Separation, Divorce and Business Valuation Truths

Divorce and Business Valuation
Valuing The Family Business In The Family Law Context

From my years of experience assisting either the business owners or their spouses, I know that people sometimes have inflated opinions of the worth of a business. This can often be attributed to people having paid too much when they originally bought it or having an inflated number in their mind about what they think they could sell the business for in the future.

However, in the context of dividing assets upon the end of a relationship, the Court looks at the value of a business based on what it could be sold for in the current market. Often that figure can be less than one or both parties may have expected.

In this instance we’re talking about trading businesses. Whilst some businesses are valued on a net-asset basis, that is, the value of a business is determined by the value of the business assets less the value of the business liabilities, what’s not accounted for in that calculation is any goodwill or superprofits, which is explained below.

Accountants often talk in multiples of the annual profit after the owner’s salary is taken into account. Sometimes the value of a business is one, two or three times that number depending on their trading history and what the norm is for the particular industry.

Once the business value is determined using the multiple they then subtract the net value of the assets and liabilities and if there is a surplus that is the value attributed to goodwill. What happens more commonly though is that people have a large amount of capital tied up in their business and there is no goodwill, even when it is first thought that there would be.

Business Valuations and Goodwill

The ATO defines goodwill as value associated to the reputation of an established business. It can be considered to be an asset. Therefore it can be included in the asset pool for division when a couple separates.

Goodwill does not exist in all businesses. It should not be assumed that if you bought a business and have paid for goodwill, that the goodwill still has value.

When considering the value of your former spouse or de facto partner’s business it is important not to presume that their business will have a value on it or that it will be able to be sold.

When Does Goodwill Have Monetary Value?

I have seen many people who have bought businesses and a value for goodwill has been included on the balance sheet but when they go through this exercise as part of their separation, they realise they have paid too much for it.

So when determining whether goodwill exists in a business, my rule of thumb is to answer these questions:

• Is the owner/owners making significantly more than a commercial wage for what they do in the business?
• Is the current profitability level sustainable if they were no longer part of the business?

If you answer yes to both of those questions, there may be goodwill.

The difficulty is that there is transferable and non-transferable goodwill. That is, value that can be transferred because there is no reliance on one person to maintain that value.

For example, a surgeon earning $1 million a year, has no transferable value because the business relies on them to bring in personal referrals and personally doing the work.

Goodwill and Super Profits

Goodwill is sometimes connected to what is called “super profits”. For example, if the owner of a business was working in the business and was paid a salary that’s commensurate with a market salary of, say, $100,000 and the profit was $250,000 then that difference could be considered a super profit and could be translated into goodwill and may be transferable.

If, for example, you were running a successful business, you have a number of employees and your super profit is $500,000 a year, then it may be that the business has goodwill that has value and can be sold to somebody.

Alternatively, if you have a business that has contracts in place for years ahead, along with a team that does not rely on your input to keep it going, there is some degree of certainty that the business will continue to be sustainable beyond your exit from the business.

When accountants typically value businesses, they look at the nature of the business, the history of the trading business and then assess the future of the trading. They also assess the viability of the trading income of business continuing and that determines whether a value can justifiably be placed on goodwill.

Other Triggers for Reduced Business Valuations

The value of an interest in a business can be significantly affected if you are in business with other people outside the marriage or de facto relationship.

Interests in Businesses with Third Parties

If, for example, your former partner is in business with three other partners, and your former partner owns 25% of the value of that business, there may be a partnership or shareholders agreement. Typically those agreements will provide a formula on how to value the business for the purposes of one party selling their interest. There are often terms in that agreement that says that the only persons permitted to buy that share are other business partners or shareholders. So, your partner may not be able to sell or transfer their stake in the business if partners or shareholders do not agree with someone else buying or receiving the share.

These sorts of restrictions on saleability lead to discounts for lack of control or minority interests. For example, if your former partner’s business is worth $1,000,000, a quarter share is theoretically worth $250,000 on paper. But because they have only a 25% share, that value can be discounted because of the lack of control they have over the business. The 25% share may be reduced to being valued at $225,000 or $200,000.

Another area of difficulty can arise when a couple separates and their minority business is their most significant asset. That may mean they will need to sell their interest in the business in order to divide their assets. If they cannot reach an agreement, a Court may order the sale of their interest in the business to complete the financial settlement. The Court will typically not be in a position to order the other partners or shareholders in the business to buy that parties interest or to have to sell the entire business.

Given the complexities that arise in these scenarios, family law and financial advice is essential, as early as possible.

Separation, Divorce & Business Valuation Disputes

In the event of a dispute about the value of a trading business, lawyers for both parties will engage a single-expert accountant to undertake the valuation.

That accountant will review the financial performance of the business for the last three to five years. They will also review the forecasts for the next year or so, and speak to the key stakeholders in the business as well as the accountants who have been involved in the financial management of the business. Sometimes they also get valuations of hard assets and inventory. From this they determine their independent valuation.

When going through separation, divorce and business valuation processes, it is common for it to be both complex and emotionally charged.

It is important when considering the value of a trading business in the context of a property settlement to get realistic, independent advice about the true market value of the business before making any formal or informal agreements.

We recommend seeking the advice of experienced professionals including family lawyers, accountants, and business valuation experts to help navigate the process and ensure a fair and equitable outcome for all parties involved. The people we assist are always in control of whether they proceed or stop at any point. They can elect to do what they wish but when they have the knowledge from a source that understands the complexities of family law, they can make informed decisions with confidence.