Divorce case study: Valuation of business assets

Sometimes estranged spouses can remain fair, rational and civil during divorce proceedings. But other cases can turn ugly. When divorce involves valuation of business assets, the situation can be extremely complex.

Husbands and wives may become emotional and vindictive, hiding assets and withholding information. These behaviors can compromise the accuracy of asset appraisals and property allocations. But financial experts who specialize in divorce are accustomed to overcoming various roadblocks during discovery.

One Ohio Court of Appeals case illustrates some of the games people play in divorce court. In the end, neither spouse was satisfied with the trial court decision, so both made claims on appeal. Here are some of the valuation-related claims and how theThe proper classification of shareholder advances comes into play in divorce cases, because it affects the value of the marital estate. If a shareholder advance is categorized as an equity transaction, the loan is automatically accounted for in the business valuation, as a reduction in the value of equity (a marital asset). expert witness managed to reliably value the business, despite having limited access to the company’s financial records, management and facilities.

Access Denied, Claim Denied

When the couple decided to call it quits after 48 years of marriage, their most significant marital asset was the husband’s 100 percent interest in a mental health service company that was licensed in Ohio. During divorce proceedings, the husband refused to allow the wife’s expert to visit the company office or interview management.

The court ordered the husband to give the wife $5,000 to retain an appraisal expert to determine the value of the company, but he delayed for six months. He also delayed sending the expert court-ordered financial records, causing the wife’s expert to miss his original deposition date and submit his final report after the trial had begun.

One of the husband’s claims on appeal was that the court should exclude from evidence the appraisal testimony and report prepared by the wife’s expert. The appeals court denied this claim, because his failure to appear at deposition and untimely report resulted directly from the husband’s misconduct and repeated failures to comply with lower court orders.

Both spouses appealed the lower court ruling that the company was worth $1.5 million on December 31, 2008 on a controlling, nonmarketable basis. The husband argued the business had no value, given its liabilities and limited assets. The wife argued for her expert’s original appraisal setting the value at more than $1.9 million.

The wife’s expert used the capitalization of earnings method, relying solely on tax returns and financial statement audits from 2005 to 2008. His $1.9 million value included:

  • A 10 percent discount for lack of marketability;
  • A normalizing adjustment for nonrecurring pension plan costs;
  • A normalizing adjustment for the cash surrender value of officer life insurance policies, a nonoperating asset valued at approximately $600,000, and
  • A loan to its shareholder (the husband) for roughly $400,000 (see right-hand box on factoring in holder loans).

Consistent with Ohio legal precedent, no adjustment to the value of the business was made for goodwill. In Ohio, personal and enterprise goodwill in professional practice are generally marital property. Other states may handle goodwill differently, however.

The husband claimed the valuator’s methodology was unreliable “due to his unfamiliarity with (the company) and its business structure.” Specifically, the husband contended that the wife’s expert didn’t understand Medicare and Medicaid regulations, the financing requirements for the company’s pension plan, and the transferability of the company’s license. (Chattree v. Chattree, 2014-Ohio-489, 2/13/14)

Reliable Given the Limitations

Along these lines, the expert’s report contained the following disclosure:

Due to limited access to information and management, [my] analysis was not subject to the development or reporting standards set forth in the American Institute of Certified Public Accountants Statement of Standards for Valuation Services No. 1 (AICPA) nor the valuation standards as promulgated by the National Association of Certified Valuation Analysts (NACVA).

Additional information that could have impacted his conclusion — but the husband withheld from the expert — included:

  • Access to management or the opportunity to interview management;
  • Details about certain balance sheet and income statement accounts;
  • Corporate governance documents;
  • An organizational chart;
  • Budgets and forecasts, and
  • Other relevant information, such as significant contractual relationships and details of previous ownership transactions.

The valuator’s lack of knowledge about the day-to-day operations of the company stemmed primarily from the husband’s refusal to consent to a site visit or a management interview. The court refused to reward the husband for such conduct, so it ruled that the expert’s testimony and appraisal report, despite its limitations, were “reliable and based on application of his disciplines, practices, and knowledge of the facts of this case.” In the eyes of the court, the expert did the best he could with limited financial information.

In addition, the Ohio Court of Appeals reversed the lower court’s pension plan adjustment, which was based on an apparent misinterpretation of the expert’s original testimony. The appellate court ruled that the lower court erred in valuing the business at $1.5 million and remanded the case to the trial court to determine whether the appraised value of $1.9 million was appropriate.

Play by the Rules: In divorce cases that involve private business interests, it may be tempting for controlling shareholders to downplay assets, income, strengths and growth opportunities — and play up expenses, liabilities, weaknesses and threats — to alter the appraised value of the company. But as the case described above demonstrates, many valuation-related issues are left to the court’s discretion, and judges don’t look favorably upon spouses who hide assets, withhold information or otherwise defy court orders.

The professionals at Sol Schwartz & Associates are experienced in working with attorneys in complex divorce situations involving business assets. Contact us below if you’d like to discuss your situation and how we can help.