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  By John S. Stoner, CPA, CVA, and Francis D. Morris, CPA, ABV, CFF

Owners of a family business face many challenges in the course of running day-to-day operations. Meeting customer expectations, maintaining a healthy and productive work environment, generating a sustainable level of profitability, and addressing capital expenditure needs and debt service requirements are just some of the issues that consume the time and attention of business owners.

Another difficult challenge is presented when a business owner gets a divorce. The family business is often the central topic in assessing the overall value of marital property subject to equitable distribution. For many business owners, a significant amount of their personal net worth is tied up in the equity ownership of the business. So, the critical question is, “How much is the business worth for the express purpose of measuring the marital property value?” Below are some steps that can help answer this question.

Review recent historical financial performance: The capacity of a business to generate profits on a sustainable basis is the most significant factor in determining business value. Generally, a review of the most recent five-year history provides a good understanding of the business’s activities and trends.

Recast/normalize the five years of financial data: Private business owners, especially family businesses, have full discretion in determining the compensation paid to family members, fringe benefits and other perks they receive, the extent of nonessential expenses charged through the business, and any amounts expensed in related-party rental arrangements. These types of recorded expenses are adjusted to estimated fair market value when recasting the income statements. Determining what business owners would need to pay outside parties for employed family member roles is a good way to estimate industry-level compensation packages. Likewise, industry-level rental rates for real estate or equipment used by the business can be used to make necessary adjustments to the recorded rent expenses. In addition, unusual and/or nonrecurring income or expense items are also removed to determine a normalized level of profits.

Review the normalized level of profitability: Once the normalization process is complete, the true financial performance of the business can be evaluated. The normalized results can be quite different than the financial performance presented in year-end financial statements and income tax returns. This can be an eye-opening experience for business owners, revealing that their business is making either significantly more or less profits than realized.

Applying an income-based valuation approach: There are three approaches to valuing a business: the asset-based approach, the income approach, or the market approach. For divorce purposes, if the business generates an adequate level of normalized profits, an income-based valuation approach is commonly used. Capitalization of normalized profits is an income-based valuation method based on this simple formula:

Normalized Profits divided by Capitalization Rate = Business Value

Measuring the elements in the formula is not so simple, and will require professional judgement. Those assumptions and results are often subject to debate and dispute during the divorce process.

What about valuation discounts? The value of an ownership interest in a closely held business is seldom equal to a proportionate share of the total value calculated using the formula above. It is not readily marketable and will take time (and money) to negotiate a sale and convert into a cash equivalent. In addition, if the business owner does not own a majority interest in the company (51 percent or greater), the stock is valued as a non-controlling interest. The estimated discounts for lack of marketability and lack of control also require professional judgment, and is frequently disputed in determining the underlying value of the marital asset.

Other complexities encountered in measuring the marital value of a business:

• Was the business started before the marriage? If yes, the business value at the date of marriage is not considered martial property (only the appreciation that occurred during the period of marriage would be considered marital property).
• Was any of the stock received through a gift or inheritance? If yes, the value at the date of gift or inheritance is non-marital.
• Under Pennsylvania law, personal goodwill is not considered martial property. Many small business owners represent a significant portion of the “business” and maintain most of the critical relationships. It is difficult to view the business without their continued active participation. Quantifying personal goodwill presents an additional challenge to the valuation process.

Determining the value of a family business is a critical step in completing the property settlement phase in a divorce. There are many factors to consider, and, with the high degree of professional judgment required, it is important to address the business value issue early in the process. This allows both parties and their respective advisers time to gain a good understanding of the overall property value of the marital estate.

John S. Stoner, CPA, CVA, is a partner in RKL’s Business Consulting Services Group, and Francis D. Morris, CPA, ABV, CFF, is a manager in the group. Both have conducting valuations and financial analysis for a variety of transactions, including divorce proceedings and business sales. Stoner can be reached at jstoner@rklcpa.com, and Morris can be reached at fmorris@rklcpa.com.