As more married couples own their own businesses, it is inevitable that when a divorce arises, ownership and value of such businesses become a concern. Whether you are the spouse keeping the business or giving up the business, you will want a fair division. Hence, "What's Mine Is Mine and What’s Yours Is Half Mine."
Arizona is a community property state, and for purposes of a dissolution of marriage, the starting or purchasing of the business during the marriage, in most cases constitutes, a community asset. Absent an agreement of the parties as to what the business is worth, who will retain the business or an agreement to sell the business, the court must make those decisions. Whether it is a personal service business, such as a medical or dental practice, an accounting, legal or engineering firm, a retail business, franchise, network marketing business, real estate company, retail store, restaurant or manufacturing business, the concept of value may end up being a legal matter and a major area of controversy.
“Value” of the business could be defined as the price at which a willing buyer and a willing seller with full information would transfer ownership. There are four main approaches to valuing an ongoing business:
- Market Analysis Method. Actual, comparable sales of similar businesses that are compiled and averaged.
- Asset Accumulation Method. An analysis of the business’ balance sheet to examine assets and liabilities, including intangibles, such as “goodwill.”
- Cash Flow Method. A projection of the earnings or cash flow for a certain period of time, discounting projected cash flow to present value. An appropriate interest or discount rate should be used and a realistic projection of earnings or cash flow must be determined to calculate the total business value.
- Capitalization of Earnings Method. Commonly used and sometimes is called the “excess earnings” method, an analysis is made of the profitability of the business. Profitability is arrived at by reaching an agreed upon expense figure compared to the total revenue, the difference being the excess earnings or profitability. A multiplier or capitalization rate is then applied to the excess earnings. The capitalization rate used should be determined through analysis of historical and industry trends, future projections and comparison to other comparable businesses and investments. Again, “blue sky” or goodwill should also be considered.
Obtaining as much information as possible about the business helps determine which approach to use in a divorce case to choose the best indicator of estimated fair market value. Attorneys routinely employ a business valuation expert to review the financial data, render an opinion as to the most appropriate methodology for valuing the business and ultimately calculate an appropriate fair market value.
If a business is to be appraised in a divorce, information must be obtained from federal income tax returns for the business, financial statements, cash bank statements and reconciliations, accounts receivable, aging receivables, inventory, accounts payable, depreciation schedules, notes payable and fixed-asset listings. It is also important to become familiar with the market or industry of that particular type of business by examining past, present and forecastable trends. Understanding how the business is operated internally and how its competitors operate increases the quality of information and the accuracy of the valuation process. It is also important to examine other indicators, such as unusual expenditures or investments in capital improvements in the last two years, deferred compensation, retirement plans, stock ownership issues, excess depreciation, non reportable income and compensation of principals.
An agreement between the parties as to the value of the business is generally preferable to protracted litigation with expensive legal fees, business valuation and accounting costs. It is sometimes difficult, however, to determine a value of a business that is fair to both parties without a thorough examination of the business and application of the most appropriate method of valuation.
Once the value has been agreed upon by the parties or determined by the court, it then becomes a matter of division or equalization of other community or marital assets in property settlement. For example, if one spouse takes the business that is valued at $450,000, then the other spouse should receive a corresponding value of marital assets totaling approximately $450,000. Often there are insufficient assets to allow one spouse to retain the business and equalize to the other spouse with existing assets. Therefore, the spouse retaining the business must pay to the selling spouse an equalizing amount over time. If this is the case, it is important that the selling spouse be adequately secured. This security should include a promissory note with an agreed upon interest rate, and the principal balance of the note secured by (a) a deed of trust on real property, (b) the accounts receivable of the business, (c) the business inventory, (d) stock or (e) a security interest in the business’ assets. Assuming the retaining spouse timely pays the equalization payments, the security or collateral never becomes an issue. If the retaining party fails to pay the equalization payment, files bankruptcy or attempts to sell the business, however, then the receiving spouse would have adequate security.
In short, business valuation in divorce cases can be complicated and problematical. If you find yourself contemplating a divorce and your marital community owns or has a partial ownership in a business, the issue of business valuation must be addressed. The business issues are independent of spousal maintenance, division of other marital assets and child custody and support. Regardless of which side of the business you find yourself (either the retaining spouse or the selling spouse), be sure to know your legal rights and have the best possible estimate of the fair market value of the business. And remember, it is not true that “what is mine is mine and what is yours is half mine.”
If you have any questions about family law please contact Rowley Chapman Barney & Buntrock at (480) 833-1113 and ask for Paul S. Rowley.
