SMALL BUSINESS VALUATION IN SOUTH CAROLINA FAMILY COURT
When it comes to business valuation, there are no absolutes and no "right" answers -- only general guidelines to which individual judgment must be applied. As such, business valuation can -- and often does -- become a hotbed for controversy, particularly in the family court.
Understanding of how professional business valuators go about their task is essential, and this article deals with the first step in the valuation process --- that is, determining from whose perspective and under what conditions value is measured for purposes of equitable division in South Carolina.
For example, consider how many different values can be expressed for an interest in a family business. Family members may want to include sentimental considerations. A strategic purchaser typically considers after-acquisition synergies, but not sentimentality. For the hypothetical financial buyer who seeks a market rate of return on investment, neither sentimental or synergistic considerations affect value.
In the valuation profession, the different perspectives and major conditions of value are called standards of value. Generally in divorce settings, the standard of value is usually defined either as fair market value or investment value, depending upon jurisdiction. Although the definitions have similarities, they differ markedly in terms of who the assumed buyer is.
Fair market value is commonly defined as the price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. The definition presumes a market transfer between well-informed, hypothetical parties and ignores the actual intent and desires of any particular buyer or those of the owner.
Investment value (sometimes referred to as intrinsic value) is defined as the value to a particular or specific investor based on individual investment requirements and expectations, as distinguished from the concept of market value, which is impersonal and detached. Thus, investment value is reflective of particular knowledge, expectations, and abilities of the owner or synergy of a prospective owner.
Since the case of Reid v. Reid, 312 S.E.2d 724 (S.C.App. 1984), South Carolina appellate courts have repeatedly specified fair market value as the standard for purposes of equitable division in South Carolina. In Reid, the court noted the family court's obligation in any equitable division of marital assets to determine the fair market value of business interests. In the absence of statutory guidance, the court defined fair market value as "the amount of money which a purchaser willing but not obligated to buy the property would pay an owner willing but not obligated to sell it, taking into account all uses to which the property is adapted and might in reason be applied."
Citing the Supreme Court case of Metromont Materials Corp. v. Pennell, 239 S.E.2d 753 the Reid court said that fair market value should be determined "by considering the business' net asset value, the fair market value for its stock, and earnings or investment value." Those three value approaches are often referred to as the net asset value, market and income approaches.
The economic principle of substitution underlies the net asset value and the market approaches. Under the net asset value approach, value is equal to the cost to reproduce or replace the tangible and intangible assets employed in the business. Under the market approach, value is equal to the cost required to acquire a substitute business interest with the same utility i.e. same expected cash flow.
The income approach holds that a direct relationship exists between the amount of income a property will produce and its value. Thus, business value is equal to the present value of all estimated future income from the business or business interest.
Value indications under each approach will differ based upon which standard of value is being followed. For example, the income approach requires an estimation of income available to the owner of the interest. To the extent the income estimate is prepared from a hypothetical financial buyer's perspective, the value is likely to represent a fair market value. To the extent, income is estimated form the perspective of a specific strategic buyer, value is more likely to represent investment value, which is generally much greater than fair market value.
Values indicated by the three approaches must be weighed based on the judgement of the valuator in accordance with the controlling standard of value. For example, the fair market valuation of a professional practice will usually focus more upon value indications under the income approach rather than the net asset value approach. Typically, the most valuable asset of a professional practice is client or patient goodwill, which is typically valued based upon the income it produces as opposed to the cost of acquisition.
In South Carolina, some confusion exists over the issue of including business goodwill in the marital estate for purposes of equitable division.
Starting with Casey v. Casey, 362 S.E.2d 7 (S.C.1987) the Supreme Court granted a writ of certiorari to consider whether the Court of Appeals was correct in holding that goodwill of a sole proprietorship constituted a marital asset subject to division. Valuation testimony in the lower court (Casey v. Casey, 346 S.E.2d 726 (S.C.App. 1986)) had consisted of the wife's valuation expert testifying that the husband's business had goodwill because the earnings of the business far exceeded a reasonable sum to compensate the husband for his services in the business. However, the valuation expert could not place a value on business goodwill because of inadequate earnings data. For that reason, the Court of Appeals remanded for valuation which would as the court stated "distinguish between the entrepreneurial skills or potential future earnings of a spouse and the goodwill of the spouse's business."
Apparently without the additional valuation testimony sought by the Court of Appeals, the Supreme Court concluded that success of the husband's fireworks business was largely due to the husband's personal lobbying efforts to keep the sale of fireworks legal in South Carolina. As such, the court did not recognize the existence of business goodwill apart from that personal to the husband.
In holding that the goodwill of the husband's business did not constitute marital property subject to equitable division, the Supreme Court said "when the goodwill in a business is dependent upon the owner's future earnings, it is too speculative for inclusion in the marital estate."
In Donahue v. Donahue, 384 S.E.2d 741 (S.C. 1989) the Supreme Court considered the goodwill of a professional solo practice. The court described "professional goodwill" as attaching "to the person of the professional man or woman as a result of confidence in his or her skill or ability. It does not possess value or constitute an asset separate and apart from the professional's person, or from his individual ability to practice his profession. It would be extinguished in the event of the professional's death, retirement or disablement."
Recognizing the intangibility of professional goodwill, the Donahue court perceived valuation to be speculative and refused to consider it as marital property. The court noted that this speculative element had been it's concern in Casey.
RGM v. DEM, 410 S.E.2d564 (S.C. 1991) involved valuation of the husband's tree surgeon business. In the family court, the wife's valuation expert valued business goodwill at approximately $75,000 based on the annual earning potential of the business, net of compensation to the husband for his services as the key man in the business. Even though the family court recognized goodwill as a business asset, it ruled that the value of goodwill was excludable in computing the value of the business for equitable division purposes based on the Supreme Court's decision in Casey.
In remanding RGM v. DEM, the Supreme Court said it was contradictory reasoning to recognize the value of business goodwill under the fair market value standard and then exclude it based on Casey. It is important to note that no testimony had been offered in Casey as to the value of business goodwill apart from that of the husband's. For business goodwill to be included in the marital estate, there must be credible, quantifiable testimony to its fair market value.
For small businesses and professional practices, the valuation challenge is to estimate net business income after allowance for a market rate of compensation to key persons for all services including maintenance of goodwill. Although the standard of fair market value presumes a sale; it does not presume the loss of key persons in the business or professional practice.
To the extent compensation of key persons is based upon market considerations and no other factors indicate an imminent loss of a key person, concerns about transferability of client relationships or other goodwill are eliminated, because no such transfer need be expected. In addition, a thorough analysis of market compensation rates delineates post divorce labor value from business value, thus eliminating any "double dipping" concerns.
The salient feature of the fair market value standard is that value is determined from the perspective of the universe of hypothetical financial buyers and sellers and not from the perspective of the current owner or a particular buyer. Those latter perspectives are only appropriate under the investment value standard which Casey and it's progeny specifically reject. However, notwithstanding the appellate courts' clarity in specifying the fair market value standard, valuations based upon investment value can still be expected from the non-property spouse.
Prepared for Flying Solo by George W. DuRant, CPA
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© 1997
