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Professional Practice Valuations print this article

 

It is a sad but true facet of modern day life that divorce is a common occurrence. A common valuation/appraisal assignment concerns the unique considerations associated with this tragic event. If a business is involved in divorce proceedings, it may represent the most valuable asset of the couple's holdings and thus often becomes a major source of conflict. The situation is complicated when both spouses have been working in the business and when the business has been the sole or primary source of income. The typical resolution involves both parties obtaining business valuations and then either settling out of court or allowing a judge to make the final decision.

There are many important factors to consider when handling a marital dissolution, including the notion that distribution of the marital estate is driven by state-specific laws. In Arizona, the basis for the distribution is found in community property statutes and their related court findings. The community property standard implies that all assets acquired during the marriage are assumed to be acquired by and jointly owned by the marital community. Judicial precedent is often utilized by the court, so the hiring of an experienced attorney is a critical step towards protecting each side's interests. Typically, the valuation or appraisal is conducted by the valuation professional in conjunction with an experienced divorce attorney. Reviewing Maricopa County Superior Court cases and Division I and II Court of Appeals findings will improve the valuator's understanding of various legal interpretations of all related issues.

Selection of the valuation date is another important issue. Once again, the legal professional must guide the appraiser in establishing the "as of " date, choosing among:
     Date of marriage
     Date of actual or legal separation
     Date of legal filing for divorce
     Date of the trial


If not formally addressed by the court prior to trial, the valuator must be prepared to offer results based upon each of these dates. According to Lee Richard, attorney with Mariscal, Weeks, McIntyre and Friedlander, using a valuation date as close as possible to the trial date is the preferred approach, barring specific directions from the court.

During the "discovery" process, if one of the spouses is not actively involved with the business, it is necessary to provide a written request for copies of all relevant documents, including the articles of incorporation, by-laws, minutes, financial statements, tax returns, existing contracts and any other document that might impact business valuation. Since a second request for information is not always possible, the initial request should be as thorough as possible.

Concerning the appropriate valuation approaches and methods, once again it is important to determine the "judicial precedents" that exist. Once you know which judge will be hearing your case, it is worthwhile to review his or her prior findings to properly understand what is important from their point of view. As is true for all valuation assignments, the pertinent valuation techniques will fall under one of three major approaches: Income, Market and Asset-Based.

Income based techniques include using multiples of adjusted cash flow (ACF), e.g. three times ACF and discounted cash flow analysis (DCF); market based methods rely on using statistics related to the sale of "similar" companies; asset-based techniques rely on adjusted balance sheets and include the "excess earnings method", which holds that the value of a business is equal to the sum of the FMV of the tangible assets plus a capitalized value of the firm's goodwill (reflecting the firm's excess earnings beyond a normal return). Although each of these approaches can play an important role in a given valuation assignment, it is noteworthy that the courts in general have grown in their sophistication to a point where the most widely accepted techniques are discounted cash flow analysis and the use of market comps. The IRS, for example, which created the excess earnings approach in the 1920's, now holds that this method be used only if no other technique can be properly applied.

Other important issues include:

Value of and distinction between professional and practice goodwill
Adequate compensation
Minority interest and marketability discounts and control premiums
Covenants not to compete
Proper role of the valuation analyst

This article continues an analysis of issues surrounding the valuation of professional practices as they relate to divorce settlements. The most substantial asset in a marital community is frequently a business started by one or both spouses during a marriage. Each state has its own marital dissolution statutes and case law, creating the need for experienced legal counsel. In community property states such as Arizona, all assets acquired during the marriage are typically considered to be jointly owned by the marital community (the exceptions to this rule should be explained by your attorney).

Since most state statutes addressing marital dissolution are silent as to the applicable "standard of value", e.g. fair market value, fair value, intrinsic value, investment value, etc., the valuator must rely on legal counsel. Review of local judicial precedent is mandatory. Most courts will utilize fair market value (FMV), but some judges prefer investment value (IV). IV refers to the value of a given asset (company) to a specific buyer, i.e. the current owner, whereas FMV refers to a hypothetical buyer acting with complete information and under no duress, etc. This distinction becomes clear when dealing with professional practices such as accounting practices, medical offices or legal firms. A medical specialist may possess unique skills that are not easily replicable and relationships with patients that are not transferable. Generally, IV will be greater than FMV.

A unique aspect of professional practices is the importance of goodwill. Unfortunately, goodwill is a term that has numerous interpretations under varying circumstances. In terms of professional practice valuation, it refers generally to the value of a practice beyond the value of the tangible assets such as furniture, fixtures, equipment and real estate. The importance of this concept for medical practices is evidenced by a publication known as "The Goodwill Registry". It reports the total value of a firm's intangible assets under the term goodwill, representing such assets as favorable contracts, the doctor's reputation, below market rents, non-compete agreements, patient list, etc. Medical practices from over 250 specialty areas were tracked between 1988 and 1997, generating an average goodwill value of 35% of the firm's total revenues. To complicate matters, courts may differ in their assessment of "practice goodwill" versus "personal goodwill", also referred to as institutional and professional goodwill respectively. Some states consider only practice goodwill as a distributable asset. Practice goodwill refers to the intangible value that would continue to exist without the presence of the current owner whereas personal goodwill is reflection of the unique attributes of the primary service provider (owner). Once again, consulting experienced legal counsel is mandatory.

Covenants not to compete executed as part of the purchase contract can also be problematic. If the professional practice is sold during the divorce proceedings, the portion of the purchase price allocated to the covenant may or may not be considered part of the marital estate. In general, since this covenant would restrict the earnings capacity of the selling spouse, it would not be considered part of the marital community. The compelling question may become whether or not the amount assigned to the covenant was proper. When one spouse attempts to buy out the other, this issue grows in importance.

Finally, there may be valuation discounts/premiums involved in the final estimate of value. I recently applied a substantial discount for lack of marketability to to the value of a practice due to the nature of the company's ownership structure, which involved outside majority share owners entangled in a series of trusts (domestic and offshore). Another common valuation discount arises when there is a minority interest involved. Basically, the value of 10% of the shares is not equal to a prorata interest of the firm's overall fair market value. For example, a 10% interest in a firm valued at $1 million would be less than $100K by a factor commonly ranging between 15% and 25%. Note that when both minority interest and marketability discounts are applicable, they are multiplicative in nature, e.g. after applying the minority interest discount, the marketability discount is applied on this reduced figure.

In conclusion, valuation of firms involved in divorce proceedings is uniquely ambiguous and dependent upon state statutes and case law. Consulting experienced legal counsel is mandatory for valuation purposes alone. The attorney and the valuator must work together closely to provide a user-friendly, coherent, credible and well documented valuation report that will stand up under the close scrutiny of opposing counsel and the court.

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