Valuation of Assets


     By Anderson & Associates, P.C.

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Addresses valuation methods and issues for personal property, investments, real estate, retirement benefits and closely held businesses. The discussion of retirement benefits includes a review of the case law relating to the classification of the marital and non-marital portion of the benefits. The discussion of closely held businesses includes a review of the case law relating to personal and enterprise goodwill.

Different methods need to be used to value different types of assets. A few examples are discussed below.

A. BANK ACCOUNTS, PUBLICLY TRADED SECURITIES, CREDIT CARDS, MORTGAGES AND SIMILAR ASSETS AND LIABILITIES

The valuation of bank accounts, publicly traded securities, credit cards, mortgages and similar assets and liabilities, is less problematic than other assets. The main issue is that, pursuant to Section 503(f), the assets and liabilities are to be valued as of the date of trial or as close thereto as possible. The most recent periodic statement can be used. Up to the minute values may be available online. Keep an eye on these values throughout the litigation. They are volatile. Deposits, withdrawals and liquidations constantly change the valuations of this type of assets. To stabilize the value and prevent dissipation in contested cases, a petition for restraining order should be considered.

B. MOTOR VEHICLES
Theoretically, an expert can be called to testify regarding the value of motor vehicles. From a practical standpoint, the cost and logistical problems will generally outweigh the benefit. Blue book value, CarMax appraisals, and other such valuations are hearsay. The parties’ can testify regarding value but their opinions are likely separated by a few thousand dollars. Try to stipulate to a value. If that cannot be done, the client must be called upon to testify as to value.

The key to using the client as a witness regarding value, is to avoid direct reference to hearsay evidence. Ask the client if he or she has an opinion as to value. Ask what he or she did to research the value. The response will include such things as a review of Blue Book, CarMax, and cars that are listed for sale, or that have sold through the newspaper and on the Internet. Do not ask the client to tell you specific results of any of those investigations. Instead ask, “based on those investigations, what is your opinion of value?” If you prevent the other party’s opinion of value from being admitted because it is hearsay, and confirm your party’s opinion of value avoiding hearsay, your value will be used. As a practical matter, the judge may not let that happen and will just allow the hearsay testimony or handle it in some other way. Whatever you do, do it quickly. Domestic relations judges have little patience for motor vehicle valuation testimony.

C. REAL ESTATE VALUATIONS
The valuation of real estate is at issue in many divorces. A large percentage of divorcing couples own a marital residence. Others own a vacation home and/or real estate investment properties. Unlike many other assets, real estate cannot be easily liquidated and divided. It can also serve as a residence. One of the parties may want to live in the property after the dissolution especially in cases involving minor children. To effectuate division of the marital assets in such cases, the property must be assigned a value, and the spouse retaining ownership of the property needs to buy out the other party’s interest through the allocation of other assets, with cash received from a refinance, or otherwise. Other real estate valuation issues arise relative to contribution, dissipation, fraudulent transfer and other issues.

There are three accepted approaches to the valuation of real estate. They are the market or comparable sales approach, capitalization of income approach, and cost approach. Real estate appraisals generally include calculations using all three of the valuation approaches. One of the methods will be given the most weight based on the type of property being appraised.

1. Market or Comparable Sales Approach. With this approach, the subject property is compared to similar properties that recently sold in the area near the subject property. A value for the subject property is determined by making adjustments to the sale price of each comparable property based on differences between the comparable property and the subject property such as size, amenities, functionality, age, condition, location, and market condition. The adjustments are based on the effect such differences have had on the price of other property. The adjusted comparable sales are averaged to arrive at the appraised value of the subject property. This method is most reliable for single family properties, and vacant land and buildings that sell based on a price per square foot.

The reliability of the valuation is a function of the reliability of its components. More recent sales are more reliable than older sales. Properties located in the same subdivision as the subject property are more reliable than properties located further away. Comparable properties that are the same model as the subject property are more reliable than properties that are significantly different.

To attack an appraisal at trial, establish the appraiser’s reliance on various assumptions that he or she made regarding the subject property and the comparable properties. Produce evidence to show that better comparables were available. Show that the assumptions relied upon by the appraiser were inaccurate. Show that the adjustments were based on faulty assumptions about one or both properties, or that the adjustments are inconsistent with the actual effects these differences have in the market.

2. Capitalization of Income Approach. The capitalization of income approach is used primarily for income producing properties. The projected net income for the property is multiplied by a capitalization rate. The projected net income is calculated using existing cash flows and expenses, and assumptions regarding vacancies, upcoming capital improvements, and market conditions. The capitalization rate is determined using the comparable sales approach.

At trial, capitalization of income appraisals can be supported or attacked based on any of its elements. On direct examination of your expert, show that the income and expenses are accurate, that the assumptions are realistic and that the gross rent multiplier or capitalization rate are consistent with those generally used in this market. On cross examination of the other party’s expert, show that the income and expenses are inconsistent with actual numbers; that the assumptions upon which the appraisal is based are unrealistic and faulty and that the capitalization rate is inconsistent with that used for similar properties that have recently sold in the same area.

3. Cost Approach. The cost approach, calculates the value of the subject property by determining the value of the subject property by determining the value of the land and adding the depreciated value of the improvements. This approach is most reliable for newer properties and special use properties. The land value is determined using the comparable sales approach. The depreciated value is calculated using current costs to build a similar property and subtracting the amount by which the improvements have depreciated due to its age.

Support a favorable appraisal by showing that the comparable sales used for the land value are recent and are for properties that are similar to the subject, that the replacement costs are realistic, and that the depreciation factor accurately reflects the effects that the passage of time has on the improvements. To attack on unfavorable appraisal, the attorney should show that the wrong comparables, cost of construction and depreciation methods were used; and that the adjustments made were arbitrary and not support by the data.

D. VALUATION OF RETIREMENT BENEFITS

1. Retirement Benefits – An Overview. There are two primary types of retirement benefit plans. Defined Contribution Plans (“DCPs”) are tax deferred retirement savings plans in which the participant has her or her own account. Contributions to the plan can be made by the employer and/or the participant. Benefits are determined by the value of the contributions at the time of distribution. DCPs include 401k, SEP, ESOP, and other similar plans.

Defined Benefit Plans (“DBP”) are traditional pension plans. The funds are held in a plan trust administered by the employer. Benefits are paid in the form of an annuity. The benefits are based on the employee’s length of service and salary. DBPs include Social Security benefits as well as other governmental, labor union, and private employer pension plans.

The Employee Retirement Income Securities Act (“ERISA”) establishes the minimum standards for retirement plans in the private sector. ERISA regulates DBPs to minimize the risk of under-funding; regulates the vesting requirements for employer contributions; and governs Qualified Domestic Relations Orders (QDROs). QDRO’s are court orders entered in domestic relations cases to recognize an alternate payee’s right to receive a portion of the benefits.

The participant’s ownership of the employer’s contributions to a DBP can be contingent and delayed. This is called vesting. The benefits become vested pursuant to one of two types of vesting schedules. With Graduated Vesting, a certain percentage of the employer’s contributions vest periodically until fully vested (i.e. 20% per year for 5 years). With Cliff Vesting, the employer contributions do not vest until the employee has been employed by the employer for a specified period of time (i.e. 5 years) at which time the account fully vests.

2. Classification of Retirement Benefits as Marital or Non-Marital. Section 503(b)(2) of the IMDMA addresses division of retirement benefits in dissolution of marriage cases. Unlike other assets that are classified either as marital or non-marital, Section 503(b)(3) provides that retirement benefits that were accumulated both prior to the marriage and during the marriage, are part marital and part non-marital. As a result, the valuation and division of retirement benefits is more complex than it is for other assets. The marital and non-marital portions of the retirement benefit must be identified and valued. The marital portion is then divided between the spouses.

Various formulas have been recognized by the courts to allocate the value of retirement benefits between the marital and non-marital estates. A review of the case law follows.

a. IRMO Hunt. 78 Ill App.3d.653, 397 NE.2.d 511 (1st Dist. 1979). In Hunt, the parties were married twenty (20) years. The husband began his employment five (5) months after the marriage began and acquired interest in a pension and profit sharing plan which was entirely funded by his employer. The First District Court of Appeals in the Hunt case held that retirement benefits acquired during the marriage are marital property whether matured, vested or unvested, contributory or non-contributory. The court then distinguished between benefits for which the present value of pension benefits could be determined at the time of dissolution from those benefits for which the present value of the payments could not be determined (i.e. when the benefits are not vested or the plan is not funded). Where the present value could be ascertained at the time of the dissolution, the Hunt court adopted the following formulas to value the marital portion of the present value of the benefits.

# of months of marriage
during which benefits
Marital Portion = Present Value of X accumulated __________
Of Benefits the Payments Total # of months benefits
accrued prior to dissolution

Where the present value of the payments could not be ascertained at the time of dissolution, the Hunt court recommended that the marital portion of each payment, when received, be determined by the following formula:

# of months of marriage
during which payments
Marital Portion = Payment Amount X accrued_____________
of each payment Total # of months benefits
accrued prior to payment

b. IRMO Davis. 215 Ill.App.3d 763, 576 NE.2d.44, 51 (1st Dist. 1991). In Davis, the husband rolled interest from a profit sharing plan (a defined contribution plan), which had both non-marital and marital value, into an IRA Account. The First District Court of Appeals adopted a formula to allocate between the marital and non-marital portions of the plan. Specifically, the court took the pre-marital value of the plan ($57,815.23) and the marital value of the plan ($96,556.61) and thereby calculated the percentage of non-marital to marital (37.5% to 62.5%). Because the entire amount of the plan was rolled into an IRA, the Court found that 62.5% was marital and allocated one-half (1/2) of that to the wife.

c. IRMO Wisniewski. 286 Ill.App.3d 236, 675 NE.2.d 1362 (4th Dist. 1997). In Wisniewski, the parties were married for twenty-seven (27) years. At the time of dissolution, the Court reserved jurisdiction to divide the benefits until the husband’s retirement. At the time of retirement, the husband had contributed to two state defined pension plans, before his marriage, during the marriage and after the marriage. Under the formula applicable to both plans, the benefits were determined by multiplying the final average salary times a pension multiplier that increased with each year of employment. The Fourth District Court of Appeals rejected the husband’s assertion that his wife’s marital portion should be calculated using the value of the plan at the date of dissolution multiplied by the multiplier accrued during their marriage. Instead, the Court applied the proportionality rule. The marital interest was calculated by multiplying the total benefit times the ratio of years of marriage in which there was participation in the plan to the total years of participation in the plan.

d. IRMO Wenc. 294 Ill.App.3d 239, 689 NE.2.d 424 (2nd Dist. 1998). In Wenc, the husband had a defined benefits pension plan. The Marital Settlement Agreement (MSA) gave the wife 30% of all husband’s “vested, non-vested, and/or accrued pension/retirement benefits accumulated as of the date hereof [date of dissolution] at such time in the future when and if benefits are paid” to husband. The Agreement reserved jurisdiction to the date benefits were to be paid, but froze the wife’s share as of the date of the divorce. In recognition of the time value of money, the Wenc court observed that earlier contributions should be accorded more weight as they had more time to grow. Where payments are not to be made until many years after the dissolution, a plan that freezes the marital portion of the payments at the time of the dissolution deprives the non-participant spouse of appreciation of the marital share of the asset. Therefore, the delay between the divorce judgment and the payout period requires consideration of the appreciation.

e. IRMO Blackston. 258 Ill.App.3d 401, 630 NE.2.d 541 (5th Dist. 1994). In Blackston, the husband contributed to a federal defined benefit pension plan. The benefits were determined by multiplying the average salary upon retirement times a multiplier which increased with his length of service. When the trial court divided the benefits, they awarded the wife one-half (1/2) of the gross monthly benefit times the ratio of the number of years that the husband was a member during the marriage over the total number of years he was a member. The husband appealed arguing that this allowed the wife to benefit from his continued employment after the marriage. Contrary to the holding in Wenc, Blackston held that in this case it was improper to grant benefits to the non-participant spouse based on increases in the pension after the dissolution of marriage.

f. IRMO Ramsey. 339 Ill.App 3d.752, 792 NE.2d.337 (5th Dist. 2003). In Ramsey, the Court addressed the issue of retirement incentives in valuing pension plans for the first time in Illinois. In this case, the husband was a member of a defined benefit plan managed by the State of Illinois. The court sought to use the reserved jurisdiction approach to value the retirement benefits of the plan. The order stated that the payout to the wife would be one-half (1/2) of the amount of each check times the number of months of marital contribution over the total months of contribution in the plan. The husband elected to take an early retirement option of the plan that required a lump sum contribution for an enhanced benefit. The husband argued that the enhanced benefit was non-marital because it required the lump sum payment from post marital funds. The Court stated that both parties shared the risk that the husband would retire or change jobs reducing or forfeiting the benefits. Therefore, both parties should share in unforeseen increases in value. The Court simply required the non-participant wife to pay a proportionate share toward the monetary contribution as a precondition to her receiving the enhanced benefit.

g. IRMO Raad. 301 Ill.App.3d 683, 704 NE2d 964 (2nd Dist. 1998). In Raad, the wife contributed to a defined benefit plan for several years prior to the marriage, giving the account a vested value of $24,446.37 at the time of the marriage. During the marriage, the wife contributed $5,257.42 over two years before she changed employment. When the wife left her employment the account was valued at $35,090.99. That amount was rolled over into an IRA and no further contributions were added. At the time of dissolution, the account was valued at $79,415.38. The trial court classified only the $24,446.37 as non-marital and the rest as marital. The Second District Court of Appeals overruled the trial court, holding that that did not take into account the increase in value which was largely a result of the non-marital portion. The court remanded the case to the trial court to determine the applicable percentages to account for the increases in value.

h. IRMO Walker. 304 Ill.App.3d 223, 710 NE2d 468 (4th Dist. 1999). In Walker, the husband contributed to a federal defined benefits plan for 17 years before the marriage and for the three years of the parties’ marriage, to the plan for 20 total years. The value of the plan was $280,782. The Court applied an analysis consistent with that used for assets other than retirement benefits. The court classified the retirement plan as a non-marital contributions is a non-marital asset subject to reimbursement for the marital contributions. It stated that the marital contributions could be determined by the Hunt formula or by using the ratio of contributions made during the marriage to the total contributions.

3. Valuation of Retirement Benefits.

a. Valuation of Vested DCP Benefits. The value of a fully vested DCP is easy to determine. It is simply the account balance. The most recent statement provides the value as of the date of the statement. A more current valuation may be available on-line or upon request.

b. Valuation of Non-Vested DCP Benefits. The non-vested portion of a DCP is problematic. Whether the plan ever fully vests is dependent, in part, on whether the participant quits the job or gets terminated. Such factors are not quantifiable by actuarial principals. Alternative methods of dividing the asset subsequent to the dissolution may be considered. As a practical matter, the unvested portion of a DCP generally lacks sufficient value to warrant the expense of valuation or complex formulas for its division. Instead, it is often used as a minor bargaining chip, and is assigned to one of the parties without having been assigned a value.

c. Valuation of ESOPs. Problems can also arise with the valuation of Employee Stock Option Plans. These plans grant the employee an option to purchase shares of stock of the employer corporation. While publicly traded securities have readily ascertainable values, the stock of privately held companies generally do not. In some cases, the employer has an independent valuation of the stock for purposes of purchasing the employees stock upon retirement, which can be used as an indication of value. However, before accepting such a valuation, the basis of the valuation must be analyzed. There may also be recent sales of the company’s stock that reflect market value. In the absence of recent sales or an independent valuation, the valuation process involves the same principals as used to value a closely held business owned by one of the parties. Such a valuation may not be practical for purposes of valuing an ESOP.

d. Valuation of DBPs. DBPs are generally appraised by an actuary. The anticipated payments are discounted to a present value using a discount rate that is based on interest rates prevailing at the time of the valuation. The anticipated ending date of the payments is based on the participant’s expected lifespan based on mortality tables. The actuary usually provides a valuation based on alternate assumptions about the participant’s retirement date.

An actuarial valuation should include the basis for the valuation including: a) the anticipated payment amounts and how that amount was determined; b) the projected lifespan of the participant and the name of the mortality table from which that age was derived; c) the discount rate that was used and the reason that rate was chosen; and d) the anticipated retirement date for each of the valuations, why that date was used and how that date relates to the terms of the plan.

The attorney should analyze each of the components of the valuation. Is a high discount rate being used at a time when rates are low, resulting in a lower valuation? Look up the participant’s expected lifespan on the mortality table cited by the actuary. Confirm that the right sex and age was used for the participant to get the expected lifespan. Review the Plan to confirm the payment amounts as of the alternate assumed retirement dates. Look for other benefits of the Plan that were not considered by the actuary that may increase or decrease the value.

e. Valuation of State and Federal Retirement Plans. Most state and federal retirement benefits are Defined Benefit Plans. The Federal Thrift Savings Plans are Defined Contribution Plans and are usually a supplement to a defined benefit plan. Federal government employees are eligible for either the Civil Service Retirement System (CSRS) or the Federal Employee’s Retirement System (FERS). There are a variety of state retirement plans in Illinois including the State University Retirement System, Teachers’ Retirement System, Judges’ Retirement System, General Assembly Retirement System, and others. The largest state retirement system however, is the State Employees’ Retirement System of Illinois (SERS).

State and federal plans are exempt from ERISA. Instead of being divided pursuant to a QDRO, federal plans are divided by an order known as a Court Order Acceptable for Processing (COAPs) while state retirement plans are subject to Qualified Illinois Domestic Relations Orders (QILDRO).

Members of SERS, with the exception of police and firefighters, contribute to and receive Social Security. Members of FERS also contribute to and receive Social Security benefits. However, participants of CSRS do not. Instead, they contribute a larger portion of their base salary to the plan and receive proportionate benefits upon retirement. In some valuation cases, the court may offset social security for CSRS plan members when dividing the benefits pursuant to a COAP.

Be careful not to accept the participant account balance as the value of a government plan. The value of state and federal plans are usually determined by the length of service and annual salary. The account balances automatically increases by a certain percentage each year, to account for cost-of-living adjustments (COLAs). The employer contributions and COLA’s make up over two-thirds of the plan’s value. The participant account represents a small portion of the total value of the plan.

With federal and state plans, the non-employee spouse cannot receive payments pursuant to the court order unless the employee-spouse is receiving the annuity at that time. The payouts begin when the employee actually retires, not when the employee is eligible for retirement. Payments also terminate upon the employee spouse’s death. These factors reduce the value of the plan and must be considered.

f. Valuation of Military Retirement Plans. Military members may also be members of a variety of different plans. The type of plan a military member is a party of depends on the date of his or her service. Prior to September of 1980 military members were eligible for the Final Pay Retirement System. Between September 8, 1980 and August of 1986 members are eligible for the High 36 System. After August of 1986 military members are under the REDUX system. Under the REDUX system, members are eligible to choose between the High 36 or the Career Status Bonus/REDUX System. The type of plan in which the member is a part of will affect the payout amount. Cost of Living Adjustments (COLA) are made for both plans.

The Uniform Services Former Spouses Protection Act (USFSPA) allows state courts to divide military pensions as marital under state law. That said, there are many differences between military and other plans.

First, payouts of the retirement benefits to non-servicemembers may be made directly to the former spouse only if the 10 year rule is met. The 10 year rule provides that the couple must have been married for 10 years or longer, the servicemember must have had 10 years of service, and the two must overlap for at least 10 years. If the 10 year rule is not met, the non-servicemember can still recover from the former spouse directly by court order, but payouts will not be made through the Defense Finance and Accounting Service.

Only disposable retirement pay, rather than gross pay or disability pay, may be divided. Survivor benefit premiums must be subtracted. Furthermore, the proportion awarded to the non-servicemember spouse may not be more than 50% of the total benefits. Participants of military plans are automatically enrolled in survivor benefit plans unless the spouse provides written consent to opt out. This means that the payouts continue to the spouse past the death of the servicemember. However, the benefits terminate upon divorce unless the decree provides otherwise or the servicemember elects to continue.

E. BUSINESS ASSET VALUATIONS
For many reasons, the most problematic divorce valuation issues relate to closely held business interests.

First, such interests are difficult to liquidate and divide. The acrimony of divorce renders post dissolution co-ownership untenable. Selling the business may deprive a spouse of his or her career, profession and life’s work. Accordingly, one spouse generally needs to buy out the other spouse’s interest based on an agreed or litigated value.

The appraisals of closely held business are prone to dramatic variations. Business valuation is a complex process that includes a variety of objective and subjective criteria. The range of values that can be legitimately supported by credible evidence is substantial. The result is dramatically different settlement positions that make compromise difficult.

Finally, the value of the closely held business may be quite significant in terms of dollars and percentage of the marital estate. Accordingly, the stakes are high. The amount in controversy with a business valuation issue is more likely to exceed the cost of litigation than it is with valuation issues relating to other types of assets. Moreover, closely held business valuation is a legitimately triable issue.

1. Hiring an Expert. The business appraiser is the most important element of the valuation process. The appraiser may make or break the case. In hiring an appraiser, review his or her curriculum vitae. Discuss the instant case with the appraiser to check his or her understanding of the goodwill, property division, hidden asset and hidden income issues unique to, or pervasive in divorce litigation.

Consider retaining the appraiser as a consultant. The identity and work product of a consultant are not discoverable while the identity and work product of an expert witness discoverable. This is not always advantageous. If the attorney represents the spouse that does not own the business, the non-disclosed consultant will have access to only the information and materials already available to the attorney. An inspection of the premises and interview of the owners and employees will not be available.

Communicate with the consultant or expert witness to provide information, documents and theories. Remember that those communications may immediately or ultimately be discoverable and relevant at trial. Provide information and receive information and advise. Avoid communications that steer the expert to a more favorable position that can compromise the expert’s credibility.

Review the documents and materials with the appraiser and obtain additional materials requested by the expert. Before a deposition, get questions to which the appraiser wants an answer.

Review with your appraiser the appraisal reports prepared by both appraisers. Be sure to understand each and every element of the appraisal including all assumptions, analyses, formulas, methods of appraisals, supporting rationale for each component and strengths and weaknesses of each.

Use the deposition of the other appraiser to examine his or her credentials, methodology, supporting materials and position. Identify in advance potential issues about which the expert may provide testimony that can be impeached at trial. Do not attempt to discredit or argue with the appraiser during the deposition unless the attorney is completely confident that no trial will ever occur. In those circumstances, discovery, including depositions, is being used to convince the other attorney, the other client, and the judge at a pre-trial conference of the strength of the attorney’s position.

At trial, support your expert’s results by demonstrating the expert’s credentials are superior, the appraisal methodology is appropriate under the law and the circumstances, the data relied upon is accurate, the formulas used are valid and the best measure of value, in the circumstances, the assumptions are realistic and supported by industry standards and the facts of the case, the capitalization rates are appropriate in the subject case, that the adjustment to the compensation of officers and earnings of the business are justified and supported, that the hidden assets and income located by the appraiser are supported with solid documentary evidence, that each and every element of the appraisal is the best available and that the valuation is correct.

To impeach the other expert, show that for each of the foregoing that expert’s appraisal is unsupported and incorrect.

2. Gathering and Analyzing Materials. Gathering data for the valuation is accomplished through the Investigation Process as discussed in Section II above. The documents and electronic data that should be requested include: (1) financial statements; (2) detailed general ledgers or cash disbursement journals; (3) income tax returns; (4) Articles of Incorporation or operating agreements; (5) listings of shareholders/partners/members and their ownership percentages; (6) aging of accounts receivable; (7) a detailed list of inventory adjusted to fair market value; (8) a detailed list of property and equipment with depreciation lapse schedules (can also include insurance policies); and (9) details of loans and other accounts payable; and (10) other items. Although these are the typically requested documents, each case will have more or less considering the type of business and specific issues relating to that business.

It is important when gathering the data to try to uncover all assets, as it is not uncommon for a spouse to hide business assets or seek to have the business undervalued. Some things to look for are salary payments to a non-existent employee with checks that will be voided after the divorce; money paid from the business to someone who will give it back to the spouse after the divorce; and delays in signing long-term business contracts until after the divorce is finalized.

When analyzing the data and performing the valuation analysis, first the valuator must normalize the financial statements by adjusting the financial information taking into account irregularities. Among the adjustments that must be made are comparability adjustments, which include unordinary transactions and overcompensation or under compensation of employees. Overcompensation of employees should be considered by looking at the following factors: (1) size of the company and growth plans; (2) makeup of the management team and history of compensation; (3) job description of the officers; (4) education, experience, time commitment, and skills of the officers; (5) time at the position and employment conditions; (6) performance of the company; (7) typical compensation in the industry; (8) typical responsibilities of the officers in the industry; and (9) databases that publicize compensation materials.

In addition to comparability adjustments, non-recurring adjustments, such as sales of fixed assets, lawsuit settlements, and casualty losses must be taken into consideration. Furthermore, discretionary adjustments should be made to account for benefits, including travel, perks, and personal automobiles. These adjustments are important because without them the business will be significantly undervalued.

3. Business Valuation Approaches. The three generally recognized approaches to business valuation are the income approach, market approach and asset based approach.

a. Income Approach. The Income Approach, values the business on the basis of the income stream the business generates. Cash flow is the primary consideration in determining present value. The discount or capitalization rate is used to determine the present value of the expected returns of a business.

b. Market Approach. The Market Approach values the business based on references to other transactions. Using the Publicly Traded Guideline Company Method, the valuator can find publicly traded companies that are comparable to the business being valued and considers the capital structure, credit status, depth of management, personnel experience, nature of competition, and maturity of the business. In contrast, using the Comparative Transaction Method, the valuator would find comparable companies that have been sold and examine multiples from prices and financial data. With either method in the Market Approach, it is important to note the rules of thumb for the particular industry.

c. Asset Based Approach. The final approach to valuing businesses in the dissolution context is the Asset Based Approach, which values the business on the basis of its assets and liabilities. Essentially, the company’s assets and liabilities are adjusted to their fair market value and then the liabilities are subtracted. This approach is most appropriate for holding companies, investment companies, real estate partnerships, and start-up companies. It is not appropriate for profitable operating companies with a substantial amount of intangible assets.

4. Intangible Assets
Business intangibles are non-physical assets that have value to the owner. Business intangibles can include those things relating to innovation, such as established relationships, research and development, the website, enhancements that improve operations, patents, trademarks, and copyrights, and the like. In addition to innovation-related intangibles, organizational designs, such as sales and marketing plans, processes for reducing costs, and production plans are also business intangibles. Finally, there are the human resource-related business intangibles, including staff, employee training, and the like.

Intangible assets vary based on the type of industry. For example, technology based companies will have highly skilled and trained employees as well as large amounts of innovative resources, including intellectual property and research and design. A service oriented business’ greatest intangible assets may be customer lists, contracts and agreements, and employees. Companies which have been in business for many years may have great value in marketing or trade names, as well as established reputation and repeat business.

Another aspect of business intangibles is goodwill. Illinois differentiates between professional goodwill (also known as, and hereafter referred to as, “personal goodwill”) and enterprise goodwill. Personal goodwill is the aspect of goodwill that are directly related to the owner. Enterprise goodwill is the expectation of continued public patronage, or the good reputation of the business, that is associated with the entity rather than the professional reputation of the person. Personal goodwill, unlike enterprise goodwill, is considered non-marital and therefore not subject to division in dissolution. Enterprise goodwill is considered an asset of the business and divisible under 503(d) The differentiation between these two types of goodwill has been the subject of litigation over the years. The area is developing but remains unsettled in many respects. A review of the relevant cases follows.

a. In Re Marriage of Zells. The Illinois Supreme Court first address the issue of personal goodwill as a divisible marital asset in 1991 in the case, In Re Marriage of Zells, 143 Ill.2d 251, 572 NE2d. 944. In Zells, the Illinois Supreme Court found that an attorney’s contingent fees and professional goodwill are not marital property subject to division.

The court found that contingent fees were speculative and require additional services from the attorney. The fees are computed as part of annual income figures and relied upon in awarding maintenance and support. Similarly, personal goodwill is examined when determining the income potential of the spouse. Professional goodwill or contingency fees is duplicative and improper.

b. In Re Marriage of Talty. The Illinois Supreme Court next addressed the issue of personal goodwill in 1995 in, In Re Marriage of Talty, 166 Ill.2d 232, 652 NE2d 330 (1995). Calling it personal goodwill, the Talty court extended the concept of professional goodwill to businesses other than professional practices (a car dealership); and adopted the concept that the goodwill of a business may include two components, personal goodwill and enterprise goodwill. The court stated:

“To the extent that goodwill inheres to the business, existing independently of [the owner’s] personal efforts, and will outlast his involvement with the enterprise, it should be considered an asset of the business, and hence the marriage. In contrast, to the extent that goodwill of the business is personal to William [the husband and owner of the business] depends on his efforts and will cease when his involvement with the dealership ends, it should not be considered property.”

The court found that 503(d) requires that the court consider the elements underlying the calculation of personal goodwill when dividing the marital property; and that considering it again in determining the value of the business for purposes of division of marital assets would be double dipping. On the other hand, enterprise goodwill is dependent on aspects of the business independent of the owner and are not part of the 503(d) factors to be considered in dividing property when considering property division and should be considered as part of the value of the assets that is to be divided. The court remanded the case to the trial court for retrial with instructions to determine whether the goodwill of the dealership contain both personal and enterprise goodwill, apparently to assign a value to each, and to redistribute the marital assets.

c. In Re Marriage of Head. On remand from an appellate decision that rejected the trial court’s valuation of the husband’s medical practice, the trial court made inconsistent findings regarding the valuation of the medical practice. The parties had stipulated to the value of the tangible assets of the business which the husband’s expert said was the sole value of the business other than the personal goodwill. The wife’s expert assigned a higher value based on the excess earnings theory of business valuation. The trial court, on remand, rejected the wife’s expert valuation because it considered the factors that basically constituted professional goodwill which is barred from consideration of value under Zells. The trial court went on to assign a value in excess of the stipulated assets which the appellate court characterized as defined in Talty. The court in Head rejected the valuation and removed the value associated with enterprise goodwill because the evidence did not provide a proper foundation for that portion of the valuation. Since the court rejected the wife’s expert’s valuation, the trial court had made a finding that no such foundation in the evidence existed.

d. In Re Marriage of Joynt. In Joynt, the husband owned a minority interest in a subchapter S corporation that was a non marital asset. The husband was president of the corporation and received a salary for those services. The corporation retained certain earnings with the corporation rather than distribute those earnings to the shareholder. As a subchapter S corporation, the husband was taxed on those earnings. The corporation distributed money to the husband to pay the taxes. The wife argued that the earnings were retained rather than distributed to keep them from becoming an asset of the marital estate. The court found that because the husband was a minority shareholder unable to unilaterally declare a dividend and distribute the profits, and because the husband was paid a fair salary, the retained earnings from the non marital subchapter S corporation was an asset of the corporation and a non marital asset.

Affirming the distribution of marital assets, the appellate court found that the trial court properly classified the retained earnings as a non marital asset and properly considered all of the 503(d) factors, including those retained earnings as part of the husband’s non marital estate, in dividing the marital assets.

5. Compromise Through Earnouts. During the dissolution of marriage, each party will present its expert valuator who will use the above methods to calculate an approximate value of the business. However, the parties often strategically come to significantly varied results. One mechanism for bridging gaps in the parties’ valuation is to construct an earnout agreement. An earnout bases the payment to the spouse on the company’s profits during a specific period. Essentially, the business is valued lower than one party believes it should be, however, the parties share in the profits on future performance. Thus, for example, if one party values the business at $1 million (perhaps based on historical performance) and the other party values it at $2 million (perhaps based on projected earnings), the parties may set the value at $1 million, plus 5% of gross earnings during the following five years.

AUTHOR: Anderson & Associates, P.C.

Copyright Anderson & Associates, P.C.
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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.



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