When a divorce involves the division of a family-owned or closely-held business, determining the business’s value becomes a critical issue. Whether you and your spouse shared your business duties equally or one of you took a lead role while the other was more of an assistant (or even uninvolved), that’s a significant asset – and some or all of its value may need to be split.
Three primary valuation methods are commonly used: asset-based valuation, income-based valuation, and market-based valuation. Here is some information that can help you understand how each one works and its suitability for your situation:
How asset-based valuation works
As the name suggests, this method focuses on assessing the value of a business’s assets and liabilities. The evaluator compiles a comprehensive list of the business’s tangible and intangible assets. Tangible assets can include real estate, equipment, and inventory, while intangible assets may comprise intellectual property, trademarks, and patents.
All outstanding debts and obligations, such as loans and accounts payable, are deducted from the total asset value to determine the business’s net asset value, which is it’s actual worth.
Asset-based valuation is appropriate for businesses where the underlying assets play a substantial role in determining the company’s worth, such as manufacturing companies or real estate investment firms. It provides a clear picture of the business’s liquidation value or the value of its assets if sold individually.
How income-based valuation works
Income-based valuation methods assess a business’s value by considering its income or earnings potential. The valuation process focuses on the business’s historical and projected financial statements, including its income, expenses, and cash flow. Common methods include capitalization of earnings and discounted cash flow analysis.
The evaluator also assesses the risk of financial losses associated with the business, considering factors such as market conditions, competition, and management competence.
Income-based valuation is suitable when the business’s value is closely tied to its earning potential. It provides a forward-looking perspective and is especially useful for businesses that generate substantial income through their operations. This approach is frequently used for service-based businesses, professional practices, and companies with significant intangible assets.
How market-based valuation works
Market-based valuation relies on comparing the business being valued to similar businesses that have recently sold or are publicly traded. The evaluator researches transactions and market data for businesses in the same industry and geographic region. They can then identify appropriate valuation multiples, such as price-to-earnings ratios or price-to-sales ratios.
The evaluator then compares the subject business’s financial performance, size, and other relevant factors to those of the selected comparable businesses to determine a value range that can approximate the actual worth of the business in question.
Market-based valuation is effective when there is a well-established market for similar businesses, making it easier to find comparable data. It provides a benchmark based on real-world market transactions. This method is most applicable when there is a robust market of comparable businesses.
In divorce proceedings involving a business, selecting the appropriate valuation method is crucial to ensure a fair distribution process. Each of the three methods — asset-based, income-based, and market-based — offers a distinct perspective on a business’s value, and the choice should align with the specific characteristics of the business in question. Legal guidance can help you make good decisions about how to proceed.