By Grover Rutter CPA,, ABV,  CVA, BVAL

            John Wayne said it very well.  “Tomorrow is the most important thing in life.  It comes to us at midnight very clean.  It’s perfect when it arrives and it puts itself in our hands.  It hopes we’ve learned something from yesterday.”

            In divorce cases, how often have lawyers and judges heard arguments about the value of a particular business, based upon its future capabilities?  From my experiences, it often seems that the departing spouse (the one that will not stay with, and run the business) thinks of the value of a business in terms of the future prospects possessed by the business.  In a recent valuation I performed, the departing wife mentioned several times, that when the next “up economic cycle” hits, the business is going to be worth a lot of money. (Of course, she apparently was not willing to wait until that next “up economic cycle” to file for divorce.)

            The definition of “fair market value” gets clouded by the emotions of the parties involved in a divorce action.  At times, even the attorneys get side-tracked on the issue of “fair market value.” In this article, I want to briefly highlight some of the intricacies of the term fair market value.

            Fair market value is a standard of value. Other standards of value are fair value, investment value, and intrinsic value. A complete discussion of the other standards of value is beyond the scope of this article.

The laws of each state dictate which standard of value is to be used in that particular state. Typically, the standard of value used for divorce is either:

a.       Fair Market Value, which is based on the value in a hypothetical purchase or sale transaction.

b.      Investment Value, which determines the value of the business based on its worth to the owner.

Some states strictly adhere to the fair market value standard, while others lean toward the concept of “the value, or worth to the owner.”  Yet other states may define the standard as fair value, when they really mean fair market value. Even courts are not exempt from the confusion surrounding this issue. A court decision may state that fair market value is the standard of value; however, upon reading the opinion, it may become apparent that the court based its ruling upon some other standard of value.

            Complicating matters further, is the debate among business valuators as to whether or not “fair market value” in the divorce context, is really meant to be the “investment value” (worth of the business to the current business owner). While it is important for the reader to be aware of that debate, the issue is beyond the scope of this article. 

So, how do you define fair market value?  Recently, a Glossary of Terms was jointly developed by representatives of the American Institute of CPAs, the American Society of Appraisers, and the Canadian Institute of Chartered Business Valuators, the Institute of Business Appraisers and the National Association of Certified Valuation Analysts.  According to that Glossary, the definition of the term fair market value is:

The price, expressed in terms of cash equivalents, at which a 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 nor to sell, and when both have reasonable knowledge of the relevant facts. (Note: In Canada, the term “price” should be replaced with “highest price”)

The concept of fair market value is therefore, a concept of price range, with its value falling somewhere within a range of prices.  The low end of the range is the lowest price that a willing seller would accept and still enter into the transaction.  The high end of the range is the maximum price that a willing buyer will pay and still consummate the deal. 

True fair market value can usually be determined only by the ultimate sale of a subject property on the open market.  However, in divorces and many other legal scenarios, sale of the business interests is not contemplated. Therefore, in estimating the value of the business, the positions of the hypothetical seller and the hypothetical buyer must be considered.

In divorce cases, the party keeping the business often advances reasons why the business is not worth much.  Some of the reasons include:

1)                  Nobody would buy this, because I would open up next door and compete.

2)                  The employees will not work for anyone but me.

3)                  If my soon-to-be ex thinks the business is valuable, then he/she can have it.

4)                  Nobody else knows how to run this business, so it has little market value.

5)                  I’ll just close up shop. Then the business will be worthless.

The exiting spouse often has reasons for why s/he believes the business is valuable.  Those might include:

1)              The business provided so well for our family.  That is a valuable factor.

2)         The business could be doing better if we weren’t getting divorced.

3)            After the divorce, my ex-spouse could improve the business by…

4)            Some of our personal contacts will probably become customers someday.

5)           If somebody else owned this business s/he would improve it by…

6)          The business has so much potential.  When this or that happens…

While the above arguments from both parties might seem to have merit, it is extremely important to understand the requirements of the fair market value standard.

They dictate that the value be determined, considering the hypothetical willing and able seller, and the hypothetical willing and able buyer.  Regardless of the emotional arguments that might be espoused by each contestant in a divorce case, a business valuator must consider the objectives and actions of both seller and buyer.

For example, a (hypothetical) willing seller:

1)      would not threaten to compete with the purchaser of the business,

2)      would do everything possible to keep the workforce intact for a new owner,

3)      would not be willing to give the business away,

4)      would be willing to train new owners how to operate the business,

5)      would not close the business, when there is potential to sell it, and

6)      seeks the highest possible price for the business.

The (hypothetical) willing purchaser:

1)      would consider the ability of the subject to meet owner salary requirements,

2)      would generally rely on past and recent operating history of the company,

3)      would consider how a sale might affect relationships with existing customers,

4)      would consider the capital outlay and cost requirements to make improvements,

5)      would consider the economic conditions, the industry, and the marketplace for the target’s goods or services, and

6)      seeks to acquire the business at the lowest possible price.

The above examples are only a few things that an actual seller and buyer might consider in a real transaction. 

            So, while each contestant in the divorce advances arguments about why the business is or isn’t worth much, a seasoned business valuator must stick to the requirements imposed by the standard of fair market value (when that is the standard of value). S/he must always be thinking about what a real (hypothetical) buyer and seller would be doing and thinking. 

            Concerning the question of future potential: Will a buyer pay for the business as it is at the time of purchase, and also for what it might become sometime later?  

            What seller would not like to be paid today for what the business could be worth in three to five years, if the buyer brings in additional capital, and has a bit of luck? Some sellers will always entertain that dream, because under unique or synergistic circumstances, sellers have been paid for that investment value.

            However, in most cases buyers are not willing to pay a premium price for what they will bring to the table anyway.  Buyers want to pay no more than the fair market value for future performance that the business has already proved it can produce with a high degree of certainty. This concept should be kept in mind when projecting future earnings in divorce valuations. It is imperative to consider only the earnings capacity possessed by the business up to the valuation date that is to be used for the divorce. Earnings from capabilities acquired by the business after the divorce valuation date should generally be excluded from the earnings projections used in the divorce valuation.

            According to Dr. Shannon Pratt, “The real world leans much more toward the buyer’s perspective than the seller’s. So do the divorce courts.  Fair market value is based largely on what is there now, as opposed to what might be there sometime after a lot of changes are made to the business.  Would-be sellers are misled when they think they should be paid now for what the business may be worth after the buyer brings his own magic show to the party.” [i]

            The complexities surrounding valuation of businesses for divorce can cloud the clearest legal minds. A seasoned business valuator can bring reason into divorce business valuation situations. That sense of reason can assist the parties in settling property division issues, rather than depending upon the courts to do so.  In the event that a trier of fact must become involved, the business valuator can provide great assistance in determining if the valuation requirements, as set forth in the appropriate standard of value, have been met.

            In closing, I am reminded of something that Benjamin Franklin once said: “I conceive that the great part of the miseries of mankind, are brought upon them by false estimates they have made of the value of things.”

Ben Franklin’s words still ring true for the parties involved in divorce, and the resulting property settlement issues.  If Ben were still alive, I think he would be an avid proponent for getting business valuators involved in the earliest stages of the divorce process.