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This month's questions and answer:
Q. I am concerned that the divorce attorneys in my case (both mine and opposing counsel) have agreed that my wife's and my businesses should be valued. I am in manufacturing and my wife is a marriage guidance counselor. Her business income has been pretty regular over the last four years but my business has taken a beating lately with the soft economy. Although a couple of years ago it did great. I am concerned as I don't really understand how valuers work and whether they will take into account the fact that my business may have less income in the future in making a valuation for the divorce.
A. The answer this month is provided by Steve Kessler, CPA and frequent business valuer for divorce valuations.
Let's break your question down into discreet components as follows:
- Why are the attorneys suggesting that the businesses by valued? And is it really necessary?
- Your business is declining because of current economic conditions. Will a valuation at this time consider the current decline in sales as well as potential future decline in sales?
- How does the valuation process work?
The attorney's task is to guide you through the legal process of martial dissolution. The assets and liabilities of the marital estate will need to be divided in some fashion between the parties. The attorney will need to identify and understand the assets (both tangible and intangible), determine the value of the assets, and help the parties or a trier of fact (Judge) to arrive at a fair and equitable division of the assets. A business interest is frequently the largest and most complex asset of the marital estate. Although attorneys are extremely well educated masters of the legal process, they are not qualified to value a business interest. Consider a situation where a husband's business interest is not valued and a nominal value is used for purposes of dividing assets . Now one year later, ex-wife finds out that former husband just purchased a home on Lake Washington. While he may have won the lottery, chances are quite good that the nominal value of the business may be called into question.
Another issue that is often encountered is whether each party should hire their own business appraiser. Since business valuation is a complex area of specialization, it is expensive process. Therefore, one valuation expert rather than two results in a significant cost saving. You could agree on both using the same valuer but make it clear to the valuer he/she represents both of you. There may be instances where for whatever reason you want your own valuer and not a shared one. Unfortunately, if your case is one of approximately 2% that go to trial and your side does not have it's own valuation expert, the Judge will have no choice other than accepting the opposing expert's valuation (assuming the expert is qualified). These are a few of the considerations your attorney will be able to assist you with when considering a business interest valuation.
Lets now consider the last question since it will help us to answer the second question. It is important to understand that valuation is an art and not a science. Valuation experts will employ various methodologies depending on the particular type of business interest being valued. An extremely simplified overview of the valuation process is as follows:
- The expert will require you or your attorney to sign an engagement letter outlining the scope of services to be provided. The engagement letter will generally include provisions for a retainer that generally ranges from $2,500 to $5,000 or more depending on the complexity of the engagement.
- The expert will provide you with an extensive document request.
- The expert will frequently visit the business site/s and conduct interviews of relevant personal.
- After obtaining sufficient understanding of the business, industry, economic outlook, and financial data for the business, the expert will prepare a valuation report.
But how does the expert determine the value of the business interest? Let's take a quick look at the wife's marriage guidance practice. For this example, assume her net earnings have consistently averaged $35,000 per year. The valuation expert will first determine the fair market value of the net tangible assets i.e. cash, accounts receivable, furniture & equipment, less accounts payable, accrued liabilities, and debt. Next, the expert determines what the industry average net earnings are for a marriage guidance counselor. If the industry average were $40,000, then no goodwill value would be likely since the subject business is earning less than some similar businesses. If the industry average is $30,000, then our subject business is earning $5,000 more than the industry average. In this case, there are present indications of goodwill and the expert will determine value of the goodwill by looking at the business's future economic prospects. After the consideration the valuer is able to come up with a value which can be used in a divorce case.
Now for the second question - does the expert consider current and future economic prospects for the business? The answer is yes. The expert will use quantitative tools to determine what the most likely earnings of the business will be over an appropriate time frame. The current year is often the most relevant but not always. The preceding years in descending order are generally less relevant. Arguments can be made as to which years are the most relevant depending on the facts of the case. From these facts a model for the future is built which helps the valuer provide a value for the divorce process.
STEVEN J. KESSLER, C.P.A., A.B.V., C.V.A., M.S. TAXATION
Mr. Kessler is a principal in the firm of Morrow Kessler & Dowsing PLLC. The primary focus of Mr. Kessler's practice is taxation and litigation support services. He practices in the area of taxation, business valuations, pension valuations, and litigation services particularly for family law cases. Mr. Kessler has served as an expert witness in King, Kitsap, Snohomish, and Pierce Counties. Mr. Kessler earned his Bachelor of Arts Degree in Accounting with honors from Seattle Pacific University in December 1983. He received a Master of Science Degree in Taxation from Golden Gate University in June 1986. Mr. Kessler has earned the designations of Accredited in Business Valuation (ABV), Certified Valuation Analyst (CVA), and Diplomat of American Board of Forensic Examiners (DABFE). Mr. Kessler is a member of the American Institute of CPA's, The Washington Society of CPA's, National Association of Certified Valuation Analysts, American Society of Appraisers (Candidate Member), Seattle Estate Planning Council, Seattle University Planned Giving Community, University of Washington Planned Giving Committee.