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Standards of Business Valuation in Divorce

STANDARDS OF BUSINESS VALUATION

Standards used for business valuation differ considerably from state to state. State statute and case law interpreting those statutes will aid in a practitioner's ability to define the proper standard for business valuation in a particular state. However, many states do not do a good job of defining that standard of value. These states often simply label that standard as the "value" or "net value. We can look to the IRS for further guidance as to what standard we use to value a business. The IRS uses "fair market value" as the standard for valuation purposes. Fair market value being defined as "the price, expressed in terms of cash, at which property would change hands between a willing hypothetical buyer and a willing hypothetical seller, acting at arm's length in an open and unrestricted market where neither party is under a compulsion to buy or sell and both parties have reasonable knowledge as to the relevant facts.

There are other terms that we will see used for valuation. Those terms include "investment value", which is typically understood as the value of a business interest to a specific buyer. Investment value differs from fair market value in that it takes into consideration specific attributes of a specific buyer. Another terms we will see is "intrinsic value". Intrinsic value is the value attributable to a current business owner. This doesn't take into consideration any hypothetical buyer or hypothetical seller nor does it even consider a hypothetical sale. Intrinsic value simply looks at the value of the continued business interest to the current business owner.

There is dispute amongst the jurisdictions and also within courts of the same jurisdiction as to what standard to apply when a business cannot be sold either because of contracts to restrict transfer of ownership or otherwise. Some posit that per the definition of fair market value a business with these restrictions cannot be sold and thus cannot be valued under the fair market value approach. Others posit that despite the transfer restriction fair market value should be determined as if there were no transfer restrictions whatsoever.

There is also debate with regard to how to apply the fair market value standard to professional goodwill. Professional goodwill is often the most significant asset of a business and thus its valuation mechanism is important to understand. Some jurisdictions do not consider professional goodwill to be a marital asset, others do. Some jurisdictions differentiate between professional goodwill and personal goodwill. Professional goodwill is that goodwill attached specifically to the business. Personal goodwill is that goodwill which is attached to the individual employee's abilities and characteristics. If the jurisdiction applies and differentiates between both professional and personal goodwill then an expert must determine how to value these two forms of goodwill. Some experts say that fair market value cannot attach to personal goodwill because if that person does leave the business, pursuant to a sale, then that personal goodwill leaves with that employee. Thus a hypothetical buyer will not pay cash for personal goodwill attached to a business as that personal goodwill will no longer exist as of that employee's departure.

If we apply an intrinsic value when valuing the business then we can apply both professional and personal goodwill. The reason for this is that the employee does not leave the business per an intrinsic valuation. Thus his or her goodwill remains an asset to be valued with the business. Thus if we are seeking to prove a higher value for the business then we should seek to implement an intrinsic valuation method so as to value both professional and personal goodwill. The majority of states today do not include personal goodwill as to be part of the marital estate.

Fair market value of professional goodwill can be proven in different ways. Courts vary on what methods of proof are sufficient for such. Evidence of a recent actual sale of a similar business in a similar setting may be sufficient proof. Courts may also look to any offers which have in fact been extended for the purchase of that specific business. Expert testimony may be sufficient without either of the already mentioned valuation methods. We may also call on testimony of members of the subject profession as to the existence and quantity of goodwill in a given market for a given practice.

At the end of the day there are many different interpretations as to what is fair market value as it applies to business valuation within the context of divorce.

Categories: Family Law