The annual number of divorces and annulments in the U.S. was close to 900,000 in 2012.  While every divorce is complicated, those involving marital estates with closely held businesses are especially complex to dissolve and distribute.  Because of the unique nature of every company, businesses are often one of the hardest asset to value in the marital estate, and without a prenuptial agreement, the business is considered subject to distribution upon divorce.  There are basically three ways in which a couple can handle a business during a divorce: co-ownership, sell the business and divide the proceeds, or buy-out the other spouse’s interest.

One of the complicating and disputed factors in business valuations for divorces is the standard of value that is used. Typical business valuations are based on fair market value, which the IRS defines as, “the amount at which the property would change hands between a willing buyer and a willing seller when the former is not under compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.”  However, in many cases the use of fair value has trumped fair market value in divorce cases.

The complexity of the issue lies in the fact that fair value does not have a standard definition, and its use and exact definition vary from state to state based on case law and statutes.  Ibbitson defines fair value as, “The amount that will compensate an owner involuntarily deprived of property. Commonly there is a willing buyer but not a willing seller, and the buyer may be more knowledgeable than the seller,” but adds that its definition is subject to judicial interpretation.  In short, fair value is only focused on the sell side of the transaction, while fair market value considers both the sell and buy sides.

In cases involving dissenting shareholders, courts have ruled that the application of discounts for control and marketability in deriving the fair value of these shareholders’ stock is inappropriate.  For example, in Swop v. Siegel-Robert, Inc., the court concluded, “The marketability discount is incompatible with the purpose of the appraisal right, which provides dissenting shareholders with a forum for recapturing their complete investment in the corporation after they are unwillingly subjected to substantial corporate changes beyond their control. . . We conclude that the market for minority stock in a dissenting shareholders’ appraisal proceeding, absent extraordinary circumstances, is not a relevant fact or circumstance to consider when determining fair value.”  In reference to the preceding ruling Winn v. Winn Enterprises, Ltd. stated, “The individual (whether a dissenting shareholder or a withdrawing partner) is exercising a statutory right to withdraw from the entity and the entity is absorbing that interest. If discounts are applied, the entity obtains the withdrawing shareholder or partner’s interest for less than that interest would be worth in the hands of the withdrawing shareholder or partner.”  Thus, allowing the application of discounts for lack of control and marketability in these cases would have disadvantaged the dissenting shareholders while benefiting the remaining shareholders.

In connection to divorce cases, a number of courts have concluded that the sale of one spouse’s interest in a closely held business to the other is parallel to a dissenting shareholder withdrawing from an entity, and thus the same standard of value, fair value, should be applied.  In Baltrusis v. Baltrusis, a husband and wife holding individual minority interests in a company owned by the wife’s family filed for divorce.  The wife obtained an appraisal which applied a 33% discount for lack of marketability in arriving at the fair market value of the stock.  The court ruled that it was inappropriate to apply the discount, citing that the husband in this case was akin to a dissenting shareholder, because he was an “unwilling seller with no bargaining power.”  The reason he was selling was due to court-ordered compulsion, and the only market for his shares was his ex-wife and her family, who would benefit from acquiring his interest in the company.

Although there is not a standard definition of fair value and whether or not it is appropriate for business valuations in divorce cases, many states have ruled that it is the appropriate standard of value to be applied.  The common theme in the case law that supports the use of fair value is that there is no reason to allow one spouse to minimize the marital estate at the expense of the other spouse.  However, as mentioned before, the statutes concerning divorce cases vary from state to state and are always subject to judicial interpretation.

The issue of standard of value outlined above highlights the complexity of business valuations and the need for independent valuations performed by qualified valuation firms in order to navigate and interpret the nuances of business valuations and local law.  EP is an independent and qualified valuation and advisory firm that provides expert opinion and valuations for collaborative divorce settlements.  The firm’s expertise and in-depth knowledge allows it to advise on cases involving business with the simplest or the most complex capital structures.