Effect of Divorce on the Family Business

It is an unfortunate American reality that half of all first marriages and nearly 60% of second marriages end in divorce. When business partners divorce, the financial and emotional challenges become more complex.

In addition to negotiating the separation agreement, dividing marital assets, assessing liabilities, and determining support arrangements, they must address the myriad issues involving the valuation of their business and succession planning.
Given the possibility of divorce, it behooves every family business to establish a comprehensive divorce strategy, clearly stating how the business will be affected if the parties separate.

Some important considerations for married business partners include:

<u>Selling or Keeping the Business</u>
A business is typically any couple’s largest single asset, and a divorce could require the business to be sold and the proceeds divided between the parties. Before it can be sold or traded for other marital assets, a business valuation must be prepared. Once both parties understand and agree upon the value of the business, the decision whether to buy-out one party, split the business, or sell to a third party should become clearer.

<u>Valuation of the Business</u>
In order to determine the value of any business, one must enlist a professional Valuation Expert, whose role is to assist the parties with determining the fair market value of their business. In divorce cases, it is imperative that the appraiser be impartial and independent of both parties.

A divorcing couple should have a neutral third party appoint the valuation appraiser, avoiding a lengthy and costly “valuation war” where the parties attack the other’s methodologies and opinions, which can necessitate taking the average of both valuations.

To determine the fair market value of the business, an appraiser seeks input from many sources using a combination of three types of valuation methodologies:
• Income Approach
• Asset Approach
• Market Approach

Generally, an ‘Income Approach’ determines value by calculating the net present value of the business’ benefit stream (discounted cash flow), while an ‘Asset Approach’ determines value by adding the sum of the parts of the business (net asset value). Finally, a Market Approach determines value by comparing the subject company to other companies in the same industry/of the same size/within the same region.

The valuation is the appraiser’s educated opinion based on the results of their approach. An appraiser should not only be technically competent, but also be willing to educate the parties to ensure that both sides understand the final number, and know how it was derived.

When choosing a business appraiser, business owners should hire an experienced expert who specializes in businesses of their size (i.e. market capitalization, number of employees), their industry, or even the purpose of the valuation (divorce, buy-out, sale).

A Be
ier vs. Be
ier Divorce is difficult enough, but negotiating disposition of a jointly–owned business can present unexpected complexities.

In the 2007 landmark Massachusetts Supreme Court case of Be
ier vs. Be
ier, dueling experts feuded over valuation methodologies and the court was left to decide. In this case, the husband’s expert treated the couple’s S Corporations as if they were C corporations, applying a 35% “average tax rate” to earnings yielding a $7.85 million valuation.

The wife’s expert declined to apply C Corporation rates, arriving at a $16.4 million valuation. The trial judge, citing prior case law and an old IRS manual, adopted the “tax affected” value of the husband’s expert. But the reliance on the training manual was “misguided” according to the Massachusetts Supreme Court, and the application of the prior case incorrect.

After reviewing the case law and literature, it “generally adopted” a valuation metric from a completely different state (Delaware). This arbitrary valuation can happen when the parties can’t agree and the Court determines that both appraisers have not presented valuations using disce
able facts.

<u>Succession Planning</u>
In general, approximately 30% of family businesses successfully transition from the first generation to the second, and only 12% transition to the third. While the reasons for these low rates are numerous, the result is that many businesses are sold, split up among the family, or discontinued altogether.

In the event of Divorce, the succession rate is even smaller, and only 10% of spouses continue to operate the family business together after divorcing.

If you are contemplating starting a family business, or already have one, it would be wise to create a comprehensive strategy in the event of a divorce. As difficult a conversation as that is likely to be, it will go far easier now than in the throes of separation.