An Attorney's Preliminary Guide to Valuing a Business in Hawaii Divorces
| Publication year | 2012 |
by Thomas E. Crowley III and Stephanie A. Rezents
In a divorce action, the Hawaii Family Court is statutorily mandated to equitably divide the property of the parties, whether the property is joint or separate.1This means that, for purposes of divorce, each spouse may have an equitable interest in the other spouse's business interest, even though ownership of the business is held only in the name of the other spouse. This article provides preliminary guidelines for practitioners faced with valuing and dividing a closely held business interest in Hawaii divorces.
A spouse's business interest is often the largest asset in the marital estate. Unless the spouses agree on the value of the business — and disputing spouses rarely do — the family court must determine the value. Because business valuation is beyond the skill or experience of the average layman, lawyer, or family court judge, expert testimony is needed to assist the court in determining the value. Hawaii Rule of Evidence 702 provides:
If scientific, technical, or other specialized knowledge will assist the trier of fact to understand the evidence or to determine a fact in issue, a witness qualified as an expert by knowledge, skill, experience, training, or education may testify thereto in the form of an opinion or otherwise.
While it is the business appraiser who renders an expert opinion on the value of a business, the practitioner needs to identify the strengths and weaknesses in the expert's report and testimony. To do so, the attorney needs to understand a number of issues in business valuations, including: (1) The ownership interest being valued; (2) The standard of value; (3) The premise of value; (4) The valuation date; (5) The data relied upon by the expert; (6) The adjustment for personal goodwill; (7) The adjustment for illiquidity; and (8) Whether the non-owning spouse may receive a cash award in lieu of a division of property in kind.
The above issues are by no means exhaustive. This article is merely a "starter's kit" to help the practitioner spot preliminary issues. Space limitations preclude discussion of other equally important issues, such as: the business valuation credentials of the appraiser; the business valuation standards to which appraisers should adhere, such as the Uniform Standards of Professional Appraisal Practice ("USPAP"); the three methods (and their permutations) used to value a business: the income approach, the asset approach and the market approach; the red flag of an extremely high or low discount/capitalization rate used by an appraiser, which has an inverse relationship to the business' value (the higher the discount/capitalization rate, the lower the value of the business and vice versa); the owner's compensation (compensation directly affects the cash flows of the business, and in many privately-held businesses, the owner may over or underpay him or herself in contrast to comparable managers); and the long-term growth rate used to assume how much the business can be expected to grow per year.
The ownership interest being valued
The first step in a business appraisal is to describe the specific ownership interest being appraised. A divorcing spouse may be a 100% owner, a majority owner (such as 51% or more), or a minority owner of a privately-held business. While the prerequisites of control can differ markedly depending on the circumstances, a controlling interest is typically worth more than a non-controlling interest.
Regardless of the extent of control, stock in a private company is less "marketable" than stock in a public company, because public stock can be sold on the stock exchange at nominal cost, with the cash received generally in three business days. The sale of stock in a private company necessarily takes longer and entails more costs. The relative liquidity of the ownership interest in a private company can materially affect its value.
The standard of value
The second step in a business appraisal is to apply the correct "standard of value" to appraise the business. Haw. Rev. Stat. § 480-47(a)(3) does not specify a definition of value for property division. Hawaii case law, starting in 1988 with Antolik v. Harvey, has repeatedly held that fair market value ("FMV") is the relevant value for dividing property in a divorce action:
When dividing and distributing the value of the property of the parties in a divorce case, the relevant value is, as a general rule, the fair market value (FMV) of the parties' interest therein on the relevant date.2
Other states that adhere to the standard of FMV include Wisconsin, Illinois, Pennsylvania, Florida, Missouri, and South Carolina.3
The Antolik court's definition of fair market value requires a transaction between a hypothetical buyer and a hypothetical seller for cash, instead of what a particular spouse might do:
We define the FMV as being the amount at which an item would change hands from a willing seller to a willing buyer, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts.4
Michael T. McEnerney, Gary Kuba, and John Candon are expert business appraisers practicing in Hawaii, and are the co-authors of "Business Valuation in Hawaii Divorces," which is part of Section 7 of the 2011 Hawaii Divorce Manual ("Business Valuation Article"). In the Business Valuation Article, the coauthors quote Antolik, and write: "The relevant standard of value for any asset is that asset's fair market value ("FMV") at the relevant date."5 The co-authors warn that the FMV requirement of a "hypothetical" buyer and a "hypothetical" seller is often overlooked:
Rev. Rule 59-60 clarifies that FMV deals with a transaction between a "hypothetical" buyer and a "hypothetical" seller for cash. This point is often overlooked in valuations. A specific transaction in the stock of a closely held company is not a "hypothetical" transaction as that transaction may occur at a "price" that reflects the specific goals of a specific buyer or seller.6
Currently, there is another school of thought that rejects fair market value's requirement of a hypothetical sale if the business is not actually being sold as an outcome of the divorce. Instead of FMV, these appraisers use investment or intrinsic value, which is the value to a particular owner, specifically the operating spouse.
States that use an investment or intrinsic value standard include Arizona, California, Colorado, Kentucky, Michigan, Montana, Nevada, New Mexico, North Carolina, and Washington.7
Hawaii adheres to fair market value's requirement of a hypothetical sale whether the business is sold or not. The IRS definition of fair market value is substantially the same as the Antolik definition. The IRS Training Coursebook puts it this way: "The willing buyer and the willing seller are hypothetical persons, not actual persons . . . [T]t is irrelevant who the real seller or buyer are."8
Dr. Shannon Pratt, acknowledged as the dean of business appraisers, states that fair market value is not based on what any particular buyer or seller might do: "In most interpretations of fair market value, the willing buyer and willing seller are hypothetical persons dealing at arms' length, rather than any particular buyer or seller."9
Business appraiser Z. Christopher Mercer, author of the respected treatise, The Integrated Theory of Business Valuation (2004), explained it this way:
The lack of willingness to engage in a transaction by any particular party should not enter into the determination of the fair market value of the subject interest, else the behavioral requirements of the definition are not met. Finding that a seller would not sell because the price is "too low" or that a buyer would not buy because the price is "too high" implies analysis of the motivation of specific sellers or buyers, ignores the need to consider hypothetical sellers and hypothetical buyers, and introduces elements of speculation and subjectivity not contemplated by the definition of fair market value.10
The attorney should confirm whether the standard of value used by the appraiser is "fair market value," or the intrinsic value to a particular owner.
The premise of value
The third step in a business appraisal is to determine the "premise of value," meaning whether the business should be valued on a "going-concern" basis or on a "liquidation basis."11"Going concern" means an ongoing business enterprise.12 "Liquidation" means the net amount that would be realized if the business were terminated and the assets were sold piecemeal.13
The family court is likely to order that a business be valued as a going concern even where the company has been operating at a loss.
The valuation date
The fourth step in a business appraisal is to identify the "valuation date," meaning "the specific point in time as of which the valuator's opinion of value applies."14 As Dr. Pratt explains...
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