Family Businesses: How to Survive a “Divorce”

Many successful small manufacturing businesses are run by families. Unfortunately, when business and personal lives are so intertwined, disagreements sometimes happen and family members decide to part ways. Here are valuation methods that apply when divvying up a marital estate that includes a family-owned business — or when buying out a dissenting shareholder.

Valuing a private business interest

The question on everyone’s mind in shareholder divorces and buyouts is: How much is the business worth? There are three ways to value a privately held manufacturing business. First, the cost (or asset-based) approach starts with the company’s balance sheet. Then adjustments are made to various balance sheet accounts — such as inventory or equipment — to reflect fair market value (rather than historic cost).

For example, raw materials inventory may be undervalued if your company uses the LIFO (last in, first out) method. Similarly, equipment may be undervalued, because manufacturers typically use accelerated tax depreciation methods.

The cost approach may overlook “goodwill” and other intangible assets. The value of intangible assets is better captured by the market and income approaches, however.

The market approach derives value from sales of similar businesses. Here, the value of the company is derived from a pricing multiple, such as price-to-earnings or price-to-EBITDA (earnings before interest, taxes, depreciation and amortization expense).

Under the income approach, a future earnings stream (typically cash flow) is discounted to its present value. When future cash flow is expected to be stable, it may be divided by a capitalization rate, which can be thought of as the mathematical inverse of a pricing multiple under the market approach.

Measuring goodwill

Goodwill is the excess of a business’s value (under the income or market approach) over its net tangible book value (the cost approach). In a few states, the entire value of the business — including goodwill — is part of the marital estate. Alternatively, some states exclude all goodwill from the marital estate.

About half the states separate goodwill into two pieces: personal goodwill and entity goodwill. The former can’t be separated from the business owner. The latter is a function of the business’s location, employees, name recognition, contracts and customer lists. These states include entity goodwill in the marital estate, but exclude personal goodwill if maintenance awards are based on the owner’s future earnings.

Personal goodwill is most frequently associated with professional practices, such as medical practices or law firms. But some courts recognize that manufacturers can possess personal goodwill — for example, if the business’s success is tied to key relationships with the owner or if the owner has unique knowledge that can’t be (or hasn’t been) transferred to others.

When evaluating personal goodwill in a dissenting shareholder context, it’s important to consider whether personal goodwill could be transferred to a third party. If a shareholder would need to work closely with a hypothetical buyer to transition the business after a deal closed, a portion of personal goodwill might belong to the individual shareholder, rather than the business.

Adjusting the financials

Family businesses aren’t always run like publicly traded companies that strive to maximize profits and shareholder value. So, adjustments may be needed to reflect how unrelated parties would operate the business.

Common financial statement adjustments include:

• Owner and family member compensation and perks (including company vehicles and season tickets to sporting events),
• Non-market-value rent paid to related parties,
• Inventory accounting anomalies, and
• Unrecorded liabilities (such as pending lawsuits and warranty claims).

When valuing a minority owner’s interest, courts in divorce and dissenting shareholder lawsuits generally consider whether a buyout price is fair. So, they may sometimes be reluctant to apply discounts for lack of marketability and control if the discounts would provide a windfall to the controlling shareholder.

Finding your expert

Do-it-yourself valuations are unlikely to withstand scrutiny in court. If your business needs to be valued for a shareholder divorce or buyout, contact a business valuation specialist. Choose someone who understands manufacturing industry trends, accounting practices and key value drivers.

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