Small Business Valuation in Divorce

By Attorney Steven A. Harris 

Many times when couples get divorced, one or both of them are running a small business and have no clue what the value of it is or if it even has any value whatsoever. People don’t think of their business as an asset when they go to get divorced, but tend to think of it in terms of how much money they bring home from it each month. The value of the business and the amount the owner actually brings home each month are two completely different things and it is important to realize this when beginning the divorce process.

Small business valuation spreadsheet

So how much is my business worth? Well, determining how much a small business is worth requires several considerations including clarity on how the business was formed, whose money went into it, and what the spouses (and any other owners) want to do with the business going forward.

If the business is just owned by one or both of the spouses then determining who will ‘keep it’ after the divorce can sometimes be an easy decision for the parties. However, when other people beyond the former spouses have an ownership interest in the business it can make the situation much more complex.

The potential for conflict increases in this situation and staff or employees may get confused about who will ultimately lead the company. It is a good idea for the former spouses to address their divorce by working out an agreement between themselves first. This will allow them to be a unified front in communicating their plans to the staff and other owners.

Avoid confrontations and giving up too much by making emotional decisions

A small business is a legal entity into which former spouses have contributed money, time, and effort. There is a very high likelihood that the two parties will not agree on the next steps for the business, even if no outside party has any ownership. 

A person who is getting a divorce should tell their attorney about their plans for the business from the beginning. They should get their attorney’s advice before entering into any agreement with their former spouse. A party’s attorney can work with them to negotiate effectively. It is important to avoid heated discussions and giving up too much as a result. 

Different approaches to small business valuation

The value of a business is what a buyer would pay to purchase it. The three primary methods of finding the amount are: 

  1. The income approach, which looks at what the buyer might be able to earn by purchasing the business; 

  2. The market approach, which looks at the sale price of companies that are similarly situated; and 

  3. The asset approach, which looks at the value of the assets used to operate the business. 

Typically, the asset approach is the most appropriate for businesses that the parties want to wind down while the others are more appropriate if one or both spouses intend to keep running the business. 

Business valuation during the COVID-19 pandemic

The uncertainty that the COVID-19 pandemic presents makes it difficult to estimate multiple figures. These include the future earnings of the business, the rate of return for investing in the business, and how much money the owner will need to deal with unexpected expenses. 

For example, the owners may not be able to purchase new equipment necessary to run the business with a loan open to them, like a Payroll Protection Plan loan. Business owners who want to wind down a company may be frustrated because certain assets decreased in value during the pandemic while labor and supply shortages increased the costs of operating the business. 

Former spouses who are struggling to make sense of what to do should hire a consultant who specializes in their type of business. The consultant can give them an idea of what similarly situated businesses are experiencing and the options available to them. This impartial advice is meant for both parties and will help the divorcing couple be on the same page in their decision-making as it pertains to the business. 

How to consider goodwill in the valuation

Determining the value of certain aspects of a business such as goodwill is tricky during the pandemic. Goodwill relates to factors like location, customer loyalty, longevity, revenue, number and types of clients, and the reputation of the business and it’s owner. In 2020, many businesses saw the approximate value of their goodwill plummet. Businesses saw interruptions in service, had difficulty obtaining the labor and supplies necessary to continue operations, and dealt with significant changes in customer patterns.

Former spouses who want to continue the business should pick a point when the business is operating in a stable fashion to determine the goodwill value. That lets them see where the company is in terms of its reputation, revenue, customer base, and other factors. 

The spouses should work through their differences and do everything possible to maintain a good reputation for themselves and the business during the divorce process. This means following state and local COVID-19 safety protocols, developing responsible social media policies, being sensitive to issues relating to diversity & inclusion, not fighting in front of customers, and welcoming customers back to the business.

Ownership options following divorce

The traditional three options relating to business ownership are for:

  1. one party to buy out the other;
  2. the parties to sell the business; or
  3. the parties to continue to co-own the business.

The first option has a big tax advantage. The sale of a business interest between spouses as part of a buyout is not considered a sale for tax purposes. Such a transfer is not taxed if it occurs within one year after the marriage ends. The transfer also is not taxed if it is related to the end of the marriage. To meet this criteria, the divorce or separation agreement must mandate the sale of the business interest and the transfer must occur within six years after the marriage ends. 

The second option of selling the business and splitting the proceeds is extremely popular. However, economic circumstances have changed so much that former spouses should expect some surprises. A business consultant can help the parties understand what has changed due to the pandemic and why. 

Continuing the business as co-owners is usually a good possibility if the former spouses have an amicable relationship. A former spouse should not consider this option if the other party has been verbally, financially, emotionally, or physically abusive. This is also not a good option if the primary managing party has a substance abuse issue.

There is also the option of winding down the business. If there is unmanageable debt resulting from the winding down of the business, then the spouses will need to have an honest discussion with a financial advisor and/or a local bankruptcy attorney to determine what options are available.

Consult with your business attorney during the process

Often, former spouses have previously retained an attorney for a small business before seeking a divorce. Whenever possible, they should involve that particular attorney in group discussions about the future of the business. The primary role of the attorney who previously advised the business is to explain arrangements and obligations relating to the business to all of the parties. This attorney can share the history of the company’s decisions and new information that will benefit both former spouses when the divorce is over. 

Bringing in this attorney in a consultant type of capacity can only help the parties in their valuation process since valuing a small business can be tricky under normal circumstances and are especially due to the ongoing pandemic and the economic climate both nationally and locally at the moment. 

Steven A. Harris is a divorce attorney in Huntsville, Alabama. He is also the owner of The Harris Firm LLC, a family law and bankruptcy firm with offices across the State of Alabama. He regularly writes informative articles about bankruptcy, family law and other topics and lives with his lovely wife of fifteen years.

Related: