Business assets on divorce or dissolution: business valuations

A business can be one of the most valuable assets to be considered on divorce or dissolution, and knowing accurately what it is worth can be critical in working out how the matrimonial wealth should be divided.  

The process of understanding the value of the business, and whether a formal valuation will be required, starts with the requirement to provide full and detailed disclosure about the business. The information that is provided for each business will depend upon its form, which will broadly be one of three: limited company, (public or private); partnership; or sole trader.

Is a valuation always necessary?

Not every case will necessitate a formal valuation. A business that is simply an income stream is unlikely to give rise to the need for a valuation, and likewise where a spouse’s interest is a small minority shareholding in a quoted company.

There are however indicators that will lead to you wanting a business to be valued, such as:

• where there is a likelihood of the business being sold in the foreseeable future, including where the parties may be approaching retirement and looking at a buy-out
• the accounts show significant capital assets or where there is concern the capital may be undervalued, such as land or property that may be based on historic purchase prices
• the accounts show sizeable profits and turnover or where there is a significant discrepancy between profit and the standard of living maintained by the parties
• where there are complicated structures involving trusts and holding companies
• if there are concerns relating to the liquidity of the business
• there are concerns of non-disclosure relating to the accounts, which may not therefore provide the full picture.

If there is any doubt it is always worthwhile asking a forensic accountant to review the business accounts and provide a preliminary opinion.

Who will value the business and when?

If a valuation report is required it is important that this is dealt with as early as possible. Only once all assets have a value can meaningful negotiations begin.  

If financial remedy proceedings have already been issued, then Part 25 of the Family Procedure Rules and corresponding Practice Directions make it clear that any application for expert evidence should be made as soon as possible and no later than the First Appointment.

In most cases it will be preferable for the parties to instruct a Single Joint Expert, usually a forensic accountant, to prepare the valuation report. The expert would be instructed jointly by the parties to prepare an independent valuation.

How should a business be valued?

There is no one formula for valuing a business, and the approach that the expert is asked to take, including the variables that may need to be applied, requires careful consideration and will differ from one case to another.

There are a range of possible approaches to valuing a business on divorce or dissolution as follows:

• earnings
• net assets
• discounted cash flow
• dividend yield approach.

The forensic accountant will advise on the most appropriate method for valuing a particular business.

What is an earnings based valuation?

This is the most commonly used method for valuing ongoing trading companies. It looks at the maintainable earnings of the business and compares that against similar for which market values are known in order to work out a suitable multiple (or capitalisation) to arrive at the valuation.

This approach requires the expert to identify the level of earnings that are representative of the business in the future and, therefore, what would be considered as ‘maintainable’. Earnings in this context will usually be the turnover, EBITDA (earnings before interest, taxes, depreciation and amortisation), or profit after tax of the business.

In practice, most valuations will rely on the EBITDA figure, as it makes comparison with other businesses easier when determining the appropriate multiple or capitalisation. It is therefore important that the level of director remuneration in the company is in line with directors in comparable companies. Excessive remuneration may need to be added back and replaced with an industry standard. Likewise, if it is significantly lower than average, additional remuneration may be deducted from the EBITDA.

Determining the maintainable earnings of the business in the future will require a careful examination of its previous financial statements, together with current management accounts and budgets. Those earnings may then need to be adjusted, for example where payments to shareholders or directors have been in excess of, or below, the appropriate market level. There may also be anomalous years, for example trading during the covid period, where it may be appropriate for the expert to apply a weighted average when determining maintainable earnings.

Once the maintainable earnings have been determined, the multiple that is applied must then be identified. This is done by considering comparable businesses from either comparable quoted companies and/or the actual sale and purchase of comparable businesses.

Whether comparable quoted companies are used, or information from the sale of comparable businesses, an adjustment may still need to be applied to account for any perceived differences with the business that is being valued before the appropriate multiple is then generated.

When an appropriate multiple has been identified it may be necessary to then adjust that to take account of the following:

• if information is based on the sale of a small percentage of shares in a comparable company, that may not necessarily reflect the premium a buyer may otherwise be willing to pay for a controlling interest or the entire capital in the company. It may therefore be appropriate to apply an adjustment to account for a ‘control premium’. Discounts applied to minority or fractional shareholdings should however be considered with caution and will be dealt separately below
• private limited companies can be considered as less saleable than those traded on recognised exchanges. It may therefore be appropriate to apply a ‘marketability discount’.

When the appropriate multiple has been determined and adjusted, it can then be applied to the maintainable earnings to give an estimate of the value of the company as a whole. Where the valuation has been based on the EBITDA of the business then a final adjustment will need to be made to account for the net debt and any other surplus assets.

What is a net asset valuation?

This is usually considered the most appropriate method for property investment companies, those trading in investment trusts, or certain financial institutions.

For most trading companies, this method is only likely to show the minimum or base value to be considered as part of a wider range and therefore unlikely to be considered appropriate on its own.

When requesting a net asset valuation it is important that consideration is given to the following:

• are there doubts regarding the recoverability of any debt, including inter-company debt?
• are there any potential unrecorded liabilities, such as deferred tax on the sale of land or break fees on loan arrangements?
• does the land or property value recorded in the accounts reflect the current market value, or are they based on the historic purchase price?

What is the discounted cash flow valuation method?

This method converts the future cash flows predictions of the business into a single current capital value. This is usually only suitable where there are detailed three to five-year cash flow forecasts, after which a risk-adjusted discount is then applied to the estimated future cash returns to arrive at an equivalent capital sum.

These calculations, however, are often complex and carry with them the following risks:

• there is always uncertainty in projected cash flow figures
• a residual value at the end of the forecast period, (the terminal value), is required. This residual value will be an estimation based on a separate valuation method
• the discount factor to be applied may or may not be possible to benchmark and will therefore require a certain level of judgment
• relatively small changes in the initial assumptions can give rise to large variations in value.

In practice, the inherent difficulties in carrying out this method of valuation and the degree of certainty required in the future forecasting often mean this is not used within the context of family proceedings.

What is the dividend yield approach?

This method values an individual’s interest in a business based on the dividends that an investor in that business would receive and then capitalises that figure. It is therefore only suitable where a small parcel of shares is being valued, where the shareholder has no control in their own right, and the company has a consistent and identifiable dividend pattern. It is not a valuation of the business as a whole.

The difficulties of trying to use this method to value a private company as a whole are that assumptions have to be made in respect of both of the following:

• future dividends, and their growth (or otherwise), and the financial returns required by an investor
• an uplift in value to reflect the "control premium" arising from a change of control of the company as a whole.

Other factors to consider

Depending on the circumstances of each case, other factors may necessitate an adjustment being applied to the value of a business, as follows:

What is a key man discount?

Where the business is heavily reliant on a specific owner or manager, an adjustment may be needed to reflect the reduction in the value that would result from the loss of that key individual. The key man discount may be particularly relevant for a successful family-run business that relies on one individual’s skills or close relationships with suppliers or customers for its continued profitability.

Will a minority shareholding discount be applied?

Care should also be taken when considering whether, and if so to what extent, a discount should be accepted for a minority shareholding.

In the case of Clarke v Clarke [2022] EWHC 2698 (Fam) the court rejected the argument that the husband should receive a 20% discount for the fact the he only held 50% of the company shares and therefore did not have a controlling interest. The court found that, in reality, the husband was only ever likely to sell with his fellow 50% shareholder and would not, on a balance of probability, suffer.

Summary

Navigating the complexities of divorce and dissolution where one or both parties own business assets requires careful consideration.

Seeking professional advice from legal and financial experts familiar with both family law and business and accountancy can help couples achieve a fair settlement that protects their interests and preserves the viability of the business concerned.