Valuation of Business Assets in Divorce: One Case Provides Insight

Valuation of Business Assets in Divorce: One Case Provides Insight

Sometimes estranged spouses can remain fair, rational and civil during divorce proceedings. But in other cases, a divorce can turn ugly. When the couple’s assets involve a business interest, 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 the 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 Arun and Mona Chattree decided to call it quits after 48 years of marriage, their most significant marital asset was Arun’s 100 percent interest in Community Behavioral Health Center (CBHC), a mental health service company that was licensed in Ohio. During divorce proceedings, Arun refused to allow Mona’s expert to visit CBHC’s office or interview management.

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

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

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

Mona’s expert used the capitalization of earnings method, relying solely on tax returns and audited financial statements 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 (Arun) 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.

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

Factoring in Shareholder Loans

Professional practices sometimes advance fund to owners — or vice versa — to bridge cash flow gaps or finance large, unexpected personal or business purchases.

For appraisal purposes, these advances may be classified as:

  • equity transactions (either additional paid-in capital, or dividends),
  • or as a bona fide receivable or payable.

How they are categorized depends on the facts and circumstances.

The 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).

But if it is categorized as a receivable (or a payable) on the company’s balance sheet, then a corresponding liability (or asset) must be accounted for elsewhere in the marital estate. Whether the shareholder advance is marital property depends on the origin of the funds used to make the advance, its intended use, timing or other relevant factors.

In the Chattree case, Arun had advanced CBHC approximately $400,000 of marital funds during the marriage. When valuing CBHC, the appraisal expert included this obligation as a debt that reduced the company’s value, because a hypothetical buyer of CBHC’s stock would immediately owe Arun for the loan.

The appeals court ruled that the trial court erred and the company’s shareholder liability should be included as a marital asset subject to allocation between the parties. The issue was remanded to the lower court.

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 Arun 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 CBHC stemmed primarily from Arun’s refusal to consent to a site visit or a management interview. The court refused to reward Arun 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.