Value of a Business or Professional Practice
The value of a spouse’s ownership of a business or professional practice may be a very valuable asset, but it is also difficult to value. To divide property, the court needs to know the property exists and have some evidence regarding the value of the property.
Is the business an asset of the marriage?
If the ownership of the business is only in the name of one of the parties to a divorce (or one of the parties and other shareholders or partners) can the business be considered an asset of the marriage?
Yes. If the interest in the business was acquired during the marriage, it is a marital asset, much the same as the marital residence.
Is an inherited business a marital asset?
If my interest in the business was inherited, received as a gift, or owned by me before the marriage, will it still be part of the marital assets?
Generally, no. Assets which are received during the marriage by inheritance or gift are not marital property and, after the divorce you will continue to own these assets as your nonmarital property. But this subject is legally complex. It depends on the facts, so you need to seek an opinion from your lawyer to address specific potential exceptions.
But what if my spouse cannot run the business/is not qualified to engage in the business?
The divorce court looks for the value of the business/professional practice. In apportioning assets the court will place the value of the business or professional practice on the side of the ledger of the party operating the business or professional practice. This means there will have to be an offsetting asset on the other party’s side of the ledger, or a buyout.
How is the fair market value of the business or professional practice determined?
Usually by an appraisal. The court looks to the fair market value of the business. This is a hypothetical number of what the business would be worth if it were sold. Often it is believed that the value of the business is based upon one preferred approach – an income approach. In an income approach, the future income stream of the business is discounted back to present cash dollars. There are many critical calculations in using an income approach. A second approach to value a business is a market based approach. Such approaches are similar to an appraisal of real estate with three comparables. Therefore, using a market based approach, an valuator focuses on sales of similar businesses. A third approach to valuing a business uses the asset-based approach and focuses on the assets of the business.
Can you explain a bit more about the income approach to valuing a business?
In theory the value of an interest in a business, or in a professional practice, depends on the future benefits that will accrue to that interest, with the value of the future benefits discounted back to a present value by an appropriate discount (capitalization rate). The discount rate is a critical element. The difference of a point or two may make a significant difference in value.
In a buyout agreement, the partners or other shareholders may buyout the interest of a party who is withdrawing. Is this buyout agreement evidence of value?
Yes, but it is not controlling. The judge may also consider other evidence of value.
Is the goodwill of a professional practice or business included in the fair market value?
In Illinois, personal goodwill is not a marital asset subject to distribution in a divorce. A distinction is made between the institutional goodwill of the business and the personal goodwill of the owner of the business. Personal goodwill is not a marital asset.
My business is not a professional business but is service business highly depending on me. Does the same concept hold?
Yes. There is a leading Illinois Supreme Court case called Marriage of Talty. In this case, the Illinois Supreme Court (the highest court in Illinois) addressed the problem that occurs because of the potential double counting of the goodwill of a business. The Supreme Court believed that in apportioning marital property the court was to have already considered two factors which might already be part of a goodwill calculation by an appraiser. These factors look to the earning capacity of each spouse. In short, Talty ruled that to the extent that goodwill of a business exists independent of the personal efforts of the business owning spouse, it should be considered as an asset of the business. To the extent that the goodwill of a business depends upon the efforts of the spouse who owns the business, it should not be considered to be marital property. Essentially, the focus in such business valuation cases in a state such as Illinois is to focus upon whether it would be possible to replace the owner of the business with another person and continue to operate the business at the same profit level. In 2005, the Illinois Supreme Court essentially reaffirmed its position in the Schneider decision. IRMO Schneider.
Is it true that it is usually expensive to have an appraisal made of a business/professional practice?
I practice primarily in McHenry County, Lake County, Kane County, and DuPage County Illinois. In these counties, I have handled a number of cases involving business — with some businesses being small service oriented business and others being far larger businesses. I have found that most appraisers charge a minimum retainer of perhaps $7,500. The cost of the business valuation will ultimately depend upon a number of factors – one of the most significant of which is the degree of cooperation of the spouse who owns the business (or has an interest in the business) with the professional appraiser. The other significant factor is whether it is necessary that the appraiser must do what is called “forensic accounting.” If the books and records of the business are trusted to be accurate, then the cost of an appraisal is significantly lower than a business where the financial statements of the business may not be entirely accurate.
Unlike the appraisal of a house, the appraisal of a business/professional practice has many elements, some of which are highly complex.
I have heard of the use of a neutral appraiser. What are the advantages and disadvantages of the use of a neutral appraiser?
The advantage of using a neutral appraiser may be cost. If the parties agree to the use of a neutral appraiser and the appraisal is accepted by both parties, this approach will result in the lowest overall cost. Commencing in 2016, Illinois law for the first time clearly allows the use of a neutral business appraiser. More specifically, the new law provides:
The court may seek the advice of financial experts or other professionals, whether or not employed by the court on a regular basis. The advice given shall be in writing and made available by the court to counsel. Counsel may examine as a witness any professional consulted by the court designated as the court’s witness. Professional personnel consulted by the court are subject to subpoena for the purposes of discovery, trial, or both.
A concern about using a neutral appraiser is that such appraisals work best where there is no need to do forensic accounting, that is, where the numbers as stated by the financial statements are trusted by both parties. I do not recommend the use of a neutral appraiser in cases where one party has significant concerns about the accuracy of the financial statements of the business.
Can a case be handled collaboratively if it involves the issue of business valuation?
Yes. One of the advantages of collaborative law and collaborative divorce is the use of neutral appraisers. The real question is whether the business owning spouse will cooperate sufficiently to ensure disclosure of documentation necessary to value a business. Often the business owning spouse will wish to use a collaborative approach because the parties have more control as to what will happen in a collaborative law setting. For example, often the business owning spouse is concerned that during an on-site visit the other side’s expert will inappropriately ask questions of employees, etc. These sorts of concerns can readily be addressed in a collaborative divorce setting.
Where else can I get more detailed information?
You may read Gunnar J. Gitlin’s article regarding business valuation available on this site.