Divorce is an inherently messy process. Tossing a business into the mix can weave an even more tangled web.
“Because it’s such an emotional situation, there’s not a lot of openness on either side. It’s tough to manage expectations,” said Linda Buckley, a Colorado Springs CPA and valuation analyst who specializes in financial services related to family law. “I always tell my clients, ‘Just because you don’t like the numbers doesn’t mean they’re wrong.’”
Valuing a business is traditionally the main point of contention for a soon-to-be-divorced couple, said Carl Graham, owner of Graham Law on North Cascade Avenue. And often, spouses who head their own small professional service — such as a medical practice or law firm — are not even aware their business has any value, Graham said.
“It’s a hard thing for people to get used to, but a business has value even when it’s just you,” Graham said. “That’s people’s attitude toward a business — ‘There is no business except [for what] I created for the secretary of state.’
“Well, that’s wrong,” Graham said. “There is a business.”
FINDING A DOLLAR AMOUNT
In family law cases, a CPA’s job is, “in essence, to figure out what would this guy make if he were a salaried physician working for somebody else?” Graham said.
“That’s the baseline — how much is he making?” Graham said. “Whatever the increase is by virtue of running a business, that’s a starting point for valuation.
“Your business is based upon the goodwill that you’ve earned in the community, and it’s based upon the fact that your business is paying you $400,000 a year, but an attorney with years of experience earns only $200,000 a year,” he added. “Your business is paying you extra because you’re a business owner. That’s a big adjustment for people to get used to.”
During the valuation process, the first priority is always to examine the last four or five years’ worth of tax returns and financial statements in order to paint a picture of how the business has fared during that period, Buckley said.
“Sometimes we actually have to reconstruct them because they don’t, often, have a very sophisticated bookkeeping system,” she said. “Then we prepare what’s called a trend analysis — that way, we can see at a glance what the business has done for the last five years. That helps us determine what questions we need to ask management.”
Buckley’s next step is usually a site visit, which she called the most important piece of the valuation.
“A picture is worth a thousand words, and I find going to the business location is really helpful,” Buckley said. “No. 1, you can get an idea what kind of equipment or furniture they have if it’s an inventory situation. … More than anything, it helps to see the owner in their environment, see who else is working there, what the interaction is. … It gives us information that it’s not possible to see on paper.”
Once she has collected the necessary data, Buckley will meet with the business owner and his or her attorney to make sure no additional information should be included in her final report.
“Same thing with the [spouse] — we go through the same process and talk about why we think the value is what it is. These are important meetings to have because it helps everybody understand where we’re coming from,” Buckley said. “They can give us input and we can factor that into the final report, which we typically issue prior to going to court.”
When dealing with a closely held business during divorce mediation, it’s also important to bear in mind that the court bases spousal and child support calculations on the actual taxable income, plus certain “add-backs” the CPA finds, Graham said.
Examples of add-backs include fringe benefits, such as profit-sharing plans and medical insurance, as well as personal items like cellphone and automobile expenses, Buckley said.
“A lot of times, people do write off more for their car for tax purposes than what I think is really the economics of the situation,” she said. “Maybe it was something the IRS has said is OK, but we do take a look at that, especially if we get a lot of feedback from one side or the other.”
Graham recalled a client who was taking home only half of his profits each month, tucking away the other 50 percent in his business bank account in order to build up roughly three to six months’ worth of reserves.
He was shocked to learn the court was using 100 percent of his profits to determine maintenance costs, Graham said.
“Even though he wasn’t paying it to himself, he was the one choosing not to pay it to himself. He had control of the funds and the ability to take the money — he was just choosing to invest it in the business instead,” Graham said. “That counted as income.”
There are three approaches Buckley can take when helping couples put a dollar amount on their business. The first is the asset approach — or, as Buckley put it, “If we took everything and put it out in the front yard and had a giant garage sale, what would it be worth?”
Buckley said businesses can’t be worth less than that.
“Most businesses are worth more than their furniture or equipment is,” she said.
The second, what Buckley calls a market approach, is only reliable with certain kinds of businesses, such as dental practices or restaurants. She scours various databases for similar companies that have been sold in the last five to 10 years in order to find a ballpark figure for her client.
“More than anything we’re looking for sort of a trend, but a lot of businesses are not really bought and sold, especially service businesses,” Buckley said. “You can’t really rely on the market approach.”
The third — and most common — method is the income approach, in which Buckley evaluates the current and historical cash flow of the business to predict its future value.
“What we really try to do is figure out what [the cash flow] is going to be going forward,” Buckley said. “A lot of the reason that we rely on that method is that case law in Colorado has indicated a standard of value which is similar to investment value, or value to the holder.
“A lot of times we have people say, ‘If I wasn’t here, this business wouldn’t make any money,’” she added. “That’s true, but we also know you are able to derive a certain level of cash flow from your business that has some value.”
WHAT YOU SHOULD KNOW
Even if the company predates the marriage, there is still marital equity in the business, Graham said.
“Let’s say the CPA valued the business at $400,000 at the time of the marriage, and now it’s worth $1 million,” Graham said. “The business owner gets the original $400,000 set aside as separate property, but the $600,000 increase is marital — half of that increase belongs to the spouse.”
In that case, although the spouse had no claim to the business, the owner would have to pay the spouse $300,000 to buy out their share, Graham said.
Graham also advises his clients not to play “hide-the-ball” — essentially that during the mediation process, spouses owe each other a fiduciary duty to be as frank as possible about their finances.
“There are reported cases in the Colorado Court of Appeals where a major contract is being negotiated, the business owner doesn’t tell the other spouse about it, and within six months of the divorce, the business suddenly thrives with this major contract,” Graham said. “And guess what? There were emails, there were phone calls — it’s not that tough to prove that the negotiations were occurring before the divorce happened.”
In those cases, the court will almost always reopen the settlement, Graham said.
“If you have an offer on a piece of property that the business owns, don’t just sit on it, wait until the divorce and then sell it,” he said. “That’s sleazy and unethical.”
In the same vein, Graham said, if business owners have made it a practice to pay for personal expenses like groceries and automobile costs using their professional account — “stop doing that,” he said.
While this isn’t technically cheating if the owner doesn’t claim it as a business expense on their W-2, “you tend to lose credibility when you do things like that,” he said.
“Judges don’t like you treating the business as your own little private bank account,” Graham said. “Start paying yourself a fixed amount each month in salary … and then pay for your personal expenses out of your own account.”
Graham’s biggest piece of advice to his clients?
“From the word go, treat a business as a professional endeavor,” he said. “Have a bookkeeper, have a CPA, don’t pay personal expenses [out of your business account], pay yourself a proper salary, keep proper records.”