As if divorce weren’t painful enough on its own, small business owners have a very significant complication to deal with: dividing the equity in the business in the divorce case.
Nobody wants lose their business in a divorce after investing so much time and effort into building a successful company. And no business owner wants to lose control of their business operations.
Good news: Ohio courts rarely “kill the golden goose” in divorce cases involving small businesses or closely held corporations. The goal of the courts is to divide the equity in the business fairly without putting so much strain on the business that the business fails.
In this Article:
- How Businesses are Divided in Divorce
- Dividing the Ownership Interest
- Assigning Value and Requiring Payment
- Finding the Right Divorce Lawyer for your Small Business
How Businesses are Divided in Divorce
There are two methods the courts use to divide businesses in divorce.
- The Courts can divide ownership interests by dividing the stock or membership interest of the business between the parties. The benefit to this solution is that it does not require an expensive business valuation.
- The Courts assign a fair market value (FMV) to the business and order the spouse retaining the business to pay the other spouse, either in a lump sum, or over time.
Dividing the Ownership Interest
The simplest and most inexpensive method to divide the business is to simply divide the ownership interest between the parties. This method is the least expensive option because you do not need to hire an expert to perform a fair market business valuation of the company.
If the company is a corporation, the court can simply divide the shares of stock between the parties. This is particularly effective if the company is owned by multiple parties, and the parties getting divorced own less than 50% of the company anyway.
If the company is an LLC, the court may assign a silent membership interest to the spouse who is not participating in the business. However, dividing LLC membership interest is more complicated than simply signing shares, so dividing LLC membership interests is less desirable then dividing stock in a corporation.
With both of these approaches, the court’s ability to divide membership interest in the corporation or LLC will be governed or restricted by the operating agreement or shareholder agreement of the company, if there is one.
Assigning Value and Requiring Payment
Valuing the Business
In most divorce cases involving small business owners, the parties will have the business valued to determine the fair market value of the business, and one spouse will keep the business and pay the other spouse for their share of the equity in the business.
In order to value the business, an expert must be hired (and paid) to conduct a fair market valuation of the business for purposes of the divorce. There are typically three methods the experts use to value the business: (1) an Asset-based approach, (2) an Earnings-based approach, and (3) a Market Value approach.
1. Asset-Based Approach
Often called the “book value approach,” this methodology uses the standard formula of “Equity =- Assets – Liabilities” to determine the equity value of the small business. In other words, this is the amount of money the business owners would expect to receive if they conducted a “fire sale” or liquidation of the business, selling everything the business owns and paying down all of the debts of the business.
Typically, these numbers can be found on any year-end balance sheet of the company’s books. All the assets of the business are valued and added together, all of the outstanding liabilities are identified and subtracted from the total assets, and the remaining value is the equity of the business. The spouse keeping the business would then pay the other spouse a percentage of the equity, typically 50% in a case where the business is entirely marital property.
2. Earnings-Based Approach
In an earnings-based approach, the fair market value and equity of the business is largely predicated on the amount of earnings the company has produced in the past and is likely to produce in the future.
The typical earning value approach is Capitalization of Earnings.
In the Capitalization of Earnings approach, the expert valuator determines an expected level of future cash flow for the company using the company’s past earnings, normalizes the earnings by making adjustments for any atypical revenue or expenses, and then multiplies the adjusted cash flows by a capitalization factor. The capitalization factor varies between businesses depending on factors such as the industry the businesses is in (e.g. restaurant vs. manufacturing), the marketability of the business (how easily is it sold), and the geographic location of the business.
The valuator will apply the capitalization factor to the normalized earnings to reach a fair market value for the business. The Capitalization of Earnings approach tries to reach a value based on the rate of return the buyer would receive from the business after purchasing the business.
A second methodology for valuing a business is the Discounted Future Earnings method. In this method, instead using past earnings, the expert valuator determines the predicted future earnings of the business and divides the future earnings by the capitalization factor.
3. Market Value Approach
The market value approach to determining the fair market value of the small business is based on comparing the parties’ small business to the recent sale prices of other similar businesses. Expert evaluators have access to reported sales of many, many businesses, and they will use that data to reach a fair market value for the parties’ small business.
This methodology only works well if there are a sufficient number of similar businesses that have been recently sold available for comparison, and the business being valued is somewhat standardized (such as a franchise operation).
Typically, this method is inappropriate for most small businesses, as each small business is usually fairly distinct from other companies, even within the same industry. Further, information regarding the sales price for privately held small businesses is rarely reported and available to the public.
4. Combining the Methods
Each expert has the opportunity to choose the appropriate methodology for valuing the business based upon circumstances of each case. Oftentimes, an expert will utilize all three methods in reaching their opinion of the fair market value of the small business.
5. The Battle of the Experts
In particularly contentious divorce cases, the parties may not agree to use one expert valuator to determine the value of the business. In these cases, each party will retain their own expert to value the business, and each expert will conduct a thorough analysis to reach an opinion of their fair market value. Typically, you will see the experts utilizing different methodologies in their opinion of value in order to minimize or maximize the value of the business.
In these cases, both experts will testify at trial, leaving the court to decide which expert opinion to use and dividing the equity of the business. This scenario is the most expensive scenario of all, because each party will be paying for their expert business valuator independently, and having those experts testify in court and critiquing the others reports require significant time and labor, resulting in very high expert witness fees in these matters. It is not unusual for each party to pay their experts 10,000 or $30,000 for testifying in their divorce cases when the parties go to trial over the value of the business.
6. Paying for the Business
Once a fair market value is determined, the parties know the value of the business that is to be divided in the divorce case. Typically, one spouse will keep 100% of the business, and pay the other spouse a sum of money for the spouse’s marital share of the business.
If there are sufficient assets, this payment may be done in a lump sum form. Alternatively, the value of the business may be offset against other assets that the parties own that will be divided in the case. For example, if the business owner owes his spouse $400,000 for the business, and the other spouse owes the business owner $400,000 for the equity of the house they are keeping after the divorce, then neither party would owe any cash to the other. One would keep the business, the other would keep the house.
If there are insufficient assets to pay a lump sum or offset, and the court will typically order payment for the equity in the business to be made over time, usually with interest. For example, the court may order the business owner to pay his spouse $400,000 for the business over 10 years in monthly installments, at an interest rate of 3%. The methods and terms of payment over time are variable, and the exact terms for each case may be different depending on the circumstances.
Finding the Right Divorce Lawyer for Your Small Business
Dividing a small business is one of the most complicated issues in a divorce case. If you own a business and are involved in a divorce, you should make sure you find a divorce lawyer with experience in handling divorce cases involving small businesses and closely held corporations. Ask any attorney you are considering hiring if they have experience in dividing small businesses in their past cases.
We have represented many small business owners and spouses of small business owners in divorce cases in Summit, Medina, Portage and Stark counties.