As we explain in our CFL™ course, forensic analysts base business valuations on future expectations of value or economic benefits. They don’t follow a set formula, therefore, valuations are sometimes more of an art than a science. Timelines and current economic conditions affect the overall appraisal.
How Does Business Valuation Work?
Among the main factors, business appraisers use a standard of value, a suitable valuation approach, and an appraisal date.
Depending on your jurisdiction, the standard for asset valuation is often fair market value. The IRS defines fair market value as the price a willing buyer and seller agree on in an open market, “with neither being required to act and both having reasonable knowledge of the relevant facts.”
Appraisers evaluate businesses using one of three approaches:
- the market approach: comparing a business or business interest to similar ones that have sold recently
- income approach: converting the future value of economic benefits, such as cash flows, into present values; this is often used when reliable market data isn’t available and for businesses with an operating history
- asset-based (cost) approach: combines the fair market value with the net assets; it suits real estate, holding companies, and start-ups
When a valuation date has been set, the appraiser’s data is based on facts known and knowable as of that date. For example, if a divorce was final on December 31, 2019, the valuation will likely differ compared to a case that began on that date.
Handling the Date of Valuation in an Uncertain Economy
In a changing economy, attorneys can decide whether to continue or postpone divorce cases. Clients may also think about making a claim for relief based on unprecedented economic uncertainty.
According to state law, consider whether there’s a cut-off date or date of commencement or valuation that may pre-date the case.
For appraisal purposes, the attorneys involved can also agree to change the date of valuation; some evaluators are wary about adjusting a valuation already done for an existing date. Some parties might seek a settlement based on an older valuation date, or be open with time-frames or deferred payment terms. Others may decide to wait before they resolve a settlement tied to a business valuation and work on other parts of the case.
How Economic Crises Influence Valuation
Especially in an uncertain economy, the same valuation principles for private businesses generally don’t apply to public companies.
Most economic downturns occur because of traditional factors, but some are hard to predict. The COVID-19 pandemic began to trigger capital markets from mid-February to early March 2020; stock market and unemployment rates changed suddenly.
Business evaluators use IRS Revenue Ruling 59-60 as a checklist for valuations, but as expert Ken Pia noted in a recent webinar, COVID-19 has probably required a reassessment of those guidelines.
In deciding how an economic downturn may influence a settlement and/or a valuation, among the variables to consider, evaluators determine:
- the effect on the business
- how it handles expenses
- whether it received investment money
- how it reacted to similar situations
Further, the appraiser considers the factors that affect the return on investment or risk-adjusted discount rate, such as the length of business operation, unique company and/or regional characteristics, and market uncertainties.
Under the income approach during a recession, cash-flows may have decreased. If a business reduces spending, it can lower or stabilize financial risk and potentially minimize a decrease in value. During COVID-19, over the short term, cash flow and growth rate projections based on what was known or knowable as of the valuation date could be skewed. Evaluators may then consider reporting any material developments that happen after a valuation date.
Loans and investments and any associated debt also factor into a valuation, especially during a downturn. For instance, Paycheck Protection Program (PPP) and other loans businesses receive for relief can affect cash flow statements, but not operation earnings. The PPP is more of a forgivable loan (like a one-time grant). A business should change future 2020 financial statements because of the loan, but tax issues, such as large refunds from amended tax returns, can also affect cash flow statements. This is also helpful to know for calculating income for spousal support.
As they assess whether the impact of the pandemic will be similar, some appraisers may reexamine some of the valuation changes that occurred during the Great Recession (2007-2009).
Why an Investment in Knowledge Pays Off
Financial literacy is the cornerstone of a successful family law practice. Our CFL™ course teaches you all about business valuation and other complex financial matters in divorce to help you serve your clients better.
We thank all the AACFL members who join us in advancing the cause of financial literacy in family law. Greater knowledge of the subtle aspects of business valuation, calculating support, and more benefits our entire legal system, from the attorneys to the courts and the clients.