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 evidence of the property’s value.
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’s a marital asset, much the same as the marital residence.
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 places 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 the court awards offsetting asset on the other party’s side of the ledger—a buyout. The difficulty is determining the fair market value of the business (without considering personal goodwill). We will consider those topics next.
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 interest would be worth if it were sold.
- Income approach. 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. And the key question is determining that reliable income stream.
- Market-based approach. A second approach to value a business is a market-based approach. This approach is similar to an appraisal of real estate—that will usually compare the subject property with three “comparables” or comps. Therefore, using a market-based approach, a valuator focuses on sales of similar businesses or arms-length transactions within the subject business. And consider the provisions for a buy-out within a shareholders’ agreement as a subset of the market approach.
- Asset-based approach. 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 a professional practice depends on the future benefits that will accrue to that interest. That future value is then discounted back to a present value using an appropriate discount (capitalization rate or discount rate). This rate is a critical element. The difference of a point or two makes 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 a shareholder’s agreement does not control. The judge can consider other evidence of value. The specific facts and circumstances surrounding the particular shareholder’s agreement are critical.
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. Illinois caselaw distinguishes between institutional goodwill of the business and personal goodwill of the business owner. The court does not consider personal goodwill as a marital asset. See for example, BVR’s “Valuing goodwill in divorce: State-by-state breakdown of enterprise & professional goodwill jurisprudence.” It provides a state-by-state breakdown. It shows that many states follow the trilogy of Illinois Supreme Court cases. These cases only allow for enterprise goodwill to be valued in a divorce.
For a good basic description of personal goodwill concepts, click here.
My business is not a professional business but is a service business highly dependent on me. Does the same concept hold?
Yes. Consider the leading Illinois Supreme Court case called Marriage of Talty. The Illinois Supreme Court in Talty addressed the problem that occurs because of the potential double counting of the goodwill of a business. The Illinois Supreme Court believed that in apportioning marital property, the trial court would have already considered two factors that might otherwise 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, the court considers the value. To the extent that the goodwill of a business depends upon the efforts of the spouse who owns the business, the court does not consider this portion of the value to be marital in character. Essentially, Illinois law focuses on whether it would be possible to replace the owner of the business with another person and continue to operate the business at a similar profit level. In 2005, the Illinois Supreme Court essentially reaffirmed its position in the Schneider decision. IRMO Schneider, 214 Ill. 2d 152 (2005).
Is it true that business values are expensive?
Yes. I practice primarily in McHenry County, Lake County, Kane County, and DuPage County Illinois. In these counties, we have handled many cases involving businesses—with some businesses being small service-oriented business and others being larger businesses. Most appraisers charge a minimum retainer of $10,000. But you need to know what you are paying for. Business appraisers refer to this as the “scope of the appraisal. Full-blown appraisals are obviously more expensive that limited appraisals.
So, what are the types of appraisals.
- Appraisal or valuation: This expresses an unambiguous opinion of value, supported by all procedures that the appraiser deems relevant to the valuation;
- Limited or restricted appraisal: It provides an estimate of value based upon a scope that excludes some of the procedures required in a full-blown appraisal.
- Calculation: It provides only an approximate indication of value, sometimes called a preliminary indication of value, based on limited procedures as agreed upon by appraiser and client.
A good chart explaining different standards and how they apply to the process is here.
More basic is this summary comparing an appraisal with a calculation.
Please discuss more the overall cost.
The cost depends on several factors. First, if one is obtaining a full appraisal without limitations, this is the more costly appraisal. Yet limited appraisals may not be admissible at trial.
The key factor involves the degree of cooperation of the business-owning spouse (or of shareholders holding the majority of the stock) with the professional appraiser. Another factor is whether the appraiser must conduct “forensic accounting.” If the books and records of the business are trusted to be accurate, the cost of an appraisal is far lower than a business where the financial statements of the business aren’t 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 using 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 results in a costs savings. Illinois law allows the use of a neutral business appraiser. It 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 for forensic accounting. This means that a neutral appraiser works best when the figures as stated by the financial statements are trusted by both parties. I don’t recommend the use of a neutral appraiser in cases where one party believes the financial statements of the business aren’t accurate.
Can a case be handled collaboratively if it involves the issue of business valuation?
Yes. An advantage of collaborative law and collaborative divorce involves the use of neutral appraisers. Before agreeing to a collaborative divorce involving a business ask yourself whether the business-owning spouse will cooperate sufficiently to ensure disclosure of documentation necessary to value a business. Often the business-owning spouse may wish to use a collaborative approach because the parties have more control in a collaborative law setting. For example, the business-owning spouse might be 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.
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 received during the marriage by inheritance or gift are generally not marital property. With some exceptions this means that 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 potential exceptions.
Where else can I get more detailed information?
- You may read Gunnar J. Gitlin’s article regarding business valuation available on this site.
- Gitlin on Divorce: A Guide to Illinois Family Law has the definitive in depth treatment of business valuation caselaw and concepts for Illinois divorce cases.
