Overview on evaluating a small business in divorce
A small business interest is a typical asset to be dealt with in a dissolution (divorce) proceeding, particularly in medium-to high-income-bracket divorces.
In almost every field of law, a person will encounter the “general law” on an issue or subject, which is typically what a lay-person will learn via ordinary channels (initial consultation, television, neighbors, etc.). But each “general law” will typically have “exceptions” and those exceptions (I call them red flags) are what lawyers are trained to look for and deal with as effectively as possible. That is where a lawyer’s education, skills and experience will set him or her apart and justify the hourly rate that lawyers charge.
Generally speaking, a business interest that is owned by one spouse before marriage is that spouse’s separate property. The exception to this general rule would be if the operating spouse’s efforts, skills or talent expended during marriage caused the value of that business to increase. If that was the case, then the community (aka “the marriage”) could acquire an interest in the business. Even though the business itself would most likely be assigned to the operating spouse, there might need to be a financial pay-out to the non-operating spouse for their share of the community interest. This is called an apportionment. Now, of course, an exception to this exception is if a prenuptial agreement or other contract exists that governs the issue. It is moderately difficult for an operating spouse to enter into an agreement with their business partners that seeks to limit a spouse’s interest in case of divorce, absent a prenuptial agreement, marital agreement or other transmutation agreement, because of issues with spousal consent and the fiduciary duties that each spouse owes to the other.
There are three main approaches for determining the value of a business: 1) an income-based approach; 2) a market-based approach; and 3) an asset-based approach.
Speaking in the most general terms, the income-based approach seeks to determine the value of a business by assessing the present value of its expected future earnings. The market-based approach is what it sounds like – a business value is determined by comparing it to other similar businesses. (Think of “comps” in real estate). This is a typical approach when dealing with a closely held corporation. The last approach being discussed is the asset-based approach wherein the assets of a business are given a fair market value which is then off-set by liabilities.
Business appraisals must be conducted by a professional, usually a CPA or forensic accountant. For cost saving measures, the parties can select a joint appraiser, but usually each party will have their own appraiser, or the court will appoint a “court’s expert.” Business appraisals can be quite costly, typically running between $5,000-$20,000 or more, so the utilization of a joint expert or a court’s expert can be financially prudent.
The expert will inspect financial documents, visit the business, and speak with key personnel. It is an intrusive, but necessary task, in order to determine the value that the community has in a business interest.
If you a have a business interest and are contemplating divorce, conducting preliminary “divorce planning” is a prudent and worthwhile investment. Divorce planning can allow you to make wise changes before divorce litigation is filed, or at the very least, enable you to be prepared mentally and financially for the anticipated process. Do not hesitate to contact Kring & Chung, LLP to set up a consultation to address your divorce plan.
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