Business Valuations in Light of Thornhill
| Publication year | 2009 |
| Pages | 77 |
2009, August, Pg. 77. Business Valuations in Light of Thornhill
August 2009
Vol. 38, No. 8 [Page 77]
Family Law articles are sponsored by the CBA Family Law Section to provide information to family law practitioners. Articles focus on practice tips and discussions of current issues within the realm of family law.
Coordinating Editors
Trish Cooper, Denver, of the Law Office of Stephen J. Harhai (303) 329-8300, tcooper@harhai.com; Meredith Patrick Cord, Colorado Springs, of Johnson & Cord, PC (719) 471-4034, mpc@johnsoncord.com
About the Authors
Jennifer G. Feingold is an associate at Foster, Graham, Milstein & Calisher, LLP, specializing in family law and civil litigation. Robert M. Glucksman is a staff consultant with GHP Horwath, P.C., specializing in valuation and corporate finance services and forensic and litigation consulting services. Steven B. Epstein is a shareholder with Litvak, Litvak, Mehrtens & Epstein, P.C., specializing exclusively in family law.
This article examines the history and future of business valuations in the context of domestic relations cases in light of the Colorado Court of Appeals decision in Thornhill. It also discusses alternate approaches to valuing and dividing a business ownership interest.
The Uniform Dissolution of Marriage Act (UDMA) directs trial courts to divide marital property of parties in a dissolution of marriage action.(fn1) CRS § 14-10-113 provides that the trial courts have discretion when dividing marital property. Specifically, the trial court in a dissolution proceeding is required to divide marital property equitably when considering each party's contribution to the marital estate, the value of marital assets, the economic circumstances of each party, and the appreciation or depreciation of separate property.(fn2) "Marital property" is defined as all property acquired during the marriage.(fn3)
The court, as the trier of fact, is vested with broad discretion to determine the value of an asset for division. Property must be valued as of the date of the decree.(fn4) The overarching public policy inherent in the UDMA includes the desire to divide assets equitably and to mitigate harm to spouses and their children caused by the dissolution.(fn5)
It is not uncommon to have a business ownership interest as part of the marital estate. The ownership interest must be valued to achieve an equitable division of assets and debt.(fn6) Historically, although Colorado case law has discussed acceptable valuation methodologies, such valuation expertise is largely delegated to certified public accountants and business valuation experts.
In 2008, the Colorado Court of Appeals issued the In re the Marriage of Thornhill decision.(fn7) Although Thornhill stands for a number of propositions within the family law arena, its holding with regard to business valuations and, specifically, discounts for lack of marketability, is of particular significance.(fn8) Understanding how this body of law evolved, what Thornhill may mean for its ongoing evolution, and how this area of law may look in the future is integral to advocating for a client when a business entity is involved.(fn9)
History of Case Law Defining Acceptable Valuation Practices
When dividing martial property, it is important for a business interest to be valued and divided with specificity and certainty.(fn10) If a court does not affect a divisive order for all property, it has not complied with the mandate contained in CRS § 14-10-113.(fn11) For a property division to comply with the statute, it must, at the very least, be evaluated. Should the property be fractionally divided, the mechanics must enable the division, however done, to be effectuated within a reasonable time after the proceedings. The family law practitioner should be aware that in dividing the marital estate, specific findings as to the value of each asset are not required if the basis for the trial court's decision is apparent from its findings.(fn12)
The Huff and Page Opinions
Under the broad rubric of valuing an asset, one of the first major cases to emerge on this issue was In re the Marriage of Huff.(fn13) The Colorado Supreme Court considered opposing expert testimony as to the value of husband's interest in his law firm. Husband argued the value should be based on the formula contained in his partnership agreement.(fn14) The Court rejected this argument, explaining that the formula did not consider all the present factors and intentions of the parties necessary to yield a present day value.(fn15) Instead, the Court accepted the value based on the excess earnings method.(fn16)
The excess earnings approach capitalizes the amount by which the business owner's historical earnings exceed that which a business owner with similar education, experience, and capabilities earned during that period.(fn17) This method results in a valuation that represents the value of both the tangible assets and goodwill of the partnership interest on the dissolution date.(fn18) The Huff Court held that the excess earnings valuation method is an appropriate valuation in a dissolution proceeding because it provides the present value of the partnership interest to the participating spouse and "avoids the problem of valuing a business on the basis of post-divorce earnings and profits."(fn19) Further, the excess earnings approach does not convert the husband's future income into property; on the contrary, it avoids valuing a business or partnership on the basis of post-divorce earnings and profits and achieves the mandate of the UDMA to divide property with clarity and definition.(fn20)
In addition to valuation methods, courts have focused on the application of particular factors that affect the value of an interest. One such factor is discounts. Discounts are a reduction in the value of an ownership interest based on certain characteristics of the interest, such as owning less than a majority, or an interest with a lack of marketability that would make selling the interest more difficult. Courts have focused on the appropriate timing of applying discounts when valuing a small business.
One of the first reported cases discussing discounts was In re the Marriage of Page.(fn21) In Page, the trial court heard conflicting testimony as to the value of husband's business stock.(fn22) In analyzing the different valuations presented, the court noted the contrast was due to husband's expert applying a minority discount to the minimum valuation and averaging the value using four methodologies.(fn23) The court accepted this averaging as most credible, settling on a value two to four times less than the values presented by wife's expert.(fn24) The appellate court affirmed the trial court's decision. The Page decision highlights the important role business valuation experts play in dissolution of marriage cases, as well as the significance a discount may have on the value of an asset.
Business Valuation Methodologies
As long as the resulting order is based on the factual record, courts have wide discretion to use any number of methods when valuing a business interest.(fn25) It is important for the practitioner to understand the basic tenets of different valuation approaches. Such an understanding of valuation methodology enables the practitioner to analyze valuation outputs and explain them to the court. Generally, a valuation expert should explore three approaches to business valuation: (1) the income approach; (2) the market approach; and (3) the asset approach. In many instances, the valuator must employ multiple approaches and be able to reconcile any differences between them; this ultimately will bolster the expert's results.
Income Approach
The income approach to valuation can be broken down into methodologies based on the particular characteristics of the entity. One valuation method involves estimating an entity's expected future economic benefits that is, annual earnings or cash flows and then discounting them to present value using a discount rate suitable for the risks associated with realizing those benefits.(fn26) This is also known as the discounted cash flow method.
It should be noted that forecasting future cash flows may be speculative; the value ultimately relies on management assumptions. In the context of valuations for marital proceedings, this can be a strong point of contention between parties. Underlying assumptions of the valuation would in some part be coming from the party owning the interest. Thus, that party would be driving the valuation. As a result, the discounted cash flow method is not employed in the context of marital proceedings.
An alternative method of the income approach involves taking an entity's normalized level of ongoing benefits expressed as a single amount and capitalizing them to estimate value. This is known as the capitalization of benefits method. Generally, this approach is used for profitable entities wherein the company has an established earnings history, enough reliable data is available to reasonably estimate expected normal earnings, and the company's value is derived primarily from the present value of the economic benefits of ownership therein. However, a weighted average of earnings over a designated time period may be capitalized to reflect expectations of future performance.
An additional method involves deriving excess earnings by subtracting from net income a reasonable return on the net tangible...
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