Ending a marriage equitably can be a complex process when spouses and their attorneys face the daunting prospect of determining the value of a business. In these cases, it is always a good idea to consult a business valuation expert who also has experience in marital dissolutions to help the parties reach a fair valuation of the business.
“Rarely do the parties fully understand the issues that exist in valuing a business in these matters,” said David Anderson, principal of David Anderson & Associates, and a collaborative business valuation expert serving divorce lawyers and their clients in Bucks County, Chester County, Delaware County, Montgomery County and Philadelphia County. “The process often begins as an educational one in which the business valuation expert must explain to the spouses and their attorneys how valuation issues are addressed in a divorce.”
Anderson said there are four key business valuation issues that arise repeatedly in marital dissolutions. They are:
∙ The cost of the in-spouse’s services to the business being valued (the in-spouse is the spouse who owns the business interest being valued as opposed to the out-spouse who does not have ownership in the business);
∙ Personal goodwill and its impact on the business being valued;
∙ The presence and impact of unreported cash sales;
∙ Personal expenses charged to the business.
This article, the first of a two-part series, will explore the first two of these issues — the cost of the in-spouse’s services to the business being valued and personal goodwill and its impact on the business being valued.
The cost of the in-spouse’s services
Anderson said he was once asked to value a one-person ophthalmology practice in which the in- spouse earned about $200,000 a year. The out-spouse and his divorce attorney believed the business would be valued at more than $1 million, but Anderson assigned a value of less than $150,000.
“The out-spouse and his divorce attorney did not consider the cost of the in-spouse’s services to the practice,” said Anderson. “If a hypothetical buyer of the practice was not an ophthalmologist, the buyer would have to hire an ophthalmologist at a cost of $180,000 a year for a person with the same level of education and experience as the in-spouse. Hence, the annual net income of the business available to the buyer would be only about $20,000, not $200,000.
“If another ophthalmologist purchased the practice, that person would know he or she could earn $180,000 working for some other practice without having to invest money in this practice. Why would anyone spend more than $1 million to earn only an extra $20,000 per year? They wouldn’t,” said Anderson. “The practice simply was not worth as much as the out-spouse thought.”
Of course, a valuation can go either way. Anderson was once asked to value a retail furniture business whose CEO (the in-spouse) had an annual salary of more than $1 million and whose business had annual net income of less than $50,000. The in-spouse and her divorce lawyer expected the business to be valued at about $300,000, and was shocked when Anderson valued it at approximately $3 million.
“At the time, a hypothetical buyer could hire a CEO for about $350,000 per year, not the $1 million plus salary the in-spouse was taking,” said Anderson. “The $650,000 per year salary differential had to be added to the business’s bottom line, thereby resulting in a higher-than expected valuation. These are the types of issues a business valuation expert specializing in divorce has to consider to determine the fair value.”
Personal goodwill and its impact
Personal goodwill is the portion of a business’s value and income that is attributable to the personal reputation, expertise or contacts of one or more of the business’s owners, according to Anderson. This issue comes into play mostly in professional services businesses, such as physicians, attorneys, accountants, engineers, etc.
A business valuation expert must disregard personal goodwill when valuing a business in a divorce because it is assumed the in-spouse’s reputation, expertise or contacts would not accompany the business if it was sold.
Anderson recalled a case in which he was asked to value an anesthesiology practice whose senior member (the in-spouse) had a stellar reputation on the east coast.
During his investigation, Anderson discovered that the practice regularly received referrals from other doctors because of the in-spouse’s widespread, excellent reputation. Further Anderson found that the business that came from the referrals represented a significant percentage of the practice’s revenues. As a result, Anderson reduced the value of the practice to reflect that the personal goodwill of this senior member was responsible for a large percentage of revenues.
“The out-spouse and her divorce attorney clearly expected that a higher value would be placed on the business,” said Anderson. “But so much of the practice’s business came from the anesthesiologist’s highly regarded reputation. If the in-spouse left the practice or it was sold, the business would have dropped off precipitously, meaning the true value or the business was far less than it seemed.”
Stay tuned for part two of this series exploring valuation issues that a business valuation expert must consider in divorce cases. Part two will discuss the presence and impact of unreported cash sales as well as personal expenses charged to the business.
About David Anderson, CPA, CFE, CVA
David Anderson, CPA, CFE, CVA is a forensic accountant and collaborative business valuation expert serving divorce lawyers and their clients in Bucks County, Chester County, Delaware County, Montgomery County and Philadelphia County. He provides a full range of divorce- related business valuation and forensic accounting services including forensic accounting, business valuation, fraud investigation, fraud deterrence, litigation support services, economic damage analysis, business consulting and outsourced CFO services. Anderson has more than 30 years of experience in financial and operational leadership positions. He is a Certified Public Accountant, a Certified Fraud Examiner and a Certified Valuation Analyst. Anderson also has provided expert witness testimony in the Greater Philadelphia area, and served as a forensic consultant and business valuation expert on both civil and criminal cases.
