Whether attacking or defending your expert business judgment in a divorce trial, it’s important to know and avoid eight landmines that can blow up your case:
- Reasonable Owner’s Compensation – Business valuations usually require an expert to make adjustments to the subject company’s income statement. This process is called “normalization.” Normalizing a company’s financial statements allows valuation experts to compare the subject company to other businesses in the same geographic area and industry. One of the most common normalizing adjustments is owner compensation, which can be increased or decreased to reflect market rates. The appraiser is not a vocational expert, so how can he or she give an opinion on what a business owner should get? Business appraisal experts typically rely on published survey data sources for the industry in which the subject’s business is involved. This is one reason why it is important to interview or fire a business owner to learn about his or her skills, duties, hours, compensation, and benefits. If the survey data that the appraiser relies on doesn’t match the characteristics of a particular owner, then these landmines can blow up his opinion of value!
- Matching Asset Value to Market – Another common normalization adjustment is the “adjustment to the book”. Tangible assets such as real estate, inventory and equipment must be adjusted for market value if a “book value” or “excess revenue” approach is used. Again, most business experts are not appraisers, so it may be helpful to engage a real estate appraiser or equipment appraiser to provide their opinion. Many business experts rely on the opinion of business owners, which can be dangerous. Review the limiting conditions in the assessment report to see if the expert is tiptoeing between landmines.
- Adjusting Rent to Market – If the company pays rent to owners or other insiders, the rental amount may be greater or less than market. The safest route is to hire a real estate appraiser to provide a reasonable estimate of the rental value. If a business expert relies on the opinion of a market rental owner, it must be disclosed under restrictive conditions.
- Certain Company Risk – Perhaps the most common method of selecting a capitalization rate in business valuation is called the “Ibbotson build-up” method. Assessment professionals rely on data published annually by Ibbotson Associates to calculate the risks associated with a particular business. Generally there are four elements of risk that are added together (thus, “build”). The first three elements – the risk-free rate, the equity risk premium, and the size premium – are pretty cut-and-dry. Real subjectivity comes into play when an expert adds a particular firm’s risk premium. Before going to trial, it is very important for the attorney to understand a particular company’s risks and talk to an expert about his or her opinion and how it was derived.
- Value Match – Most lawyers don’t know that the capitalization rate is calculated differently to match different types of benefit flows: cash flow before tax, cash flow after tax, net income before tax, net income after tax, excess income, cash flow projections, etc. When preparing for a trial, don’t forget to ask an expert to explain how the capitalization rate fits into the benefit stream.
- Taxes and Transaction Fees – Most divorce courts have not addressed the issue of whether it will “tax effect” the company income of Sub-chapter “S”. Another issue is whether to deduct taxes and transaction costs from the hypothetical proceeds a business owner might receive on the sale of the company. This will require an expert to allocate a selling price and maybe even provide an opinion on brokerage fees. This is uncharted territory, so don’t forget to bring your metal detector with you when crossing this minefield!
- DLOM/DLOC – Many business experts apply lack of marketability (DLOM) discounts to their assessment of closely held companies. They can also apply a lack of control (DLOC) discount to a minority interest (less than 50%) of a business. In recent years, the US Tax Court has aggressively challenged business valuation experts who apply discounts for property and gift tax purposes. Intuitively, it makes sense that investors will pay less for businesses they cannot liquidate as easily as publicly traded stocks; and the disadvantages of having a minority ownership in a company are obvious. The evidence for measuring these discounts, however, is far less clear and should be examined.
- Identifying Non-operating Assets – Some companies maintain investment portfolios or own property that is not used in business operations. On the other hand, some businesses need capital reserves to replace expensive equipment or inventory, to secure commitments or financing, or for other reasons. Non-operating assets generally increase the value of the business because the business expert will isolate those assets and add them to the capitalized income of the remaining assets.