Ryan Kalamaya breaks down how businesses are valued in a divorce in Colorado.
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Ryan Kalamaya (1s):
Welcome to divorce at altitude, a podcast on Colorado family law. I'm Ryan Kalamaya each week, along with my business partner and cohost Amy Gosha or an expert, we discuss a particular topic related divorce or co parenting in Colorado. In addition, we have created a short series of lessons that will take you through the legal process of divorce and answer your questions from simple to complex divorce. Isn't easy. The end of a marriage, especially when children are involved, brings a great deal of loss and change. We hope these practical tips and insights will help you on your journey to a new and better life.
Ryan Kalamaya (43s):
This episode is on Business Valuations. It's part of our series on property division in a Colorado divorce. If you aren't familiar with Eric Wolf story, you should check it out. It's in episode one, and you can also search online for Eric Wolf and my last name. And you'll be able to read the story about Eric Wolf. The reason that's helpful is Eric Wolf is a business owner. One of the questions that he has that we frequently hear is what is going to happen to my business. And also how do we value a business in a divorce? So let's kind of cover some general concepts before we dive into specifics on Business Valuations and Colorado divorce.
Ryan Kalamaya (1m 22s):
First property shall be valued as of the date of the decree or the date of the hearing. If the hearing predates or proceeds the date of dissolution. So if you go to trial on the value of your business, it's going to be your trial date. It's not when you separated, it's not when you filed. And so if your business is making a significant amount of money during the pendency of the divorce, that's going to be included as marital property. The objective of the core is to determine the approximate current value of all property owned by the parties. The determination of value is within the sound discretion of the court. So the court is given wide latitude in determining value of business interests in a divorce.
Ryan Kalamaya (2m 6s):
Valuations generally require the testimony of experts. If you are concerned, or you want to understand more about how experts are involved in their color, a divorce, we have a variety of other episodes, including one involving Eric, six evaluation expert, and a presentation that we both gave to the family law Institute. It's also important to understand that business interests and the owner of a business can testify as to their opinion on value, even though they're not an expert and that's pursuant to a case called NRA marriage, a plumber. So let's get into the nitty-gritty of what experts generally will look at when they're evaluating business interests in a Colorado divorce, there are three basic approaches to Business Valuations.
Ryan Kalamaya (2m 51s):
The first is an income approach. In essence, under an income approach, the value is estimated based on the company's future earning capacity. Now that might seem in conflict with the general principle of the fact that post decree earnings or money earned after a divorce is not supposed to be considered marital property. But if we look at the income approach, there are various methods based on the income of a business. One of those is the access earnings methods commonly used in dissolution of marriage proceedings, particularly where a service business or a professional practice is involved. That would be a law firm, a medical practice somewhere where there's a professional involved.
Ryan Kalamaya (3m 35s):
So an accountant, something of that variety, the access earnings method applies a multiple that reflects the stability and predictability of future earnings attributable to the ownership of the business. And the way to think about the excess earnings method is you look at a baseline or what the average of professional earns in that particular business. And then anything above that is going to be the access earnings. Now, many valuation experts will use the excess earnings method in a professional practice. And that's because there is a case called NRA marriage of Hough in which the access earnings method was used on a professional practice is actually a lawyer.
Ryan Kalamaya (4m 15s):
And you should understand or know that in Hoff, there was a multiplier of three times excess earnings. So many valuation experts will rely on three as the default multiplier, but it's going to depend on the case and circumstances. Some professional literature would use a lower multiplier for professional services. There are other methods with in the income approach, those would be capitalization of earnings, as well as a variety of other methods. Another way a valuation expert will value a business interest in a cholera divorce is to look at the market approach. That is where the value is calculated by comparing the subject business with transactions involving comparable businesses.
Ryan Kalamaya (5m 2s):
The easiest way to think about this is that there's a stock market, say the NASDAQ, and you can look at how much a business is worth based on what the market is willing to pay. Now, most business interests that are involved in, in Colorado Divorce are going to be closely held or private businesses. Many valuation experts will have access to information regarding sales or markets regarding closely held businesses. For example, restaurants or dental practices or estate planning for lawyers. Those kinds of businesses across the country are frequently sold. And there can be a different methodology that is used for each particular industry to determine what the market rate is now in a market approach to accommodate the differences between the reported transactions and the subject business.
Ryan Kalamaya (5m 52s):
There must be various adjustments based on risk and the differences that be involved in the particularities of that case. Finally, we have the cost or asset approach in this approach. The value is based on the value of the underlying assets, less the liabilities, the easiest example is a business that owns some sort of real estate. The value of the business is based on the underlying real estate that is owned by that business. The asset approach is typically used for businesses that are not profitable for which the other methods would produce a lower value than the value of the underlying assets of the business.
Ryan Kalamaya (6m 35s):
So if there's some sort of building or some sort of interest that is not producing that much income, we might look at the asset approach to determine the true value of that particular business. And one related topic is whether or not we're talking about some sort of auction or fire sale or duress in terms of selling these various assets. Now, other valuation experts, they might take a hybrid approach. So they might look at the cost approach or the asset approach and put 50% on that value. And then look at the income or the market approach and put 50% weighting. All of these things are going to be within the professional decision-making of an expert witness.
Ryan Kalamaya (7m 19s):
Next, let's talk about the standards of value and discounts as they relate in a business valuation in a Colorado divorce. First there's investment value. That is the value of the business in the hands of the current owner. So if Erik owned some sort of software business, then the value of the software business is how much is it to Eric? And that would Eric specific knowledge, his earning potential expectations of risk and so on. Then we also have fair market value, fair market value is that software business that Eric owns. And that's the price at which the property would be changing hands between a willing buyer and a willing seller.
Ryan Kalamaya (7m 59s):
So it's under the assumption of a buyer and a seller, but it's not under a, for sale. So it's, how much is it going to sell for, if there is a seller and a buyer with reasonable knowledge of the relevant facts, then we get into fair value and that's going to be implied in measuring the value of a business for the purpose of a dissenting shareholder action. Generally, that's not what is going to be used in a Colorado divorce. Typically what we're dealing with is investment value in fair market value. So how do the courts decide? Well, generally speaking, fair value is not used in a cholera divorce. Often valuation experts will put out two different numbers, one for investment value and the other for fair market value.
Ryan Kalamaya (8m 43s):
Generally speaking, courts will follow investment value when the asset, the business is not going to be sold and, but they might apply the fair market value. So what kind of discounts would apply in a business? Well, the first is you have lack of control. So if you are a minority shareholder or owner of a business, and you don't have control over the various business decisions, there could be a discount. And that's because the business is worth less because you can't control it. Controlling interest has the power to determine the business's operations, which is more valuable than obviously a minority or passive interests. What else? Well, you're talking about a marketability discount.
Ryan Kalamaya (9m 23s):
This was raised in the case of NRA. Marriage of Thornhill in marriage of Thornhill was a case that loud courts to consider discounts and Business Valuations, for lack of marketability. Now it, sometimes people refer to NRA, marriage, a Thornhill and say that it requires such discounts, but that's not what the case says. Instead allows if the court decides whether or not it's appropriate and experts vary widely on the extent of the discount to be taken. And essentially it's going to be lack of liquidity and lack of marketability in the fact that the business is not for sale, or can't be converted into income at that particular moment.
Ryan Kalamaya (10m 4s):
Now I'll wrap up in terms of buy, sell agreements. Typically those are involved or an operating agreement that will spell out what exactly an owner is entitled to. If there's a dissolution or some sort of divorce. Now, frequently owners of businesses will say, well, that's just the end of the story. We'll just follow the operating agreement or the buy-sell agreement. Colorado courts will consider these agreements in evaluation, but they're not conclusive. And that's pursuant to the Kaiser case. Typically buy, sell agreements are adopted with a view to provide a disincentive for the withdrawal of a shareholder partner or member. So the buy sell agreement is typically going to have a value that would be significantly less than if he or she stayed with the business.
Ryan Kalamaya (10m 49s):
Now, there are so many different elements of Business Valuations. If you're dealing with some sort of business that requires an expert, you're also probably going to be typically dealing with a divorce lawyer. Who's going to explain these details or these concepts in detail, but for now, hopefully that's helpful for you in understanding what Business Valuations ha and how they work in a Colorado divorce. Thanks for listening or watching this short lesson on the Divorce at Altitude podcast. If you found this helpful, please leave a review or share with a friend. It does help for others that are going through or thinking about a divorce in Colorado. If you want to find out more information, please visit Kalamaya law or Divorce at Altitude dot com.
Ryan Kalamaya (11m 30s):
That's K a L a M a Y a dot Law. Remember, this is educational information. It's not intended to be legal advice. Please consult with an attorney about the particulars of your case. We're happy to answer questions. Feel free to give us a call at (970) 315-2365.