This business would be worth nothing without me. I am the business.
Original content pulled from www.ValuationStLouis.com | Melissa Gragg is the author.
Here is a top valuation issue every business owner should know before filing for divorce.
One question people will ask is
4. This business would be worth nothing without me. I am the business. I have all the customer relationships. If she wants the business, she can have it and I will just go start a new one.
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Almost all business owners think that the business would be worth nothing without them. Maybe the business owner is the primary sales person or driver of the business, or maybe they have all the relationships with all of the clients, or maybe they have special training or a proprietary process that makes them unique.
I think most business valuation people understand that the business is heavily reliant upon the main owner, especially in small businesses, but that usually does not mean that the business is worth nothing if the owner steps aside. And this is definitely true in divorce court, the judge is not going to assume that the business is worth nothing when that same business has provided a significant lifestyle for the couple. This means if you look back - has your business allowed you to buy a nice house, multiple cars, vacations, private school, basically a comfortable living? If the business has provided for the family and increased your assets, then you have to consider that there is value to the business – at least in the eyes of your spouse and the court.
How a valuation analyst treats the significance of the owner becomes a very important issue and this is why one of the things the expert reviews is the owner’s salary in the valuation. There are various cases in each state that specifically deal with compensation and a concept of the “double dip”, which is a complex issue in valuation. Better saved for another conversation.
Many times we can incorporate the reliance on the owner in two ways – in the cash flow of the business or the risk that that cash flow will continue. Take for example you have a business owner who makes $250,000 net profit in the business – but pays themselves no salary, just distributes cash as necessary for living expenses. Now if we think the business is worth four times profit then the business is worth $1,000,000 or 4 times $250,000. Remember, since this person takes no salary all of the profit flows to the bottom line.
Now, in the state of Missouri and many other states, we have to consider the “fair market value” as the standard of value in a divorce. Fair Market Value is the value of the business with a willing buyer and a willing seller. This means - what is the value of the business to someone who has no knowledge of the industry but would come in and start to operate this company – someone off the street. For example, If the judge bought this business – how much money would he make and what would he pay for the cash flows? Maybe the new owner will hire a manager or CEO to run the business, or a salesperson or several people. So that might mean that the new operator would have to replace the business owner with one or two people depending upon how much the business owner is involved in the business.
So this is where reasonable compensation could be a valuation adjustment in the income statement. The valuation expert would need to add this additional expense, which would reduce the profit. So let's say that same business owner who is making the $250,000 of net profit in the business really should have been paying himself $200,000. Now we only have $50,000 left and the value of the business is $200,000 – or 4 times $50,000. It is not the $1,000,000, because we had no cost for the owner. This is kind of the issue of the double dip. I know what you are thinking, maybe the business is a pass-through entity, or sole proprietorship, where the owner doesn’t take a salary. The valuation person still typically has to consider a salary to the owner, as a pseudo replacement value – and adjust the valuation accordingly.
This deals with the cash flow, but what about the risk. There could also be increased risk because of owner dependency, key-man issues, which reduces value. Typically these adjustments don’t necessarily result in the company having no value, but the value is reduced when taking into consideration the effects of the reliance upon the owner. Again, thinking YOU, as the business owner, can just go into court and testify that the business relies upon you and then claim that the business is worth nothing without you, is a risky proposition. The judge could look at all of the other “stuff” you have accumulated and think you are just trying to screw over your spouse. Are there times when you take out a salary and there is no profit left and therefore no value to the business, sure, this can happen. But your testimony will probably not get you there. Work with a valuation expert to understand the reality of the situation and how the expert can show the compensation or owner dependency issues in a way that supports your reality, but does it within the constructs of valuation theory and in a way that will stand up to the scrutiny of the judge in court.
So, I am considering filing for divorce, but want to be prepared - What should I do next?
Give us a call! No really, you should reach out to someone who specializes in valuations for the purpose of divorce. There may be many valuation companies near you, but do they understand the divorce court system in your state? That would be a good first question to ask. Then see how many times they have testified. Are they trained as a mediator? Do they understand how to negotiate settlements with other experts?
If you have any additional questions or would like to talk about your specific situation, please give us a call or text us at (314) 541-8163 or check out our website at https://www.ValuationStLouis.com/
Click here for our next video in our series for business owners + divorce.
