Business Valuation in Divorce Cases --
101 — What A Family Lawyer Needs to Know to Competently Represent Your Client

By: Gunnar J. Gitlin
The Gitlin Law Firm, Woodstock, Illinois
© 2008
www.gitlinlawfirm.com

I.         INTRODUCTION

The most factually and legally complex area of divorce law is business valuation. In the 1980s and 1990s huge strides were made in business valuation techniques due in large part to personal computers and the ability of business appraisers to develop intricate spreadsheets.   These spreadsheets and "canned" computer valuation programs have allowed valuators to create models for valuing businesses which would have been virtually impossible before the advent of the personal computer. An additional reason for the progress in business valuation technique has been the mergers and acquisitions which occurred during this same period. These mergers and acquisitions provided a database to more accurately gauge the value of businesses based on actual transactions. Moreover, case law regarding business valuation in divorce cases is more complex than in other areas of law because the states have different positions on whether the business appraiser must differentiate enterprise goodwill from personal goodwill in valuations of closely held businesses.

Family law lawyers handling business valuation cases face an additional challenge in presenting these issues as many family law judges have very little of the accounting or financial theory background necessary to readily understand the testimony of the business appraisers. Therefore, a lawyer handling a business valuation issue in a matrimonial case has to be able to effectively work with the valuator to simply explain to the court the series of complex calculations which are at the heart of a business valuation.

Business valuation requires an unusual degree of cooperation between the lawyer and the expert business appraiser. This material is written for use by either the lawyer or the business appraiser.   A divorce lawyer should keep in mind that all correspondence sent to the business appraiser may be subject to discovery.  Therefore, it is suggested that this outline could be forwarded by the lawyer to the business appraiser to provide the business appraiser with additional background about legal issues necessary for the appraiser to effectively work with the lawyer through the business valuation process.

II.        BACKGROUND REGARDING INITIAL ISSUES IN BUSINESS VALUATIONS IN DIVORCE CASES

            A.        Forms of Business Organizations

There are four basic forms of business organizations: sole proprietorships; general or limited partnerships; limited liability companies and corporations. I am assuming that these types of business organizations will be covered in Session II of our materials and therefore this discussion will be general in nature.

Sole Proprietorship: The simplest form of business organization is the sole proprietorship. All earnings and losses of the business are taxed to the sole proprietor personally on their personal tax return, Schedule C. The sole proprietor bears all the risks of the business. In divorce cases, often a sole proprietorship is a service oriented business.

Partnerships: A partnership may be the most common form of business enterprise. Partnerships range from relatively informal associations to highly structured organizations. A partnership is an association of two or more persons to carry on as co-owners of a business for profit.

C Corporations: Generally, divorce case valuations will not involve valuations of “C corporations.” C corporations pay income taxes on taxable income, so the shareholder-owners may be subject to double taxation: once at the corporate level and again when corporate earnings are distributed as dividends. Rather than pay additional taxes on dividends, the owners of closely held corporations often pay themselves additional compensation which reduces the corporation's taxable income.

S Corporations: The double taxation problem can be avoided by electing “S corporation” status. Generally, an S corporation's earnings are taxed only to the shareholders. In an S corporation, all shareholders must participate in the allocation of profits, losses and distributions according to their percentage of ownership. The distributions of an S Corporation will be shown on the corporation's I.R.S. form K-1. Only common stock can be issued by an S corporation. Finally, the S corporation may not have more than one class of common stock, although there can be voting and non-voting shares of stock in an S Corporation. All distributions to shareholders must be based in proportion to their ownership.

LLCs: Limited Liability Companies (LLCs) are the newest form of business entity. They have characteristics both of corporations and of partnerships. LLCs are created through specific state legislation and most states have enacted such legislation. Many believe that LLCs may become the predominant form of organization for small businesses. LLCs generally shield their owners from personal liability in the same manner as corporations. Similar to S corporations, in limited liability companies, owners are taxed on earnings once. Before LLCs were created only Subchapter S corporations permitted the combination of corporate and partnership traits, and then at the cost of relatively burdensome requirements under the provisions of the Internal Revenue Code. An LLC may issue more than one class of equity, i.e., stock, giving them greater flexibility than an S corporation.

III.       HIRING AN EXPERT — TYPES OF BUSINESS APPRAISERS, PROFESSIONAL ACCREDITATION CRITERIA AND STANDARDS OF BUSINESS VALUATION

            A.       Payment of Experts

The associate will likely be assisting the partner with arranging for payment of experts, etc. The method of payment to the expert should be indicated in the expert's engagement letter. Most valuation experts require a retainer. Some may requirement payment for services rendered to date before releasing their valuation report. If the lawyer represents the non-owner spouse who does not have sufficient funds available, an interim fee petition should be filed early. The expert's engagement letter should be attached to the petition along with an affidavit from the expert defining the scope of services and minimal anticipated fees. It should be noted that the appraiser's retainer is just that, and funds to complete the assignment should be budgeted. A projected budget and total fee estimate should be brought to the court's attention as part of the interim fee petition so that funds will be available not only for payment of the initial retainer but for payment of the expert's additional fees needed to complete the assignment. Also, the interim fee petition should clearly set forth any specific assignments the expert will be performing in addition to the valuation so that the fee is supportable.

A good valuation expert, experienced with divorce cases, can serve many functions for divorce attorneys and their clients. Areas of assistance can include: preparing for the deposition of the opposing expert; preparing for cross examination of the opposing expert; educating the attorney on the business and the fine points underlying the valuation; drafting of a comparison schedule using both experts' valuation reports which outline their differences; analyzing the economic value of “perks” taken by business owners; performing a cash flow analysis; and assisting the lawyer in structuring an appropriate settlement of the business valuation issue.

            B.        Certifications and Qualification of the Business Appraiser

Finding the right expert is important in preparing a business valuation case. The appraiser should be familiar with state divorce law, especially in those states that differentiate between enterprise and personal goodwill. A skilled appraiser should have good oral and written communication skills and be able to coherently integrate quantitative and subjective data. The appraiser should also have an understanding of financial and tax matters. Shannon Pratt's, The Lawyer's Business Valuation Handbook: Understanding Financial Statements, Appraisal Reports and Expert Testimony, American Bar Assn. 2000, contains an excellent discussion regarding selecting and evaluating the business appraiser (although the discussion regarding Illinois law is not generally accurate, nor up to date).   Michelle Miles writes in that chapter, “Whatever the background of the appraiser, he or she should possess or be working toward one or more of the professional certifications available. Business appraisal designations are available to all appraisers and counsel should note the substantial differences among these designations. For example, one difference is the requirement of peer review. It is possible for a business appraiser to be granted a professional designation without having to author a single report in an actual client assignment.... For these reasons, designations that involve peer review offer some assurance that the business appraiser's work product has passed juried scrutiny.

In hiring a business appraiser the lawyer should examine a number of factors. These include:

            --         The formal credentials of the business appraiser, the number of reports the business appraiser has completed, both in family law cases and in non-family law settings;

            --         The number of times the appraiser has testified previously — either in a family law case or in a non-family law setting.

            --         The number of times the evaluator has submitted a written report. The lawyer may ask to review sample reports of the appraiser, not for the purpose of reviewing the appraisers methodology but to determine if it appears that the appraiser has a knowledge of case law that would apply to the proceedings. Additionally, the lawyer should be able to evaluate a report and determine if the evaluator writes well, especially in those jurisdictions where the court may accept the report of the appraiser into evidence.

            —          The evaluator's knowledge and experience in the subject type of business. It is clearly helpful if the appraiser has valued businesses of the same general type as the subject business.

Today there are many nationally recognized business valuation organizations that a business appraiser may join. To become certified under a particular organization, the appraiser usually needs to take an exam and submit samples of their valuation work product. These organizations are the American Institute for Certified Public Accountants (AICPA), the American Society of Appraisers (ASA), the Institute for Business Appraisers (IBA), and the National Association of Certified Valuation Analysts (NACVA). On a local basis, there is the Chicago Business Valuation Association. This group consist of local business appraiser in various fields of business and academia.

CPAs as Business Appraisers: Certified Public Accountants have many of the necessary tools required to render sound business valuations. State law is relatively lenient in the issue of qualification of an expert to testify as to business value. See, for example, In Re Marriage of Olson, 585 N.E.2d 1082, 160 Ill.Dec. 60 (2d Dist. 1992), which held that being an experienced CPA qualifies one as a witness for valuation of a business. See also, In Re Marriage of Blinderman, 283 Ill.App.3d 26, 669 N.E.2d 687, 218 Ill.Dec. 544 (1st Dist. 1996). Nevertheless, the position of the American Institute for Certified Public Accountants (AICPA) is that specific specialized training is needed to be a professional / specialist in business valuations. Thus, the creation of the ABV (Accredited Business Valuator) designation. The prerequisites for the ABV certification is that the member must be a member of the AICPA with a current CPA license. To obtain an ABV accreditation the applicant must be experienced in at least 10 business valuation engagements. There is a one day examination. To maintain the accreditation, a member must complete 60 hours of related continuing professional education during the three year period after obtaining the ABV accreditation.

In selecting a business appraiser, the lawyer may review certain on-line resources. The AICPA has an online directory of its members who are Accredited in Business Valuation (ABV) credential holders which can be found at www.aicpa.org. The list is organized by state. The directory includes only the name, firm affiliation, and city of each ABV credential holder.

American Society of Appraisers: The American Society of Appraisers has an online directory of its accredited members. The web address is www.appraisers.org. Within the ASA there are three certification types: accredited members (AM); accredited senior appraiser (ASA) and Fellows of ASA (FASA). An accredited member does not have to be a certified public accountant but must have a college degree. Minimally, there is a day long exam. The applicant must also pass an ethics examination. The American Society of Appraisers is the only organization which has a separate ethics examination. To become an accredited member the expert must submit two valuation reports. There is also an experience requirement: the individual must have two years full-time or equivalent work. An accredited senior appraiser must have three years full time or equivalent experience. A Fellow of the ASA must meet the same requirements as an accredited senior appraiser and also will be voted into the ASA College of Fellows.

Institute for Business Appraisers: The third organization providing for accreditation of business appraisers is the Institute for Business Appraisers (IBA). It offers programs of interest to members whose business valuation activities are less than full time or whose practice includes valuation of small to mid-size businesses. The IBA has an online directory of its members at http://www.go-iba.org/directory.asp. Within the IBA there are four certification types: certified business appraisers (CBA); Master Certified Business Appraiser (MCBA); Fellows of the IBA (FIBA); and Business Valuator Accredited for Litigation (BVAL). A certified business appraiser does not need to be a certified public accountant. The prerequisite is four years of college or its equivalent. There is a 3.5 hour proctored examination to become a certified business appraiser (CBA). Similar to the American Society of Appraisers, to become a certified business appraiser, an individual must submit two business appraiser reports showing professional competence. Unlike the American Society of Appraisers or the American Institute of Certified Public Accountants there is no experience requirement to become a certified business appraiser with the IBA. To become a Master Certified Business Appraiser, the individual must also have 10 years' practice experience or received credit for published writing or lecturing. The appraiser must also have four work product references from other CBAs. Fellow of the IBA have the same requirements as an MCBA and are voted into the IBA College of Fellows. 

The IBA has Rules of Professional Conduct.  The preamble states, "A member of the Institute of Business Appraisers (IBA) assumes an obligation beyond any imposed by law. By accepting membership, the individual recognizes a responsibility to the public, to clients, intended third party users of his/her reports and to colleagues. The individual member agrees to be bound by the contents of the following Institute of Business Appraisers pronouncements, in addition to any rules set forth, herein."  The IBA also has Business Appraisal standards. 

National Association of Certified Valuation Analysts: The fourth organization that provides accreditation for business appraisers is the National Associated of Certified Valuation Analysts (NACVA). Family lawyers may encounter two types of appraisers certified by NACVA: Accredited Valuation Analyst (AVA) and Certified Valuation Analyst (CVA). The NACVA web page address is www.nacva.com. They have an online directory of members.  To gain the AVA credential, an appraiser must have a business degree and must take a 30 to 50 hour, take home examination which includes one case study. To become a Certified Valuation Analyst an individual must be a CPA.

The examination is a half day proctored exam which includes a case study. There is no requirement to submit actual reports to become a CVA.

The above organizations have attempted to make business valuation practice more consistent and to this end the organizations have a joint Business Valuation Glossary Committee, which has prepared the first draft of a jointly approved glossary for business valuation terms.

Other experts who may perform business valuations in divorce cases include Chartered Financial

Analysts awarded by the association for Investment management and research. Generally, such experts tend to value larger, publicly held companies.

A lawyer reviewing an expert's curriculum vitae may see certain abbreviations which indicate the expert's professional background. The following chart summarizes these accreditations.

            C.        Uniform Standards of Professional Appraisal Practice and Business Valuation Standards of ASA and Other Organizations

                        1.         Importance of USPAP Generally

The American Standards Board of the Appraisal Foundation promulgated the Uniform Standards of Professional Appraisal Practice (USPAP). These standards apply to any appraiser including an appraisal of real estate, personal property, intangible assets and business interests. Shannon Pratt in his treatise, VALUING SMALL BUSINESSES & PROFESSIONAL PRACTICES (1998) states: “The fact that these standards are reaching a position of general acceptance is evidenced by the frequent references to USPAP in both judicial and in professional literature.” An updated version of the USPAP is published annually, generally in November. To order an interactive copy see:  https://commerce.appraisalfoundation.org/.  There is a charge of $30. 

Standards 9 and 10 of the USPAP address business valuations.

The American Society of Appraisers mandates compliance with USPAP for appraisals prepared by its members. The Institute for Business Appraisers generally endorses USPAP but compliance is not mandatory for its members. Additionally, USPAP is not binding on members of AICPA or NACVA.

The ASA has also issued “Principles of Appraisal Practice and Code of Ethics.” This Code is designed to provide guidance to appraisers generally and to provide a structure for regulating conduct of members of the ASA through disciplinary actions. These standards apply to both business valuations and other types of valuations and are general in nature.

                        2.         Business Valuation Standards promulgated by the ASA Business Valuation Committee

While USPAP addresses ethical issues and generally addresses the process of business valuation, the American Society of Appraisers recognized that the USPAP did not comprehensively outline the factors that should be considered in a business appraisal. Accordingly, the American Society of Appraisers Business Valuation Committee developed business valuation standards that every member must follow in a business valuation.

Currently, there are eight Standards. Additionally, there is one Statement on Business Valuation Standards and one Advisory Opinion. The Business Valuation Standards differ from USPAP and Revenue Ruling 59-60 (discussed below) in terms of required specificity of the various steps of the business valuation process. The standards represent the minimal criteria that must be present in a business valuation. Every appraiser who is a member of the ASA must adhere to the various standards. Additionally, because these standards are generic in treatment of generally accepted valuation theory and practice, a business appraiser who is not a member of the ASA may find it hard to justify reasons that the standards should be ignored. In the unlikely event that an ASA appraiser has good cause to depart from the Standards, the appraiser must state the specific reasons for the departure in the report.

An example of the general nature of the ASA standards is the requirement that an income approach to value must be considered and must include an assessment of future benefits that are discounted. The standards include a section that contains a long list of definitions often used in business appraisals (Section VIII). The standards also include a “statement” which provides a specific outline of the guideline company approach to business valuation (discussed below).

                        3.         Other Standards

The National Associate of Certified Valuation Analysts has also published professional standards.  These may be used to cross-examine a certified valuation analyst. If the expert is an accountant, there are also professional standards promulgated by the American Institute of Certified Public Accountants if engaged after that date. The AICPA has general standards for consulting practice, which includes business valuations.  Effective January 1, 2008, the AICPA has now issued standards specifically addressing business valuation.  The lawyer in a business valuation case should become aware of the appropriate professional standards for the expert retained by each side in any business valuation case.

            D.        Learned Business Valuation Treatises

There are several articles, studies, and books prepared on the subject of business valuation. Some are relied upon more than others by the valuation community, though one is not necessarily authoritatively better than another. Three of the better known books are Shannon Pratt's VALUING A BUSINESS: THE ANALYSIS AND APPRAISAL OF CLOSELY HELD COMPANIES, (4^th Ed. 2000) (Valuing a Business); VALUING SMALL BUSINESSES AND PROFESSIONAL PRACTICES (2d Ed. 1988) and THE LAWYER'S BUSINESS VALUATION HANDBOOK (American Bar Assn. 2000).

            E.        Important Internal Revenue Service Revenue Rulings

                        1.         Revenue Ruling 59-60

Revenue Rule 59-60 is the best known and most often used administrative ruling in the area of business valuation. The purpose of the revenue ruling is to give a general outline and review of the approach, methods, and factors to be considered in valuing shares of the capital stock of closely held corporations for estate and gift tax purposes. Although it was written over 40 years ago, it is cited by many family law decisions in many states.

Revenue Ruling 59-60 provides a definition for “Fair Market Value” which is: “…the price at which the property would change hands between a willing buyer and willing seller, neither being under any compulsion to buy or sell and both having knowledge of relevant facts.” The ruling provides a solid basis for valuation. The business appraiser should consider it as the ruling itemizes and explains eight relevant factors to be considered in valuing a closely held business. The eight factors outlined in Revenue Ruling 59-60 Section IV are:

            1.        The nature and history of the business since inception.

            2.        The economic outlook, in general, and the condition and outlook of the specific industry the subject company operates in.

            3.        The book value of the stock and the financial condition of the business.

            4.        The earnings capacity of the business.

            5.        The dividend-paying capacity of the business.

            6.         Whether or not the enterprise has goodwill or other intangible value.

            7.        Sales of stock and the size of the block of stock to be valued.

            8.        The market price of stocks of corporations engaged in the same or similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.

A similar issue is addressed in Revenue Ruling 59-60 relative to the loss of a key-person in a small business. In both contexts, an adjustment must be made by the valuator. On this subject, Revenue Ruling 59-60 states:

The loss of the manager of a so-called "one-man" business may have a depressing effect upon the value of the stock of such business, particularly if there is a lack of trained personnel capable of succeeding to the management of the enterprise. In valuing the stock of this type of business, therefore, the effect of the loss of the manager on the future expectancy of the business, and the absence of management-succession potentialities are pertinent factors to be taken into consideration. On the other hand, there may be factors which offset, in whole or in part, the loss of the manager's services. For instance, the nature of the business and of its assets may be such that they will not be impaired by the loss of the manager. Furthermore, the loss may be adequately covered by life insurance, or competent management might be employed on the basis of the consideration paid for the former manager's services. These, or other offsetting factors, if found to exist, should be carefully weighed against the loss of the manager's services in valuing the stock of the enterprise.

                                    2.         Other Revenue Rulings

Other rulings that the IRS has issued that directly affects the valuation of an interest in a business which an associate should know include:

            1. Revenue Ruling 68-609: This revenue ruling addresses the “formula” method which was originally adopted in 1920 by an Appeals and Review Memorandum of the U.S. Treasury Department. In1920 the "formula” method was used to estimate the value of the goodwill that breweries and distilleries lost because of the Prohibition. Since then, this method has been widely used in valuations including valuations in divorce cases. In 1968, the Internal Revenue Service addressed this method in Revenue Ruling 68-609 and ruled that “….the ‘formula' approach may be used for determining the fair market value of intangible assets of a business only if there is no better basis therefore available.” The application of this Revenue Ruling is discussed below in Section

            2. Revenue Ruling 77-287: Revenue Ruling 77-287 discusses the value of restricted stock studies in determining marketability discounts. This ruling is significant in part because Revenue Ruling 59-60 failed to address marketability discounts, this issue was addressed in a later revenue ruling. While this ruling specifically relates to restricted stock (discussed below) in determining marketability discounts, the rule specifically indicates that it amplifies Revenue Rule 59-60 and commonly is considered in conjunction with Revenue Ruling 59-60. Revenue Ruling 77-287 discusses the value of restricted stock studies in determining marketability discounts.

            3. Revenue Ruling 93-12: Revenue Ruling 93-12 allows application of minority interest discounts to partial transfers even when a family owns overall control of a closely held business.

The appraiser must understand what they are valuing. It is important to know whether the appraiser is valuing a controlling interest or a minority interest in a closely-held corporation. While in simplest terms a controlling interest is generally defined as one in which a shareholder has more than a 50 percent interest in a company, it is important to understand that control is not an all or nothing proposition. A shareholder may have the prerogatives of control despite not having a controlling interest in a company. Such prerogatives of control may include the ability to appoint management, ability to determine management compensation and perqs, ability to set policy of a business, etc.

For example, the husband could have a 25% interest in a company and his father could have a 50% interest in a company. Separately considered, the husband has a minority interest, but the collective interest of the husband and his father is greater than 50% (a controlling interest). In Revenue Ruling 93-112 this issue was raised. A donor transferred corporate shares to each of his children. The question was whether the fact that the family retained control should be considered in valuing each transferred interest for estate and gift tax purposes under the Internal Revenue Code. The revenue ruling holds that if the donor transfers shares of the corporation to his children, the factor of corporate control in the family is not considered in valuing each of the transferred interest.

Assume a divorce valuation case in which the wife has a 25% interest in a corporation and the husband has a 50% interest. Furthermore, it appears clear the husband will be awarded the entire marital interest in the corporation. The issue may be whether the appraiser is valuing a 75% interest or two separate interests (i.e., a 25% interest and a 50% interest). Since the majority approach of case law has held that the court should consider imminent tax consequences when those tax consequences are not considered speculative, it is suggested the valuator should appraise the interest of husband and wife collectively. It is further suggested that the valuator should consider these interests separately only if stock will continue to be held by each party individually. If the distribution of stock in a business is not clear (the determination of which party will be awarded the stock in a marital corporation), then the appraiser may consider completing two valuations — one based upon valuing each holding individually and one valuing the marital interest of the stock as a block.

IV.      DISCOVERY ISSUES IN BUSINESS VALUATION CASES AND PROTECTIVE ORDERS

            A.        Introduction

In many matrimonial cases, the parties' real battle is often not the trial of the case, but involves the discovery process in which the rights of third persons, who also have an interest in the business, have to be balanced against the need for discovery by a divorce litigant. In the business valuation context, a spouse often has interest in a closely held corporation. The corporation is a separate legal entity and will often claim that discovery requests are unduly onerous and that the non-business owning spouse should not need copies of the actual documents upon which the financial statements of the business will be based.

V.        THE VALUATION PROCESS

            A.        General Steps in the Valuation Process

The process of performing a business valuation is broken down into five general steps: defining the assignment; gathering the data; analyzing the data and performing the valuation analysis; using various methodologies to arrive at a conclusion of value (including applying discounts or premiums where applicable); and writing the valuation report.

As the process begins, it is important that the attorney understand or at least be familiar with relevant valuation terminology. An appendix provides a comprehensive list of the most common terms used by business appraisers and their definitions. These terms have been obtained from a variety of sources including the ASA and other recognized appraisal publications.

            B.        Defining the Assignment

Standard of Value -- Fair Market Value Versus Investment Value: In valuing a business, the appraiser must define what “standard of value” the appraiser will use. While few cases specifically discuss the standard of value in divorce cases it appears that case law gives lip-service to the term “fair market value.” Very simply put, “fair market value” is the amount at which a business interest would change hands between a hypothetical willing seller and a willing buyer when neither is acting under compulsion and when both have reasonable knowledge of the relevant facts. (See, for example 26 CFR 20.2031-3 and Revenue Ruling 59-60). In the definition of fair market value, the hypothetical willing buyer should not have special motivations that are not characteristic of a typical buyer. Clearly, fair market value may differ from the value the business has to a particular buyer or investor. Such a value has been termed a “synergistic value,” an “investment value,” or a “strategic value,” but these terms are synonymous. There are a number of reasons that synergistic value ma be greater than fair market value of a given business. Take the example of a manufacturing plant that has outdated equipment but which sells well known product at a profit. Another larger business may have access manufacturing capacity within the same industry. The larger business may make an offer to purchase, based upon the fact that the company is a particularly good “fit.” The value to this particular buyer may differ from what otherwise might be determined to be the fair market value of the business. Other reasons for a synergistic value could include a personal relationship between the owners of two businesses.

Nature of Business Interest Being Appraised: The appraiser must also understand what they are valuing. Is it important to know whether the appraiser is valuing a controlling interest or a minority interest in a closely held corporation. While in simplest terms a controlling interest is generally defined as one in which a shareholder has more than a 50 percent interest in a company, it is important to understand that control is not an all or nothing proposition. A shareholder may have the prerogatives of control despite not having a controlling interest in a company. Such prerogatives of control may include the ability to appoint management, ability to determine management compensation and perqs, ability to set policy of a business, etc.

For example, the husband could have a 25% interest in a company and his father could have a 50% interest in a company. Separately considered the husband has a minority interest, but the collective interest of the husband and his father is greater than 50% (a controlling interest). In Revenue Ruling 93-112 this issue was raised. A donor transferred corporate shares to each of his children. The question was whether the fact that the family retained control should be considered in valuing each transferred interest for estate and gift tax purposes under the Internal Revenue Code. The revenue ruling holds that if the donor transfers shares of the corporation to his children, the factor of corporate control in the family is not considered in valuing each of the transferred interest.

Assume a divorce valuation case in which the wife has a 25% interest in a corporation and the husband has a 50% interest. Furthermore, it appears clear the husband will be awarded the entire marital interest in the corporation. The issue may be whether the appraiser is valuing a 75% interest or two separate interests (i.e., a 25% interest and a 50% interest).

Because the majority approach is that the court should consider imminent tax consequences when those tax consequences are not considered speculative, [See, In Re the Marriage of Olson, 223 Ill.App.3d 636, 585 N.E.2d 1082, 160 Ill.Dec. 60 (2d Dist. 1992)] it is suggested the valuator should appraise the interest of husband and wife collectively. It is further suggested that the valuator should consider these interests separately only if stock will continue to be held by each party individually. If the distribution of stock in a business is not clear (the determination of which party will be awarded the stock in a marital corporation), then the appraiser may consider completing two valuations — one based upon valuing each holding individually and one valuing the marital interest of the stock as a block.

            C.        Gathering Data

Once the appraiser and lawyer have a clear understanding of the interest that is to be valued, the next step is to begin the process of gathering the data. The information needed will involve requesting standard information that is common to all business valuation engagements and also information that is unique to the specific company being valued and its industry. Normally, the business appraiser will provide the attorney with a document and information request which the attorney can incorporate into a notice to produce.

We have included with our materials a sample production request relating to a business interest. The general information requested will include:

           —          Financial statements for the last five years, as well as interim financial statements if the valuation is to be performed as of an interim date.

           —          Detailed general ledgers and /or cash disbursement journals.

           —          Income tax returns for the same five year period.

           —          Articles of incorporation or partnership agreement or operating agreement, depending on the type of entity being valued.

           —           Listing of shareholders, partners or members and ownership percentages.

           —          Aging of accounts receivable.

           —          Listing of investments.

           —           Detailed list of all inventory adjusted to fair market value.

           —          Detailed list of property and equipment with depreciation lapse schedules including any and all appraisals indicating their fair market value.

           —          A request for copies of insurance policies might also assist in this process.

           —          Details of loans and other significant accounts payable.

Other items typically requested are based on information obtained from the company's balance sheet. If the appraiser is looking at possibly using an asset based valuation approach, the information detailed above may become crucial in the analysis. Even if the valuator considers an approach other than an asset based valuation, these items may be important in determining if the company has any non-operating assets and liabilities on its books, or whether the company has any excess working capital or working capital deficiencies.

Non-financial documents will normally also be requested to provide the appraiser with additional knowledge about the company, including its corporate structure, obligations and various business agreements. These documents would include items such as: shareholder agreements, organizational charts, business plans, forecasts or projections, marketing materials, previous valuations, union agreements, stock transactions, insurance policies, information on litigation, and real estate and equipment appraisals.

A valuator may be useful in various aspects of a divorce case. For example, information obtained for purposes of normalizing the companies earnings may also be of use in determining the business-owner spouse's true economic income. Some of this information may be obtained through an on-site visit and the appraiser's discussion with management. If opposing counsel prohibits the appraiser from meeting with management personnel or refuses to provide information, the attorney will need to pursue other means, such as depositions or detailed interrogatories. Most states limit the number of interrogatories that may be asked without leave of the court or written stipulation of the parties. Because interrogatories directed to a party are limited in most states, it is necessary for counsel representing the non-business owning spouse to seek leave of court to propound additional interrogatories if the responding party objects.

            D.        Initial Financial Analysis and On-Site Visit

It is necessary for the associate to work with the valuator to secure, review, and analyze as much historical financial and operational information as possible. This type of information acts as a building block for the valuator in gathering additional data, research and in applying appropriate valuation methodology in the final preparation of the report. A thorough review of this information can point to the true historical performance of the company, trends in the operating business and identify other issues for valuation analysis. In addition, this analysis will prepare the appraiser for one of the most important parts of the appraisal, the site visit.

One of the first steps in the analysis by the appraiser is to prepare what are called “common size financial statements.” In this format the balance sheet is presented with each asset line item reported as a percentage of total assets and each liability and equity item reported as a percentage of their total. The income statement is also presented in a similar fashion with each category of income and expense reported as a percentage of net sales. This simple analysis highlights the relationship of the various account balances to one another and is also useful in spotting trends over the years. It also helps identify unusual or non-recurring items and identifying differences from industry norms.

The appraiser should also look for trends in the company's annual sales growth, annual net income growth, gross margins and operating expenses. A tool used in performing this analysis is financial ratios. The computation of financial ratios is useful in comparing the subject company to other companies or industry statistics. A summary of the common ratios used by the appraiser are summarized in an Appendix. Identification of the trends of a business enables the appraiser to make further inquiries of management about the effect of those trends on future operations during the site visit.

A site visit is a key element of the appraisal process that cannot be ignored if the valuation is to be complete. During the site visit, the appraiser attempts to accomplish the following objectives:

            -          Tour the facilities and observe the operation of the business.

            -          Interview key management personnel to discuss the industry, the subject company's operations, and its outlook for the future.

            -          Present to management questions raised during the preliminary analysis phase of the valuation, review trends displayed during the analysis, and get management's feedback on those trends.

            -          Follow up on any missing information from the original request list.

Shannon P. Pratt, when discussing the relative importance of site visits/management interviews in his book, VALUING SMALL BUSINESSES AND PROFESSIONAL PRACTICES (2d ed. 1998) states:

[F]or valuations subject to contrarian review (which most are), courts are becoming quite sensitive to the importance of site visits and management interviews. Many clients and attorneys dismiss or downplay the importance of a site visit and/or don't want to incur the interruption or the cost of the analyst's time for it. We prefer to make site visits and conduct management interviews. In our experience — as well as in many court cases -- the site visit not only helps the analyst get a better perspective, it makes a difference in the analyst's credibility in the eyes of the court.

In addition to simply interviewing management, a tour of the company's facilities is also essential when valuing a business. The tour of the physical plant provides the appraiser with information that cannot be gleaned simply by looking at financial statements and other related financial information. The tour should provide the analyst with a better idea of the company's operations from a physical viewpoint. It permits an evaluation of the plant's physical adequacy and allows the appraiser to observe the efficiency of the location as well as the layout and condition of the facilities.

Dr. Pratt also addresses cases where the intended user of the report is unfamiliar with the business or has never seen the facilities in question. He indicates:

If the analyst will need to communicate some description of the operations, facilities, or both to someone lacking the opportunity to visit the facilities, such as a judge in a court case, it may be desirable to take a set of pictures while on tour.

It is widely accepted in the valuation profession that a site visit/management interview is a very important part of the valuation process, and is, in fact, imperative if an appraiser is to perform a complete analysis of the operations of the company being appraised.

            E.        Completing the Financial Analysis and Normalizing the Earnings Stream

Once the site visit is complete, the appraiser should be in a position to complete the financial analysis. Based on the documents received, discussions with management and the site visit, the appraiser determines what, if any, adjustments need to be made to the original financial statements provided. This process is known as “normalizing” the financial statements. Normalizing is a process of adjusting the financial information to take into account the following items:

            -          Non-recurring items such as sales of fixed assets, lawsuit settlements, and casualty losses.

            -          Non-operating items such as depreciation and related expenses for non-business real estate or personal property and investment income or expenses.

            -          Owner's discretionary expenses such as personal automobiles, insurance policies, travel, and other personal “perks.”

            -          Related party transactions which do not reflect market rates, such as leasing space from a building owned by the shareholder at above market rates.

            -          Compensation which does not reflect market rates.

By adjusting for these types of items, the appraiser portrays the business operations as they should be expected to look, under normal conditions as on an ongoing basis, to a prospective buyer of the business. The appraiser must identify what is being valued because the adjustments that the appraiser might consider could be different depending on whether a control or minority interest is being valued.

If the appraiser is valuing a controlling interest in a closely held corporation, the issue of reasonable compensation must be addressed. The key is the ability to distinguish between how much in dollar amounts is taken by the business owner as “reasonable compensation” and what portion is the return on capital. In other words, given the services that an owner provides, the appraiser examines what is the reasonable amount that the business would expect to pay outside personnel to perform similar services.

Overcompensating the owner of a business will reduce the profitability of a business. By normalizing the owner's income, the appraiser may lower the owner's salary, which increases the profitability of the business, which in term increases the amount of the valuation. While this is a standard technique of business valuators in non-divorce cases, this presents problems with “double dipping” issues in that the owner's income (without a normalization adjustment) is counted once as income for the purpose of either child support or maintenance and a second time for the purpose of determining the value of the business. See, e.g., Gunnar J. Gitlin, "Business Valuation in Divorce - What is Double-Dipping and How is it Quantified?, American Journal of Family Law.

Despite the double dipping argument, the rationale for normalizing the owner's income is that the critical issue in these cases is the earnings stream of the business excluding the earning capacity of the business owning spouse. Thus, the valuator must assume the replacement of the business owing spouse with another person who would assume the duties of the business owning spouse. If this hypothetical person would normally receive a lesser amount of compensation from the business without a loss in business earnings, then there is a sound argument that the appraiser should normalize the business owner's income.

In analyzing the reasonable compensation issue, the lawyer should work with the appraiser to obtain factors the court may consider, such as:

            -          The appraiser must develop a full understanding of the operating entity. This includes the size of the company and the historical as well as the future growth plans of the company.

            -          The appraiser must consider the make up of the management team. Determine who is included in officers' compensation and how much are they paid. The valuator should obtain a complete history of the various compensation levels.

            -          What are the job descriptions of the applicable officer(s).

            -          What is the strength of the management team/officer group? Obtain the background of each member of the management team or officer group including their education, experience, time commitment (are they employed on a full-time or part-time basis), skills (what specialized skills do the individuals bring to the table). How many hours do the individuals spend at their jobs, and how successful has the individual been at his/her particular job?

            -          How deep/diversified is the management, i.e., is management distributed among a number of managers? Is management succession in place? What is the length of time have various managers been at their positions? What are the local employment conditions, especially regarding the ability to find and replace management personnel?

            -          What is the performance of the company before considering officers' compensation and how does it compare with the industry that they are in?

            -          What is typical compensation; how are officers compensated (e.g. salary versus bonus); what are the typical perks in the company's specific industry, etc.?

            -          What are the typical responsibilities for officers in that specific industry? In some industries the officers / management team perform many functions.

Once the appraiser fully understands the composition of the owner's officer/management team, the appraiser reviews the various databases and surveys which publish officers' compensation material. Some of sources include:

1. Robert Morris Associates, Annual Statement Studies (obtains information from bank loan applications).

            2. Financial Research Associates, Financial Studies of the Small Business.

            3. Dun & Bradstreet, Industry Norms and Key Business Ratios.

4. Surveys performed by specific industry associations, such as: National Tooling & Machine Association, Executive Compensation Report and compensation surveys for the medical profession by the AMA and MGMA, etc.

Caution is required when using this data. The appraiser must not blindly apply the percentages provided from the various studies even when the compensation information is given as the mean, median or broken down by quartiles as to the subject company's sales. The appraiser must consider the information about the officer/management team as discussed above and use common sense. The appraiser should consider whether he could reasonably expect to hire the applicable number of outside personnel for that amount of compensation considering the local employment conditions.

After all adjustments have been made, the appraiser must recomputed the income taxes based on the normalized income.

VII.     BUSINESS VALUATION APPROACHES

            A.       General Introduction to Business Valuation Approaches

Business valuation treatises, such as this one, are used both by the general practitioner and the divorce “specialist.” A general practitioner will not frequently have cases with complex business valuation issues, but the general practitioner will have such cases from time to time. There is an analogy here.

The general practitioner, from time to time, will also represent a plaintiff in a personal injury suit, a suit involving medical issues. How does the general practitioner prepare to settle or try the case? A general practitioner will usually rely on the advice and explanations which are received from the client's physician, or the health care professional who is retained for the case. The general practitioner does not attempt to develop comprehensive medical knowledge. On the other hand, a lawyer who “specializes” in cases where people are injured, will have a comprehensive knowledge of medicine.

To this point, we have dealt with general concepts of evaluation. Next, however, are the more complex matters dealing with the approaches and methods of valuing a business and the application of premiums and discounts drafted. These are intended for the general practitioner who needs to develop an expertise in a particular area of evaluation, and as a review for the “specialist.” After, the more advanced discussion of business valuation topics, we will address the approaches taken by various states and how the case law applies these approaches and methods.

There have been volumes written on the topic of business valuation approaches, premiums and discounts. This book will provide the lawyer with an overview of the major approaches to valuation in divorce cases and highlight the key concepts. The appraiser considers the use of three approaches in valuing a closely held business: the income approach, the market approach and the asset based or cost approach. Within each of these three approaches, the appraiser may use a number of different “methods” in determining the value of the business. The particular approach and method used by the appraiser depends on the facts and circumstances of the business interest being valued. The business appraiser must consider each approach and determine which approach or approaches are most appropriate.

The three business valuations approaches are:

The Income Approach: Using an income approach the business is valued on the basis of the income stream the business generates.

The Market Approach: Using a market approach, the business iv valued based upon referenced to other transactions -- in real estate referred to as comparable sales.

The Asset Based Approach: Using an asset based approach, a business is valued on the basis of its assets and liabilities.

As sub-topics of these overall approaches are certain methods used in valuing a business: these may be summarized as follows:

            Income Approach Methods:

                        Discounting: Under the discounting method, each increment of the projected economic income of an investment is discounted back to a present value rate of return known s a discount rate.

                        Capitalizing: Under the capitalizing method, a single period's economic income is divided by a rate of return known as a capitalization rate.

            Market Approach Methods:

                        Publicly Traded Guideline Company Method: In this method valuation the valuator finds publicly traded companies which are comparable. The valuator examines the multiples from the prices and financial data of the guideline companies and applies these multiples to the financial data of the business being appraised.

                        Comparative Transaction Method (Mergers and Acquisition Method): In this valuation method the appraiser finds companies that have been sold which are comparable. The valuator examines the multiples from the prices and financial data of such companies and applies these to the business being appraised.

                        Past Transactions Method: This method of valuation is often significant in divorce valuations because it uses any past transactions of the companies own stock. Similarly, “buy-sell agreements” are often considered by the divorce courts in fixing the value of a business — especially when they are negotiated when a divorce is not contemplated.

                        Rules of Thumb: Rules of thumb are not a business valuation method. Nevertheless, rules of thumb may have their origin in market transactions and therefore rules of thumb are generally considered under the rubric of a market approach.

            Asset Based Method:

                        Adjusted Net Asset Value Method: Under this method of valuation, the company's assets and liabilities are adjusted to their current fair market value. Under this method the valuator in a divorce valuation is generally valuing the business on the basis of a going concern value. Occasionally, a business will be in the process of liquidation and, if so, the valuator will adjust the assets and liabilities to their fair market value (not as a going concern) but based upon the premise that the business will be liquidated.

            Hybrid Method - Excess Earnings Method: The excess earnings method has often been used in divorce cases. This valuation method has components of an asset based approach as well as an income approach. This method might be classified under an asset based approach because the appraiser will added the values of the tangible and intangible assets. On the other hand, it also has features of an income approach because using this method the valuator will consider the income stream of the business in determining the intangible value of the business and the evaluator will apply a capitalization rate to the excess earnings of the business. Therefore, it is more properly considered as a hybrid method.

            B.       Income Approach

The income approach is probably the most widely used approach in business valuation. It is also the approach which may present the most problems for the court in differentiating between enterprise and personal goodwill. Under the income approach, the value of the business is based on the company's earnings, or the future earnings that the business is expected to produce. The company's earnings stream or future benefits is converted to a present value. This is done by either capitalizing the current benefits using an appropriate capitalization rate, or by discounting the future benefits using an appropriate discount rate. The capitalization of earnings method derives the company's value by looking at a single period of normalized earnings stream. The discounted future earnings method is derived by looking at the company's normalized earnings stream to be received over a number of years in the future. Using an income approach, there is a direct relationship between the amount of earnings or benefits the company will generate and its value.

The two primary methods used under the income approach are the discounted future earnings method and the capitalization of earnings method. Theoretically, both methods should produce identical results. Practically, the results will often differ due to the assumptions that are made in applying each method. Each method assumes that the company is a going concern and that earnings are expected to exist in the future.

                        A.       Capitalized Returns Method Compared to Discounted Economic Income Method

In the capitalization method, since the appraiser is converting only a single number (a measure of income for a period) to a present value. The appraiser has determined that historical returns of the business are indicative of future results and that the company's growth rate is stable and predictable. In the discounting method, the appraiser concludes that past results do not necessarily indicate future results and anticipates that the company will report earnings that vary significantly from year to year. Therefore, using the discount method the appraiser anticipates that the company has specific future earnings expectations, such as that the company is expected to grow rapidly in the near term with growth slowing and leveling off in the future.

Under both methods, the appraiser needs to determine a normalized earnings stream. Usually, this is a cash flow earnings stream but there can be other types of earnings streams. The key is identifying the earning stream that the appraiser is using and matching the appropriate capitalization or discount rate for that particular income stream. For example, the appraiser does not apply the same discount rate to net cash flow and net income. There usually must be an adjustment to the capitalization or discount rate to reflect the type of earnings stream that the appraiser is using.

Even though the income approach is widely accepted by business valuators, it may present problems in divorce valuations. The lawyer handling a business valuation case needs to understand that the appraisal using an income approach results in a single value for the business which may include elements of personal goodwill. In looking at the future earnings stream of the company, the appraiser might assume that the continuing personal efforts of the business owning spouse is a significant contributing factor in determining the future growth of the company — the future earnings stream of the company. Since doing so would be contrary to Illinois case law, discussed below, the appraiser must make certain that the future earnings stream of the business does not take into consideration the earning potential and personal efforts of the business owning spouse following the divorce.

Whenever the capitalization of earnings method is used, it is simply assumed that the expected state of affairs will continue indefinitely. While the capitalization of earnings method derives the company's value by looking at a single period of normalized earnings stream, long term, sustainable growth may still be built into an appraiser's calculations using the capitalization method. In addition, the single period of normalized earnings stream used by the appraiser may already take into consideration earning potential of the spouse who owns the business. Thus, use of the capitalization of earnings method, is no indication that personal goodwill cannot be built into the overall value of the business.

                        2.        Determination of Capitalization/Discount Rate

The lawyer should conceptually understand the impact of the discount or capitalized rate on value. The discount or capitalization rate will be expressed as a percentage. As the rate goes up, the value of the business goes down. A relatively small difference in the discount rate or capitalization rate chosen, can have a significant impact on value. Accordingly, it is important for the lawyer handling a business valuation case to understand how the discount or capitalization rate is selected based upon the two approaches that the appraiser will generally use.

                                    a.        Build-up Approach and Modified Capital Asset Pricing Model (CAPM) Generally

In the capitalization method, the appraiser divides next year's estimate of economic benefits (which could be based upon the immediate prior year, a simple average of prior years, a weighted average of prior years, etc.) by a capitalization rate. This capitalization rate equals the discount rate less the appraiser's estimate of any long-term sustainable growth of the company. Since a company's capitalization rate is derived from its discount rate, the appraiser must determine the discount rate before determining the capitalization rate. In developing a discount rate, appraisers generally use either the “build-up” approach and the “modified capital asset pricing model” (CAPM).

                                    b.        The Build-up Approach

The most common approach appraisers use to determine the discount rate for closely held businesses is the build-up approach. The build-up approach is based on the concept that the rate of return an investor would require to invest in a particular company is determined by increasing the risk free rate by an amount sufficient to compensate for all the identifiable risk factors associated with that company. The appraiser simply adds these various percentage amounts together to determine the discount rate. The following summarizes the discount rate components under the build-up approach:

            1. Risk Free Rate of Return: The appraiser determines the risk-free rate of return as of the valuation date. This is the rate of return that an investor could obtain from a relatively risk-free investment. It is generally accepted that an appraiser can use the rate on a long term U.S. Treasury bond, such as the 20 year U.S. Treasury bond yield.

            2. Equity Risk Premium: The appraiser adds to the risk free rate an equity risk premium. The equity risk premium represents the additional return an investor would require based on the perceived risk of ownership in a publicly traded company as compared to the return on U.S. Treasury bonds. The addition of the risk free rate and the equity risk premium produces an average market return for a large publicly traded company. Since closely held companies being valued in divorce cases are much smaller than large publicly traded companies further adjustments must be made.

            3. Size Premium: The valuator next adds a risk premium for size. This assumes that an investor requires an additional return for investing in small companies rather than large ones because of the additional risk. The Ibbotson Yearbook measures the difference between the return required on small company stocks and large company stocks. It should be noted, however, that what Ibbotson considers a small company is still significantly larger than most closely held companies the family lawyer encounters.

            4. Investment Specific Risk: Finally, the appraiser adds an additional premium for the return an investor would require to account for particular risks associated with the company being valued. This specific company risk number will generally be a positive number assuming greater risk for the companies set forth in step 3 above. Some factors the appraiser considers in developing this premium include the depth of company management, the companies competitive position, and a number of other subjective factors. The specific company risk premium is the most subjective factor used in the build-up approach.

Source: See Exhibit 9-2, Valuing a Business, 4^th Edition, p. 163.

                                    c.        Modified Capital Asset Pricing Model

The formula under what is called the “Modified Capital Asset Pricing Model” (CAPM) is very similar to the build-up approach except that it considers “beta.” Beta simply measures the variance between stock price of a single company and a broad index of stocks, such as the S&P 500. If a company, or industry group, has a beta less than 1.0 it indicates that the returns of that group tend to go up less than the market when the market goes up and tend to go down less than the market when the market goes down. If a company's beta is greater than 1.0, its returns would tend to go up more than the market when the market is up and down more than the market when the market goes down. Securities with betas greater than 1.0 are characterized as aggressive securities and are more risky than the market as a whole. Thus, beta can be characterized as a sort of volatility index. The formula for modified CAPM considers beta as well as the same factors in the build-up approach: the risk free rate, an equity risk premium, a small company risk premium and a specific company risk adjustment. Valuing a Business states, “a ‘modified CAPM,' which includes adjustments for size and specific company risks, is generally accepted.

While beta is readily available for publicly traded companies, the appraiser must estimate it for privately held companies. Doing so is a laborious task which is not required when using the build-up approach. It is done by referring to proxy companies which are must be substantially similar to the company being appraised. Generally, Capital Asset Pricing Model should not be used by the appraiser of a closely held business unless the company is a candidate to go public or a candidate for acquisition by a public company. See e.g., Estate of Klauss v. Commissioner, T.C. Memo 2000-191 (June 27, 2000). The essential problem with use of the CAPM model to value a closely held corporation is that the beta to be applied must be estimated from comparable publicly traded companies and often there are not comparable public companies when valuing a relatively very small closely held business.

Under both the build-up approach and CAPM approach the discount rate derived is generally assumed to be a rate to be applied to a net cash flow earnings stream. If the earnings stream being used is one other than net cash flow, the discount rate needs to be adjusted further.

                                    d.         Determination of the Capitalization Rate from the Discount Rate

Once the appraiser has calculated the discount rate, to determine the capitalization rate, the valuator simply subtracts the company's long-term growth rate from the discount rate. The capitalization rate which results from this calculation should appropriately be applied to the following year's income or earnings stream. Thus, if the appraiser is using the current year's earnings stream or an average of prior years' earnings, an adjustment to the capitalization rate is needed. The appraiser does this by dividing the capitalization rate by one (1) plus the long-term growth rate. This calculation lowers the capitalization rate thereby increasing the value of the business.

                                    e.        Growing Acceptance of Discounted Economic Income Approach to Valuing Business Interests

Pratt's Valuing Small Businesses & Professional Practices treatise discusses using the discounted economic income method at page 248. The heading under this section is, “Growth Acceptance of the Discounted Economic Income Method.” It states in significant part:

Some analysts are reluctant to use the discounted economic income method in marital dissolution matters because they are afraid that it impounds the results of future efforts of the operating spouse (which are not marital property) into the present value of the business. If this is a potential issue, the analyst should be careful when using the discounted economic income method to reflect only cash flows that would reasonably be expected from running the business with an employed, nonowner manager. This procedure would not reflect the potential contribution of extra efforts or special talents of the owner/manager.

In the chapter on Marital Dissolution, Pratt states, “The trend in many family law courts is to emphasize income approach methods more than asset -based methods of valuation.” It also states:

However, recent family law court cases have indicated that the courts are turning more frequently to other valuation methods. This is because these other methods (such as the discounted cash flow method) have achieved wide acceptance in the valuation community at large.

                        3.         Debt Inclusive Method (Valuing Company's Equity) vs. Debt Free Method (Valuing Company's Total Invested Capital)

The above analysis assumes the appraiser is valuing only the company's equity (e.g., the stock of a corporation). This is known as the debt inclusive method or direct equity method. In many privately owned businesses, unlike their publicly traded counterparts, debt is kept to a minimum because the debt of the business is limited by the private finances of the company's principal owner(s). However, as privately owned businesses grow, at some point in their development, they begin to resemble their publicly traded counterparts and will often take on more debt.

Alternatively, the expert could value the total invested capital (both the equity and the interest bearing debt). This is known as the total invested capital or debt free method. In a controlling equity valuation, the appraiser examines the capitalization structure of companies in its industry. This is because only a controlling owner has the ability to change the company's capital structure. By valuing a company's invested capital, the appraiser considers the effects of debt on the company's valuation.

The following example illustrates why it is important for the valuator to consider assessing the total invested capital of a business. Assume there are two companies, company “A” and company “E”. Each company has $100 cash as its only asset and each company earns $25. Company A's capital structure consists of $50 in interest bearing debt and $50 in equity capital while company E's structure consists of $100 in equity capital (i.e., there is no interest bearing debt). Company A's return on the money invested (equity) is 50% ($25/$50) while company E's return on equity is 25% ($25/$100). If the two companies were publicly traded, company A would have a greater value than company E. In the real world, company E would likely be forced to eventually modify its capital structure to conform to that of other companies in the same industry. While any investor should be interested in a company's return on equity, it should be kept in mind that only a controlling investor has the ability to alter the subject company's capital structure. Therefore, when valuing a closely held company under the fair market value standard of value, the appraiser should consider the company's capital structure, notwithstanding the fact that no change in the existing business is likely to occur as a result of a divorce — when there is a valuation of a controlling interest.

If the appraiser is using the total invested capital method of valuation, a rate of return associated with investing in both the equity and the debt capital of the business must be determined. There is an averaging of each of these components of the business' capitalization. This average is not a simple average. Instead, the discount rate is the weighted average of the cost of each of the components in the business' capital structure. This is called the weighted average cost of capital (“WACC”). In order to develop a discount rate under WACC, the appraiser needs to determine the cost of equity capital, the cost of debt capital, the proportion of equity in the capital structure and the proportion of debt in the capital structure.

First, the appraiser determines that the cost of the company's debt which is usually based on the current interest rates on the company's current interest bearing debt. The debt cost is than adjusted for taxes.

Next, the appraiser determines the weight to be applied to the debt and equity (the proportion of debt and equity in the capital structure of the business.) The weights that are applied to the cost of debt and the cost of equity are based on whether or not the appraiser is valuing a controlling interest or minority interest. When appraising a minority interest where the buyer cannot control the capital structure of the company, a WACC based on the company's actual weight of debt and equity is used. If the appraiser is valuing a controlling interest where the potential buyer would also have control over the capital structure, the appraiser may use WACC based on the debt and equity cost and weights of capital that are typical in the industry — that is a hypothetical capital structure discussed above.

Third, the appraiser determines the cost of equity capital. Typically, this is the discount rate that the appraiser has calculated previously for the return to the equity holder. After applying the respective weights to the costs of debt and the cost of equity, the appraiser finally adds the weighted cost of equity and debt together for the determination of the WACC. The WACC must be applied to an earnings stream that has been adjusted for the cost of the debt. For example, interest expense is added back to determine the net cash flow to invested capital. The appraiser looks to determine the earnings stream that is available to both the debt holders and equity holders (the total invested capital of the business).

Using the WACC method, once the appraiser determines the value for the total invested capital of the company (which includes the company's interest bearing debt), the appraiser then subtracts out the amount of this debt to arrive at the value of the equity of the company.

            B.       Market approach

                        1.         Introduction

A “market approach” is a general way of determining a value of a business interest using one or more methods that compare the company to similar business interests that have been sold. Market transactions in businesses, business ownership interests or securities can provide objective data for developing value measures to apply in business valuations. Such value measures are frequently derived from "guideline companies.” Guideline companies are companies that provide a reasonable basis for comparison to the relative investment characteristics of the company being valued.

Transactions entered into in a free and open market can provide the clearest indication of what value the market places on a particular type of business. However, the key to using this method is the ability to obtain financial data for companies which are comparable to the company being valued. The key is comparability, because, unfortunately, businesses are not interchangeable assets.

                        2.        Past Transactions Method:

First, the appraiser examines transactions involving the stock of the company being valued. However, it is important to review these type of transactions carefully to determine if they were an arms-length transaction, as opposed to simply a transfer of shares to related or friendly parties. The next place to look for transactions is the market place which consists of both publicly traded companies as well as private transactions. An advantage to looking to the market place to value a business is that doing so appears to measure the business more objectively without considering the involvement of the business owing spouse.

Case Law Re Evidence of Prior Sale of Stock in Determining Value: In Re Marriage of Grunsten, 304 Ill.App.3d 12, 709 N.E.2d 597, 237 Ill.Dec. 342 (1st Dist. 1999), ruled that the trial court erred by not giving sufficient weight in a 1994 hearing to the price at which the husband bought half the business in 1989. A critical issue of fact upon which the appellate court in Grunsten reversed the trial court was the price which the husband paid previously for a half interest in the business. In April 1989 the husband bought the other man's share from his widow, with a cash payment of $245,246 plus a consultant's salary of approximately $46,000 per year for three years to the widow and a $25,000 contribution for a "college scholarship" for the decedent's daughter. The agreed upon valuation date in the divorce case was December 31, 1993. The husband's expert placed the value of the business at $418,954. The wife's expert placed the value at $1,043,771. The trial court found a value of $558,677.

On appeal the wife argued that the trial court's valuation of the business was wrong because it was below the valuation the husband paid the widow four years earlier. The evidence showed that the financial health of the business had greatly improved since the buyout. The appellate court agreed "that the trial court failed to give the [prior] sale sufficient consideration in assessing the value of [ the business]. Had the court done so, it would have been evident that [the husband's] expert valuation was grossly inaccurate." The appellate court, instead of remanding, found the value of the business to be $816,240, a figure the review court concluded was "a most conservative valuation of GSP suggested by the record, taking into account the experts' valuations, the Simonek transaction and the company's sustained growth since 1989." In arriving at this figure, the appellate court determined that the consultation agreement was part of the consideration for the purchase because there was no evidence that the widow had any consulting skills and the husband conceded that she rarely visited the corporation. The appellate court also included in the payout to the scholarship fund as part of the purchase price.

A case which held that a past transaction of the subject company's stock was not entitled to significant weight because it was not an arms length transaction is Silker v. Silker, 593 N.W.2d 830, (1999). In Silker, the husband and his brother each owned 47.5 percent share of the stock in a family business. They executed a shareholder's agreement which provided that if either brother decided to leave the business and they were unable to agree on a division of assets, the initiating shareholder must name a price per share, allowing the other brother to either buy from or sell from him at that price. In 1990, the husband set a price on his shares at $950,000 and his brother sold his interest in the company for this amount. In divorce proceedings eight years later, the trial court rejected the wife's expert's valuation of the business at $943,000 and accepted the husband's valuation of $300,000 based upon the rationale that the belief that the husband had to pay a premium in order to buy out his brother's share of the business. On appeal the wife argued that the trial court erred in failing to follow Revenue Ruling 59-60 which states that sales of closely held businesses are indicative of fair market value unless they are forced, distressed or not at arms length. The appellate court ruled against the wife's argument noting that transaction was not at “arms length” because the husband was buying out his brother. The court held that it was not unreasonable for the trial court to decide that the husband set an inflated price in order to ensure that his brother would sell the stock to him. Additionally, the husband's experts each testified that the buyout was not indicative of the fair market value of the business.

Various tax court decisions have concluded that in determining the value of closely held stock, actual sales made in reasonable amounts at arm's length in the normal course of business, within a reasonable time before or after the date, are the best criterion of market value. Fitts' Estate v. Commissioner of Internal Revenue, 237 F.2d 729 (8^th Cir. 1956). The Fitts court held that the sale of stock occurring more than three years before the valuation date were not indicative of the value as of the valuation date.

            1) Was the transaction at arms length;

            2) How comparable was the size of the block of stock that was sold as compared to the size of the block being valued;

            3) Did the seller know the relevant facts surrounding the value of the stock.

                        3.         Guideline Publicly Traded Company Method: 

There is an enormous storehouse of reliable data from the transactions in publicly traded companies. In VALUING A BUSINESS, Pratt states:

The size requirements for a public offering and public trading are far less than many people think. Many closely held companies that might be thought of as small actually are large enough to go public if they so desired. However, it is not necessary for a company to be eligible to go public in order to use valuation guidance from the public market.

In searching for guideline companies to compare with the company being valued, the lawyer handling a family law case should try to determine from the owners or management who are their direct competitors. There are also a number of sources that compile names and data regarding companies. Whatever sources are used to identify potential guideline companies, the appraiser must use both quantitative and qualitative analysis in the selection. Revenue Rule 59-60, which favors the use of the guideline company method, states:

In selecting corporations for comparative purposes, care should be taken to use only comparable companies. Although the only restrictive requirement as to comparable corporations specified in the statute is that their lines of business be the same or similar, yet it is obvious that consideration must be given to other relevant factors in order that the most valid comparison possible will be obtained.

Determining whether or not a particular public company should be considered as most comparable depends upon a number of factors including capital structure, credit status, depth of management personnel experience, the nature of competition and the maturity of the business. See, Talichet v. Commissioner, 33 T.C.M. 1133 (1974). One of the significant factors the appraiser will examine in finding a comparable company is size. Larger companies tend to operate differently than smaller privately held c