you.

Selling a Small Company

In making divorce decisions, you may decide to sell your family-owned business. A business broker can advise and assist you in every phase of the transaction. You will work with the broker to prepare a marketing package about your company. It will include information about:

People: Company management

Product: What you make and sell

Profit: How much money the company makes after expenses

Potential: Growth opportunities

A broker will assist you in the areas of evaluation, negotiation, financial analysis, and business regulations. A broker will not advise or practice in those areas reserved for an accountant or lawyer but should be familiar with these areas and help you close the deal.

What the business owns. Forget the accounting balance sheet! All this document tells you is what an item initially cost and how long it has been owned (depreciation). If the business bought land in the '60s, the land is still on the books for '60s' prices. If the business bought a computer system last year for millions, and today the system is junk, it'll still look like millions on the balance sheet.

The important measure of what the business owns is the "market value" of its assets. Assets are only worth what they can be sold for or what they can earn for you. For now, find an asset appraiser not a business appraiser and have the real assets appraised. Don't waste your time on the intangible assets like "goodwill." You'll see why when calculation of excess earnings is explained.

What the business earns. Forget the accounting P & L (profit and loss statement)! Many owners maybe you or your spouse keep their books to minimize taxes and maximize lifestyle. Find an accountant or business broker who knows how to "recast" the P & L.

Recasting means to simply restate the profit and loss statement to show how the business would have looked if it had been run with all income showing and all expenses kept at proper levels. If your accountant doesn't know how to recast financial statements, find another accountant. Recasting isn't perfect but it's a lot better than most financial statements of privately owned companies.

What makes the business special. What we're talking about here is the subjective area of risk and desirability. High risk businesses should provide greater returns than low risk businesses. That's another way of saying they should cost less. If a business earns $100,000 and you see it as not very risky, you might accept a low rate of return, say 15%. You'd pay $666,666 for the business ($666,666 x 15% desired return = $100,000). But if you saw the business as high risk, you might want a 40% return. You'd pay only $250,000 for the same $100,000 earnings ($250,000 x 40% desired return = $100,000).

Don't learn the math, just understand the concept: it's called "capitalizing earnings". Let the professionals walk you through it. If your professional can't explain capitalized earnings, find a new professional.

The Tricky Part

Capitalizing earnings works when a business has cash flow but very few assets, like a consulting practice. When a business has only assets and no cash flow, like a manufacturing business that's just breaking even, use the market value of the assets as a ballpark figure of value. When a business has both assets and cash flow, we need a more involved valuation. The name most people use for this calculation is the "excess earnings" method.

Excess earnings doesn't mean exceptionally high profits, it means earnings in excess of what someone would have earned if they had put their money in a nearly risk-free investment like a U.S. bond or note. The idea is that if you invest in the assets of a business and it yields a higher return than you could have received from a bond or certificate of deposit (CD), you should pay for both the assets and those higher cash earnings. If fact, what you pay for those excess earnings is what is really called "goodwill." If there are no excess earnings, there is no goodwill.

Once again, you can read all of this in books, but my advice is to find a professional who fully understands the excess earnings method of valuation.

Price Not Value

Whatever value you come up with is only a starting point. Price is determined by the negotiating skill of the parties involved, by emotional factors, by supply and demand and by other factors, most importantly the terms of sale.

Business valuations in divorce need not be acrimonious and irrational. While there is always some subjectivity involved, many useful evaluation techniques are well known by professionals.

If you can sell a business for a small down payment, a long payout period, and a low interest rate, you will be able to get a higher price than if the buyer pays cash up front. Assumption and assignment of liabilities influences price. Guarantees play a part. All of this is called "the deal structure," and all of these terms get written up in the contract of sale.

Understand how these things affect price. Have your advisors explain the trade-offs. Have them give you alternatives.

Delegate, Don't Abdicate

Finally, stay in control of the valuation and negotiation processes. Use your experts, but manage them. Make them explain why they want to take particular steps. Always ask what alternatives are available and what risks are involved. Your experts work for you. And when you're uncomfortable, get a second opinion.

Business valuations in divorce need not be acrimonious and irrational. While there is always some subjectivity involved, many useful techniques for evaluation are well known by the professionals.

About the Author

Carl D. Peterson, M.S. in management, is a former senior executive at multinational companies such as International Paper, and Merrill Lynch. In 1984, Carl began his own business and now writes books geared toward assisting business entrepreneurs. A seasoned businessman whose greatest asset is knowing the process from the inside out, he steers clients and readers away from costly mistakes and toward opportunities. From Margorie Engel’s "Divorce Help Sourcebook."