Closely Held and Small Business Valuation in Massachusetts Divorce Cases

HOW ARE SMALL BUSINESSES VALUED IN MASSACHUSETTS DIVORCE CASES?

When one or both parties own a small or “closely held” business, as part of the divorce process the court must value the business for purposes of property division or assignment. The court has defined closely held corporation as a business with a small number of stockholders; with no readying market for its stock; and substantial majority stockholder participation in the management, direction, and operation of the corporation.  (See Donahue v. Rodd Electrotype Co. of New England, Inc., 367 Mass. 587, 586 (1975)).  For purposes of this discussion, small or closely held businesses are any businesses that are not publicly traded on the stock market.  Businesses may take many different forms, including a partnership, limited partnership, corporation, limited liability company, S Corporation or sole proprietorship to name a few.

When parties go through divorce, if they are unable to agree on the value of the small business then there will be a trial and the judge will make a determination as to the value. Both parties would be wise to submit evidence regarding the value, and there are many ways that evidence can be presented to the judge.

Usually, the owner-spouse tries to show that the value is low and the other spouse (which we usually refer to as the “out-spouse”) tries to show the value is high.  The reason for this is the owner-spouse likely wants to retain the business but doesn’t want to pay the other spouse for his or her interest (or wants to pay the lowest amount possible), and the out-spouse wants to be paid the highest amount possible for his or her marital property interest in the business.  Judges expect these presentations from both parties.

The evidence submitted usually takes the form of expert testimony, where a business valuation expert will testify that the value of the business, based on the factors identified below, is a particular number. The expert is usually a CPA or forensic business valuation expert. Sometimes other experts are utilized such as brokers, appraisers or auctioneers.  Litigants going through a divorce are wise to retain qualified experts at the outset of his or her case, with the assistance of qualified legal counsel.

The factors that will be considered by the Massachusetts Probate & Family Court judge to determine a business’ value must include:

• The nature of the business in general
• The business’ economic outlook including the overall economy
• Book value of the stock
• The earning capacity of the company
• Goodwill
• Market price of stock of corporations of the same or a similar business.

When it comes to valuing a business there is no exact formula and truly depends on the facts and circumstances of each case. Despite there being no streamlined process for valuing closely held business, there are three traditional approaches:

1. The Cost Approach;
2. The Income Approach; and
3. The Market Approach.

The cost approach establishes the value by netting the fair market value of the assets from the liabilities to determine net asset value or the net worth of the business; the income approach arrives at a value by methods that capitalize future anticipated benefits; and the market approach determines a value by comparing the subject company to similar business, business interests, or securities that are for sale and have been sold.

Placing a value on a small business can be one of the more complicated tasks that comes up in the divorce process and will likely require the advice of an expert that specialized in business valuation. When provided proper information, a business valuation expert can help make sense of all the information that may be foreign to you and can also provide input on whether you would benefit more from coming to a settlement or proceeding to a trial. Prior to hiring a business valuation expert, it is important to discuss the cost benefit analysis with your attorney. Once it is decided that an expert is necessary in your case, the parties can choose to hire an expert independently, or jointly. In many cases, the parties will agree to split the cost of an expert by retaining the expert jointly. From a financial standpoint retaining a joint expert may seem like a no-brainer, but issues with joint retention of an expert can arise, especially when one of the parties is not happy with the joint expert’s valuation.

Before going to trial, it is important to collect as much information as possible about the closely held business. In order to properly prepare a business valuation expert will require relevant information such as financial documents, balance sheets, and documents regarding compensation and benefits provided to employees. If you do not have these documents in your custody or control, they can be requested through the discovery process. Once your expert has enough information, they can begin conducting their valuation of the business.

Massachusetts Probate and Family Courts are no strangers to issues relating to valuations of closely held business. There is well-established case law which discusses the problems of valuing a closely held business. For purposes of context, the following are just a few examples of how Massachusetts courts have ruled on this issue in the past:

• Palmerino v. Palmerino, 79 Mass. App. Ct. 1111 (2011): The trial court did not abuse its’s discretion by concluding that the Husband’s interest in the family business fell within the broad definition of marital property set forth in G.L. c. 208, section 34, even though the business was maintained and managed separately from the martial estate and the Wife made no significant contributions to it.
• Foley v. Foley, 27 Mass. App. Ct. 221 (1989): The Massachusetts Appeals Court held that where the Husband’s business was a significate part of the marital property to be divided, the trial judge improperly refused to allow husband and his expert witness to testify as to the value of husband’s business.
• Fechtor v. Fechtor, 26 Mass. App. Ct. 859 (1989): Here the appeals court dealt with the inevitable issue of conflicting expert testimony. When faced with this issue the court ruled that it is within the judge’s discretion when expert testimony conflicts, to “accept one reasonable opinion and reject the other.” When appropriate, a judge may also choose to reject both expect opinions and relay on other relevant evidence to generate a valuation of their own. To that end, the court was very clear that it would be an abuse of the judge’s discretion to determine a valuation that contradicted the evidence presented in the case or deviated from the equitable distribution statue.
• Champion v. Champion, 54 Mass. App. Ct. 215 2015: On appeal where both parties argue that the trial judge erred in his valuation the Husband’s sole proprietorship, the court held that whether a business takes the form of a corporation, partnership, or sole proprietorship, does not affect the valuation method that a court may use even though some methods may better lend themselves to particular types of businesses.
• Bernier v. Bernier, 449 Mass. 774 (2007): In this 2007 ruling, the Massachusetts Supreme Judicial Court discussed one of the most influential yet complicated issues as it relates to the effect tax benefits have on business valuations. The court ruled that an S Corporation should not be valued by the tax which is presumed to be applicable to the income of the C Corporation when, after the divorce, one party will retain all the shares of the S Corporation and will continue to run the business. Simply put, the court determined that it was improper to apply certain tax discounts when conducting a valuation on a business since it would significantly reduce the value of the business.
• Caveney v. Cavenery, 81 Mass. App. Ct. 102 (2012): Using the ideologies from Bernier, the appeals court ruled that the trial court erred in adopting the wife’s expert value of her ownership in her family’s business. Wife’s expert applied multiple discounts to determine the value of her business interest which in turn significantly lowered the valuation. The Wife argued that her “lack of control” over the business warranted the discounts to be applied. The appeals court ultimately rejected Wife’s claims and ruled consistently with Bernier, stating that no discounts “should be applied absent extraordinary circumstances.”

For additional information about divorce and business valuations in Boston, Hingham or New Bedford, please call or email our office today. We look forward to hearing from you.