I want to talk to you about today is something that most business owners face with a divorce are going to have to deal with particularly if they don’t have a pre or a post-nuptial agreement in place that covers their business. And that is dealing with business valuations.
There are three primary ways to value a business or three different approaches. A forensic accountant or certified divorce financial analyst is going to look to when they’re trying to evaluate the true value of your business.
And those three ways are the income approach, the market approach or the asset approach. And each one of these looks at different sorts of things in order to come up with the valuation and the one that you’re going to see used more commonly than not in a situation where you’re dealing with a closely held corporation is the income approach.
The income approach basically, what it does is it takes a look at income. The total income that’s being generated for the business owner. And then what it does is it takes it and it capitalizes it. What does that mean? Well, what that means is, if I had an asset and that asset had to produce the amount of income that the business income, how much would that asset be? In other words, how much would that money be, okay? How much money would it take to generate it that?
So what they’ll do is they’ll calculate all of the income that is flowing to the business owner and then use a capitalization rate to determine what that ultimate amount is in that capitalization rate will take into account a number of different things including industry risks, risk related to size. All and any number of different things, there’s actually a pretty extensive list of things that can be considered. But that’s the one that you’re going to see more often than not when you’re dealing with a closely held corporation.
The other two methods— there is the market method, that’s number two. And the market method has to do with looking for comparable sales that have occurred, that you can get information about. The reason why this isn’t usually very good for closely held businesses is because usually when you’re dealing with the sale of closely held business, the information related that is not going to be public. In other words, it’s not going to be available, so you’re going to have a very, very hard time finding comparable sales. So for that reason, you’re very, very rarely going to see anybody do a market type calculation as to the value of the business.
The final one is called the asset based approach. And the asset based approach can apply to a number of closely held corporations where the business itself is more related to the value of the assets that are owned by the business than it is to anything else. And sometimes what you’ll see in that are situations where you have the business owner is the primary driving force behind the income of the business.
In a situation like that, when you sell that particular business, the presumption is you’re not selling the owner with it, which means that the thing that’s driving all the revenue is no longer part of it and in a situation like that in certain businesses where that’s the case, the better valuation, in order to get an accurate assessment of what the business could likely sell for is to use an asset-based approach and that approach is where they take a look at the value of all the assets. And they may include a small component of what’s called goodwill, which comes from simply the name of the business.