Divorce Business Valuations – The Discounts Dilemma

By Donald Ray Bays, CPA, ABV, CVA, CFF

In high-asset divorces, few issues spark as much contention as the valuation of a closely held business. At the center of this financial tug-of-war lies a critical question: should discounts for lack of control and marketability — standard in business appraisals, apply when dividing marital property? With potentially tens or even hundreds of thousands of dollars at stake, judges, attorneys and appraisers often find themselves navigating murky legal and financial waters to determine what a business is truly worth in the eyes of the court.

For most married couples, going through a divorce is not a fun process. This can be especially true if child custody, child support, spousal maintenance or property settlement issues are involved.

One property settlement issue that can cause a great deal of acrimony between a divorcing husband and wife is determining the value of a business owned by the couple. This usually involves a business operated by one of the spouses and usually the spouse operating the business wants to keep it. If the couple resides in a state where any property acquired during the marriage is considered owned by the marital community, then the operating spouse will most likely have to pay the non-operating spouse fifty percent of the value of the business.

Business Appraisers in Divorce Cases

Frequently, the married couple will hire a business appraiser to value the business close to the date one of the divorcing parties serves notice to the other party that they are filing for dissolution of the marriage. Sometimes the appraiser will be jointly retained by the husband and wife. However, one spouse may believe that the valuation of the company by the jointly retained appraiser is unfair and will contest the appraised value in the courtroom. They may even hire their own business appraiser to support their position.

Qualified business appraisers may treat the same factors that affect
the value of the targeted business differently. Such differences might be in the determination of an appropriate earnings, cash flow amount or capitalization rate to be used under an income approach to valuation. Different appraisers may also treat the amount of discounts
to be taken from the calculated value differently. These discounts are typically called “discount for lack of marketability (DLOM),” and “discount for lack of control (DLOC).”

DLOM and DLOC in Business Valuations

The American Institute of CPAs (AICPA) defines the DLOC as “an amount or percentage deducted from the pro rata share of value of 100% of an equity interest in a business to reflect the absence of some or all of the powers of control;” and DLOM as, “an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability.”1 And yes, two qualified appraisers can have different amounts for the DLOC and DLOM used in their valuation of the marital community’s business.

Under the “fair market value” standard used to value business interests for buy-sell purposes, the DLOC and DLOM are usually considered. Fair Market Value is defined as, “the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”2 Under the standard of fair market value a DLOM is usually considered, and under the standard of fair market value a DLOC is usually considered if an ownership interest of less than 50% is being valued, such as the valuation of a 49% or less, business ownership interest in a divorce.

Why DLOM and DLOC Matter in Divorce Cases

Where am I going with this writing of DLOC’s, DLOM’s and fair market value? Let me explain.

Judges in some of the family law courts in which I’ve testified regarding divorce business valuations believe the DLOM and DLOC are appropriate. Others believe that the valued interest should be treated like many states treat the value in oppressed shareholder valuation cases – no discounts are to be considered.

A judge who does not allow the discounts may be awarding the non-operating spouse a value that is as much as 10% to 40% higher than what the value would be under the standard of fair market value. This of course would be to the benefit of the non-operating spouse whose 50% interest is being purchased by the soon-to-be ex-spouse. The paying spouse, however, is likely going to cry “foul.” The paying spouse will argue that he/she will have to consider at least a DLOM when they sell 100% of the company in the future — that they will take the hit for the discount at that time. As noted above however, the judge may consider the valuation similar to an oppressed shareholder case valuation and not allow any discounts to be taken. The judge may also consider that the operating spouse will continue to run the business as usual the next day after the marriage is dissolved and that no discounts are warranted.

Conclusion

For business appraisers who value business interests in divorce cases, it is important to know whether the attorney retained by the appraiser’s client will argue to have the discounts eliminated from the targeted business’ value — or to keep them intact, depending on whether the attorney’s client is going to be the buyer or the seller in a divorce. Many business appraisers who value businesses in marital dissolutions will show the final value of a 50% interest both ways — with and without the discounts. They leave it to the trier-of-fact to make the determination of which value is the fairest to both parties.