Not every couple can be Chip and Joanna Gaines. Marital conflict can be particularly difficult for spouses who own their own business. A divorce not only ends the marital relationship; it can end a family business relationship. Even if only one spouse has actively participated in a business, the non-participating spouse may have a community property interest or a claim for the use of community funds to benefit a spouse’s separate property business. Accurately valuing a business can be an important part of a divorce proceeding. The divorce law team at REIDDENNISFRICK has considerable experience addressing business valuation issues in divorce proceedings.
Businesses as Assets of the Marital Estate
In Texas, a spouse’s interest in a business is an asset of the marital estate. As with other assets, it may be separate property or community property. A business interest is separate property if one spouse owned the interest before the marriage or acquired it during the marriage by gift or inheritance. Property owned at the time of divorce is presumed to be community property unless a spouse proves it is separate by clear and convincing evidence.
In the absence of an agreement to the contrary, income from separate property is community property. A spouse’s income from a separate property business interest is community property, as is any property purchased with that income, subject to a just and right division upon divorce. On the other hand, an increase or decrease in the value of an asset does not affect whether it is separate or community property.
Like other marital assets, an interest in a business can be of mixed character—partly separate property and partly community property. For example, if dividends from corporate stock owned before marriage are reinvested to buy even more stock in that company, the part owned prior to marriage is separate property and the part bought with the reinvested dividends during the marriage is community property.
Business Assets & Liabilities
Formal business organizations are recognized by law as separate legal entities. Property owned by a corporation, limited liability company, or partnership belong to that business organization, and not to the marital estate. In the absence of a valid claim to “pierce the veil” and disregard the business entity, individual assets owned by a formal business organization are not property of the marital estate and cannot be awarded by the divorce court individually to either spouse. Only the spouse’s interest in the business is a marital asset.
Similarly, business debts and liabilities are the legal responsibility of corporation or a limited liability company. In the absence of a personal guaranty or valid claim to “pierce the veil,” individual shareholders and members are not personally responsible for the debts or liabilities of such entities. With respect to partnerships, however, a spouse who is a general partner may be personally responsible for the debts and liabilities of the partnership, and that may subject part of the marital estate to possible legal collection efforts. Regardless of the form of the business entity, outstanding business debts and liabilities will affect the value of a spouse’s interest at the time of divorce.
Informal businesses, like sole proprietorships and “d/b/a”s, are not considered separate legal entities under the law. They cannot legally own assets in their own right. Individual assets ostensibly held in an assumed or common name of an informal business remain property of the individual spouse and of the marital estate. Such property may be separate or community, or of mixed character. Similarly, the debts and liabilities of such businesses remain the legal responsibility of the incurring spouse and may subject marital assets to collection efforts.
Texas law allows spouses to enter into enforceable premarital agreements, as well as post-marriage agreements. It is strongly recommended that the parties negotiate and sign such an agreement whenever one or both spouses have or acquires an interest in a closely-held business. Such agreements often address the issues that arise in divorce proceedings. In the absence of fraud, coercion, or other factors, such agreements overwhelmingly are enforced by Texas courts.
The owners of a business organization may enter into an agreement among themselves as to what will happen if one owner divorces. Such an agreement may be called a buy/sell agreement or shareholders agreement. In many instances, both spouses are asked to sign such an agreement, but it is not always necessary. When a spouse joins a business, that spouse’s interest will likely become subject to existing terms and conditions applicable to an ownership interest in that business regardless of whether both spouses sign an agreement.
Many such agreements stipulate that the business interest will be held in the name of only one spouse and that the other spouse has no right to participate in the management of the business. Some require a spouse awarded an interest by a divorce court to sell it back to the business entity itself, or to other owners, at a fixed price or at “book” value. Some specify a valuation method or “standard of value” to be used in any divorce proceedings. Our attorneys will carefully read any such agreement and help you understand how it affects your divorce.
Closely-held Businesses versus Publicly Traded Ones
Spouses often own stock in publicly traded corporations. Often, shares of stock are held in personal investment portfolios or retirement accounts. Valuing the shares of such stock may not require expert assistance. The parties, or their attorneys, can look up the “market price” of such stock per share on any given day, and multiply it by the number of shares owned. Sometimes, however, a spouse may receive shares of stock in a publicly traded corporation as part of the spouse’s compensation for work performed for such business. Such shares may be subject to restrictions as to when and how they may be sold. These restrictions usually mean that the shares are worth less than the “market price” of such stock on an exchange. In such instances, it is important to fully understand the restrictions in place to properly determine the value of such shares.
Sometimes, spouses own an interest in businesses that do not sell stock to the public. These closely-held businesses may be family-owned businesses, professional practices, service companies, franchises, manufacturers, retailers, etc. They may be S corporations, C corporations, limited liability companies (LLCs), general partnerships (GPs), limited partnerships (LPs), professional corporations (PCs) or limited liability companies (PLLCs), or another form of business organizations. Only one spouse may be an active participant in the business, or both may be. They may have only a single owner, or they may have several owners including one or both spouses. Determining the value of a spouse’s interest with reasonable accuracy almost always requires the assistance of a business valuation professional and an attorney experienced with business valuation issues.
Ongoing businesses usually have an element of value that goes beyond the replacement cost of its tangible assets and cash deposits. This value may arise from the business’s name, reputation, customer patronage, location, products, or other factors that cannot be separately identified and valued. Business appraisers refer to this intangible value as “goodwill.”
Sometimes, part or all this intangible value is closely tied to the reputation or efforts of an individual owner. This tends to be especially true when the business provides professional services, as with doctors and lawyers. In such situation, it is called “personal goodwill.” Personal goodwill is one reason many buyers require former owners of a business to sign covenants not to compete.
Personal goodwill is predicated upon the individual owner’s ability and willingness to provide future personal services for the benefit of the business (or, at least, to not provide such services to a competitor). One spouse is generally not entitled to a portion of the other spouse’s compensation and earnings for personal services performed after the divorce. Therefore, in valuing a business interest for purposes of divorce, the court must exclude personal goodwill in making a division of the spouses’ marital estate.
Discounts for Lack of Marketability and Control
Many different factors impact the value of a business interest. Some enhance the value of a spouse’s interest in the business; others require a reduction. The two biggest factors most frequently encountered in divorce business valuations are lack of marketability and lack of control.
Marketability is the ability of a business owner to convert his ownership interest to cash quickly, with minimal costs and a high degree of certainty of receiving the expected amount. Stock in a public corporation traded on an exchange is highly marketable and can be quickly converted to cash. Closely-held businesses tend to be much more difficult to convert to cash and, therefore, the value of such a business usually must be discounted due to a lack of marketability.
Control is the ability of a business owner to exercise the prerogatives of ownership including the ability to appoint management and make decisions involving major transactions. The sole member of a limited liability company may have absolute control of that company, whereas a minority shareholder in a professional practice may have little ability to exert any influence. In the latter situation, the minority shareholder’s interest will be discounted due to a lack of control.
Spouses who own their own businesses often have strong personal feelings as to the value of such business. In our experience, they are rarely accurate. Either they believe that their business is much more valuable than it really is, or they think it is worth much less. In divorce proceedings, it is not uncommon for one spouse to believe that a business is worth a lot, while the other spouse believes that it is worth significantly less. Even when both spouses generally agree, it is not uncommon that they subsequently learn they were both incorrect. Therefore, when spouses own an interest in a business, it is almost always desirable to objectively determine a reasonably accurate value for that business in the event of a divorce.
Business appraisers have the education, experience, knowledge, and training to determine the value of many different businesses to a reasonable degree of accuracy. Often, such professionals are also certified public accountants; but not every certified public accountant is accredited in business valuation. Many such professionals are accredited by the National Association of Certified Valuation Analysts (NACVA) or the Institute of Business Appraisers (IBA). In many instances, parties to a divorce proceeding should hire a professional business appraiser to assist their attorneys in determining the value of businesses owned by the spouses. Attorneys at Reid & Dennis often work with professional business appraisers in divorce proceedings.
A Cautionary Tale on Using Valuation Experts
Hiring an expert to assist in valuing a closely-held business does not mean that a divorce attorney can blindly trust that expert’s opinion of value. Usually, the spouses and their attorneys develop a more thorough understanding of the nature of the business and particular facts impacting its value. One or both spouses may have years of practical day-to-day experience dealing with the business. Divorce attorneys typically spend more time than the expert learning specific facts about the business that affect its value.
In one case handled by one of our lawyers, each spouse hired a qualified, experienced expert, but the two experts’ opinions differed by quite a bit. In reviewing the business’s financial statements, the attorney noticed a jump of $300,000 in the book value of the business’s electronic equipment in one year. Upon inquiry, the attorney learned that the business had not purchased new computer equipment but rather had signed a contract with a web-hosting service. The bookkeeper had incorrectly booked the $300,000 contract liability as an asset because she misunderstood advice from an accountant—a swing of $600,000 in the value of the business alone.
Despite his expertise, the other side’s valuation expert did not know the facts behind this entry in the business’s financial statements. Despite being board-certified in family law, the opposing lawyer had not critically reviewed her own expert’s report or did not initially realize that it was, in part, based upon an error in the business’s own bookkeeping records.
Choosing the Right Lawyer in Business Valuation Cases
Many divorce lawyers—even ones certified in family law by the Texas Board of Legal Specialization—do not adequately understand business valuation issues. They may be excellent attorneys in child custody matters, have considerable experience with military retirement benefits, understand how addiction and drug abuse impact marital relations, or have superior expertise in psychological testing used in abuse and neglect cases. But they may not be the right divorce lawyer in a case where the spouses own an interest in a closely-held business.
When screening an attorney, you may wish to ask: What “valuation date” will be used in determining the value of your closely-held business? How will “personal goodwill” affect the value? What about “enterprise goodwill”? What “standard of value” will be used? What “premise of value”? Will the value be discounted for “lack of control” or “lack of marketability”? Do you need to worry about a “buy-sell agreement”? All of these are standard terms and fundamental issues in business valuation assignments. If your attorney does not understand these questions, and is not able to explain them to you, how effective will he or she be arguing that your value is the right value for your business. Such an attorney may not be a good fit in a divorce proceeding in which the value of a closely-held business is an important issue.
Anyone with experience in modern business valuation will know the name Shannon Pratt. In many ways, Mr. Pratt is to business valuation what Einstein or Hawking is to physics. His work “The Lawyer’s Business Valuation Handbook” has been published by the American Bar Association since 2000. He is also the author of numerous other learned treatises widely accepted in the field of business valuation. Every divorce lawyer handling a case with a significant business valuation issue should at least know who Shannon Pratt is.
Particular Issues in Business Valuation Cases
Some of the particular types business valuation cases and issues that the divorce law team at Reid & Dennis is experienced with include:
- Medical & law practices
- Real estate brokers and agents
- Family-owned construction trades
- Manufacturing companies
- Nursing homes
- Entertainers, artists, and athletes
Of course, every business is unique. In light of the experience our divorce attorneys have with business valuation issues, it is likely that one or more of our attorneys will be able to help you. For all your divorce needs, contact us to schedule a consultation.