3 Standards of Value in Divorce Valuations (and why you should care)
Valuations are often required when a privately held business is part of a marital estate. In order to perform a division of property the parties must know the value of the asset, and in the absence of a public market price a third party valuation is required.
For the purposes of business valuation for divorce, we first look at standards of value. A quick definition: standard of value is defined in the International Glossary of Business Valuations as:
“the identification of the type of value being utilized in a specific engagement.”
Why should you care?
Standards of value, in conjunction with premise of value, sets the stage for the circumstances and assumptions that we will make within a valuation engagement. There are various standards of value to consider at the onset of a divorce engagement; however, the most common are as follows:
- Fair Market Value (FMV) – the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.
- Fair Value – is sometimes defined as FMV without discounts for lack of marketability or control, but it depends on the jurisdiction. Fair value most often assumes the interest valued has control (and as such does not need to consider the above mentioned discounts).
- Intrinsic Value (otherwise known as Value to the Holder) – The value to a specific, identified owner/buyer (compared to a hypothetical buyer as identified in FMV). There are myriad factors that impact the intrinsic value to a specific holder including but not limited to how much longer will they own the business, the level of compensation they will continue to earn, when they plan on retiring/exiting the business among many others. Again, there are no discounts considered as ownership is not changing hands or status.
Conclusion of value is impacted based upon the intended purpose of the valuation. Divorce is a great example of valuation purpose affecting value. For example, If we assume for a moment that we are valuing a minority interest (50% or less, lacking elements of control and liquidity), as a valuation analyst we would ordinarily consider applying a Discount for Lack of Control and/or a Discount for Lack of Marketability. This may result in a discount from the pro rata share of the business of anywhere from 20-50%.
In many jurisdictions, the courts have stepped in and limited the ability to apply so called discounts. In order to not “punish” an exiting spouse, the valuation is precluded from applying these discounts, instead developing a value that is higher than what we would conclude if we were performing the value for a different purpose.
In many situations as a valuation analyst we might look at the impact of “personal goodwill’ on the overall value of a business. That is to say, how much value is attributable to an individual owner vs. the enterprise itself? This is very common in medical and professional practices, or scenarios where the “owner is the business.”
Similar to limiting discounts, states take wildly differing views on the treatment of personal goodwill in divorce matters. In many states personal goodwill is considered a marital asset, this divisible in the separation of assets. In others, personal goodwill attaches to the individual and is separated from our valuation.
Given the above scenarios, a valuation performed in the context of a divorce could have a materially different finding than a valuation performed for, say, exit planning purposes. In our examples above, not only does purpose affect the validity of a valuation, but so does jurisdiction!