Business valuations on divorce
It can be tricky to advise clients on fair financial division of assets on divorce when a significant proportion of assets is in a business.
One of the trickier aspects of advising a client on a fair financial division of the assets on divorce can be when a potentially significant proportion of those assets is represented in a business. It may be a limited company through which the family has historically enjoyed the funding of its lifestyle.
How does a divorce court deal with a business?
It is crucial to find an expert accountant to estimate accurately the value which can be attributed to the family business. The methodology used depends on the nature of that business, as explained below.
In a nutshell, the value of a family business will depend on what a willing buyer is prepared to pay for that business as a going concern in its current form and location.
This definition assumes a sale of the business, although in most divorce cases, a sale is not going to be appropriate as this will destroy the income that can be produced from the business and upon which the now separated family will still need to fund their living expenses post-divorce.
Very often in negotiations, the headline value of the business is less useful than an analysis of whether any capital can be drawn from, or funds raised against, the business without affecting its future viability. This is the liquidity argument.
The case law on business valuation shows that the family court does not have a preference for a particular method of valuation, focusing instead on the most realistic options for a family in a given situation.
Below is an overview of the methodology used by experts in this field to give a valuation estimate to assist either in negotiations or to be used by a court if it is not possible to reach a settlement.
We also add a note of caution, given the challenges created by COVID-19.
The three most common methods used are:
- the capitalised future maintainable earning method;
- the net assets method; and
- the dividend yield method.
The first two methods are normally applied when valuing either the entire share capital of the company (because the spouse is the sole owner) or where the spouse has a controlling interest.
The dividend yield method is more commonly used to value minority shareholdings.
Capitalised future maintainable earning methods
This method seeks to calculate the amount of earnings, often in the form of turnover, EBITDA or post-tax profits, which the company can sustain for the foreseeable future.
This figure is then multiplied by a factor representing the number of future earnings that a potential purchaser might consider acquiring (often referred to as the price/earnings (P/E) ratio). The P/E ratio is obtained by comparing earnings with similar businesses that have a known market value, an investor’s required return, and/or applying a multiple of the representative earnings.
Net assets method
This method values the assets (including stock) in the business, less the liabilities of that business, at a specific date, on one or two bases:
- A breakup or force to sell basis, which assumes that the assets must be sold immediately; and
- A going concern basis, which assumes that the assets will not be sold but are to be valued on an open market basis between a willing buyer and seller.
Net asset valuation is frequently used for valuing property investment companies.
Dividend yield method
This method is commonly used to value minority shareholdings. A minority shareholder is not usually able to influence the affairs of the business because of the lack of control and can only rely on dividends for their investment.
This method is rarely used when valuing a private company (rather than a PLC) as many private companies do not pay regular dividends.
Discounts might also be applied, for example, to reflect a lack of control or lack of market if the business interest were to be sold.
Effect of COVID-19
Different businesses have faced different challenges during the COVID-19 pandemic, depending on the sector in which they trade.
By reference to the three methodologies considered above, if the business has seen a significant downturn in post-tax profits, unless the expert can be confident that the business will bounce back immediately to pre COVID-19 profitability, future earnings will be reduced, which will cause a correlating reduction in the value.
Even if a business has not been adversely impacted by COVID-19 in terms of post-tax profits, its valuation may be reduced when the net assets approach is used if a significant proportion of the business value is represented by, for example, commercial properties, as both capital values and rental incomes could have been adversely affected by COVID-19.
In contrast, if the dividend yield method is applied because the business has historically paid significant regular dividends, if that business trades in a sector which has thrived in the last 12 months (for example a business specialising in home deliveries) then on this methodology, the valuation could increase, particularly if the expert considers that the business will continue to thrive because of permanent changes in, for example, on-line shopping patterns.
Business valuations are regularly considered by the courts to be more of an art than a science and to that extent, the valuation will be subject to the expert’s views as to whether the changes brought about by COVID-19 are likely to be treated as a temporary blip or a permanent change in trading conditions for the business under scrutiny.