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Valuations in Divorce Cases Pose Unique Challenges

Business valuations completed in connection with divorce proceedings can be especially complex. Photo by Kelly Sikkema on Unsplash

The South Carolina State Supreme Court weighed in recently on the long-simmering tension between recognized standards of business valuation and the goal of equity in dividing marital assets in divorce proceedings.

The decision In Clark v Clark (Appellate Case No. 2019-000442), addresses the division of marital assets, specifically the valuation of a minority interest in a family business. The Supreme Court reiterated a lower court’s assertion that the applicability of discounts for lack of control (DLOC) and marketability (DLOM) are to be determined on a case-by-case basis, then affirmed one part of that court’s ruling regarding discounts and reversed another.

The Family Business

George and Patricia Clark were married in 1987. During the marriage, Mr. Clark began working for the family business, Pure Country, a manufacturer of custom tapestry blankets and other items. His father founded the business and eventually transferred his 75 percent interest in it to Mr. Clark. A family court determined at the time that the transfer was a gift, and therefore the interest was not marital property. Mr. Clark purchased the remaining 25 percent of the business from his sister. In 2009, he transferred a 25 percent interest to Mrs. Clark. The related stock agreement limited any subsequent sale of that interest to other shareholders, immediate family members or the business.

In 2012, Mr. Clark filed for divorce. Both spouses hired experts to value Mrs. Clark’s interest in the business. The husband’s expert applied a DLOC and a DLOM. In support of the DLOM, she noted that the sale of interests in privately held companies require more time and resources and involve higher transaction costs than do sales of publicly traded interests. She also considered the restrictive language in the stock agreement from the 2009 transfer.

The wife’s expert applied a smaller DLOM, but later argued that the value should not be discounted at all. He did not apply a DLOC.

The family court found the husband’s expert more credible and agreed with her use of discounts. While it did acknowledge the “debate as to whether … discounts should apply in a divorce setting as the business is actually not being sold,” the court recognized that the valuation standard in such cases is fair market value, which assumes a hypothetical transaction between two willing parties. 

Mrs. Clark appealed the decision to the court of appeals, which agreed that a minority shareholder would not have control over the company and therefore upheld the family court’s decision to apply a DLOC, but reduced the size of the discount. The court of appeals rejected the DLOM, noting the husband did not intend to sell the business and relying on a precedent set in Moore v Moore. “To the extent the marketability discount reflected an anticipated sale, Moore deems it a fiction South Carolina law no longer recognizes.” The court found that because the husband did not plan to sell the business, the restriction on transfers of stock was moot. 

The decision compelled both parties to file appeals to the State Supreme Court.

Split Decision

The husband argued that the court of appeals erred in rejecting the DLOM when each party’s expert had applied one. The wife contended that the DLOM should not be considered because a DLOM accounts for the higher transaction costs inherent in a sale of an interest in a private company, and her husband did not intend to sell.

The Supreme Court affirmed the family court’s decision to apply a DLOM and a DLOC and the appeals court’s decision to reduce the DLOC. The decision states that a party’s interest in a closely held company is valued based on its fair market value, which has been well established as “the amount of money which a purchaser willing but not obligated to buy the property would pay an owner willing but not obligated to sell it, taking into account all uses to which the property is adapted and might in reason be applied.”

That said, the court acknowledges the tension between this principle of valuation and “the desire to fairly and justly apportion marital assets.” The court refuses to draw a bright line on the issue, stating that the applicability of such discounts is to be determined on a case-by-case basis.
The Supreme Court’s decision was not unanimous. Two of the five justices issued a dissenting opinion rejecting the application of either discount, stating that “under certain facts, faithful adherence to the concept of fair market value must yield to reality.”

The decision, while not directly applicable to New York cases, speaks to the complexities involved in divorce-related valuations and the need for valuation professionals to weigh competing considerations. If you have questions regarding the valuation issues in a divorce or another context, Advent’s professionals are here to help.

Read the Decision

You can read the rather colorful decision here:

https://adventvalue.com/wp-content/uploads/2020/06/Op.-27969-George-W-Clark-v.-Patricia-B-Clark.pdf

Changes in Bankuptcy Law a Lifeline for Struggling Businesses

Recent changes to U.S. Bankruptcy Law may provide additional relief for some struggling businesses. Photo by Melinda Gimpel on Unsplash

The novel coronavirus pandemic has caused many businesses to temporarily shut down or scale back operations. Slowly, states are allowing businesses to reopen to the public. But it may be too late for some businesses to bounce back. As a result, the number of businesses filing for bankruptcy is expected to skyrocket this summer.

Two recent changes to the U.S. Bankruptcy Code may provide greater relief for small businesses that seek to use the bankruptcy process to reorganize their finances and continue operating. The Small Business Reorganization Act (SMRA) increases access to Chapter 11 for small businesses. The Coronavirus Aid, Relief, and Economic Security (CARES) Act raises the debt threshold that qualifies for this protection. Here’s what small business owners should know.  

SMRA Basics

Effective on February 19, 2020, the SMRA creates a new subchapter (Subchapter V) of the Bankruptcy Code. To be eligible for relief under Subchapter V, a debtor, whether an entity or an individual, must have total debt not exceeding $2,725,625 (subject to adjustment every three years). The SMRA contains provisions for the following key improvements:

Streamlined reorganizations: The new law will facilitate small business reorganizations by eliminating certain procedural requirements and reducing costs. Significantly, no one except the business debtor will be able to propose a plan of reorganization. Plus, the debtor won’t be required to obtain approval or solicit votes for plan confirmation. Absent a court order, there will be no unsecured creditor committees under the new law. The new law also will require the court to hold a status conference within 60 days of the petition filing, giving the debtor 90 days to file its plan.

New value rule: The law will repeal the requirement that equity holders of the small business debtor must provide “new value” to retain their equity interest without fully paying off creditors. Instead, the plan must be nondiscriminatory and “fair and equitable.” In addition, similar to Chapter 13, the debtor’s entire projected disposable income must be applied to payments or the value of property to be distributed can’t amount to less than the debtor’s projected disposable income.

Trustee appointments: A standing trustee will be appointed to serve as the trustee for the bankruptcy estate. The revised version of Chapter 11 allows the trustee to preside over the reorganization and monitor its progress.

Administrative expense claims: Currently, a debtor must pay, on the effective date of the plan, any administrative expense claims, including claims incurred by the debtor for goods and services after a petition has been filed. Under the new law, a small business debtor is permitted to stretch payment of administrative expense claims over the term of the plan, giving this class of debtors a distinct advantage.

Residential mortgages: The new law eliminates the prohibition against a small business debtor modifying his or her residential mortgages. The debtor has more leeway if the underlying loan wasn’t used to acquire the residence and was used primarily for the debtor’s small business. Otherwise, secured lenders will continue to have the same protections as in other Chapter 11 cases.

Discharges: The new law provides that the court must grant the debtor a discharge after completing payments within the first three years of the plan or a longer period of up to five years established by the judge. The discharge relieves the debtor of personal liability for all debts under the plan except for amounts due after the last payment date and certain nondischargeable debts.

CARES Act Provision

In addition to the improvements under the SMRA, Congress decided to temporarily increase the debt ceiling for eligibility to $7,500,000 from $2,725,625 for new Subchapter V cases filed between March 28, 2020, and March 27, 2021. Thereafter, the debt limit will revert to $2,725,625.This change will make more small businesses eligible for Chapter 11 in the midst of the novel coronavirus crisis. However, the CARES Act permanently eliminates the eligibility to file for Subchapter V relief for any affiliate of a public company.

We Can Help

Businesses contemplating bankruptcy often benefit from the input of an experienced business valuation expert. Specialists with experience in accounting, valuation and mergers and acquisitions can help assess the severity of the financial crisis, determine whether liquidation or reorganization makes sense, and provide financial insight on everything from selling assets to shareholder disputes. Contact one of Advent’s business valuation professionals to facilitate the bankruptcy process and, if possible, get your business back on track.

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Are Your Company’s COVID-19 Losses Covered?

Business interruption insurance may provide some relief to owners forced to close their businesses because of the COVID-19 pandemic. Photo by Alexander Kovacs on Unsplash

The restrictions put in place to stop the spread of COVID-19 – such as limiting crowd size, closing restaurants and bars and canceling sporting events – are critically stressing many businesses.

One possible form of relief to this financial crisis is insurance coverage, including business interruption and contingent business interruption coverage. Business interruption insurance (also known as business income insurance) is a type of insurance that covers the loss of income that a business suffers after a disaster.

The loss of income covered may be due to disaster-related closing of the business facility or the rebuilding process after a disaster. Coverage may include lost revenues, rent or utilities, among other things. A contingent business interruption provision generally provides coverage for a loss of income related to a problem experienced by a supplier or vendor.

However, there are likely some hurdles to obtaining coverage based upon disruption from COVID-19. For example, a typical business interruption provision reads:

“We will pay for the actual loss of business income you sustain due to the necessary suspension of your ‘operations’ during the period of ‘restoration.’ The suspension must be caused by the direct physical loss, damage, or destruction to property. The loss or damage must be caused by or result from a covered cause of loss.” 

A “direct physical loss” has been held to exclude economic losses unaccompanied by a distinct and demonstrable loss of the physical use of the business property. Furthermore, after the SARS epidemic in the early 2000s, insurance companies began to exclude viral outbreaks from typical coverage, though exclusions for losses in connection with viruses may not be ironclad.

Coverage depends on the particular policy, and a policy review may prove useful. Not all insurance policies are identical in the coverage they provide.

You will likely find that more expensive policies often provide better coverage than lower-cost policies. Also, coverage for COVID-19 related losses might be contingent on whether the policy provides business interruption coverage as a basic term of the policy or as an endorsement. An endorsement will often provide broader coverage than the base policy because of the additional premium for the endorsement.

Insurance companies will certainly oppose paying business interruption losses in connection with COVID-19, though with advice from your insurance broker and/or attorney, filing a claim may be a good first step. In addition to filing the claim, Advent believes business owners ought to:

  • Analyze your policy and review the law. Don’t be afraid to consult your company attorney if you have questions. For example, if the policy does not adequately define “physical damage” (which can be required to recover business interruption losses) and that term presents ambiguity in the specific context of your company’s loss, you may be covered. 
  • Make note of virus exclusions. One can imagine this law is undeveloped and there is not clear precedent on coverage. Also, some policies may contain civil authority provisions, which could offer coverage for losses suffered in connection with government-ordered shutdowns.
  • Stay informed regarding legislative developments and any other pertinent changes. Finding every possible basis for recovery under your business’s policy will only enhance any potential recovery.

To learn more about the quantification of lost profits, please contact one of the experienced professionals here at Advent.

The Difference Between Price and Value

Photo by Mackenzie Marco on Unsplash

When a business is sold, it often sells for more (or less) than the appraised value. This may come as a surprise to laypeople, but valuators understand that there are many valid reasons that “price” and “value” may differ. Businesses that understand this subtlety are better positioned to make informed decisions.

Price is specific to an individual buyer and seller. It’s the amount of cash (or its equivalent) for which anything is bought, sold or offered for sale. It requires an offer to sell, an acceptance of that offer and an exchange of money (or other property). Some strategic or financial buyers may be willing to pay more than others because they can benefit from economies of scale or synergies that aren’t available to all potential buyers.

The term “value” often refers to “fair market value” in a business valuation context. The International Glossary of Business Valuation Terms defines fair market value 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 arms-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.

Fair market value is essentially a consensus of what the universe of potential buyers would agree to pay for a business, a business interest or an asset. In the real world, sales may occur for more (or less) than fair market value, because the individual parties have their own perceptions of the investment’s risk and return, are under duress to buy (or sell), or lack relevant knowledge about the transaction or the subject company.

Another reason that value and price frequently differ is timing. In many cases, a valuator’s work is done months or years before the company is sold. Differences in market conditions or the company’s financial performance between the two dates could cause the company’s selling price to vary from its appraised value.

Real World Example

To illustrate how price and value may differ, consider the sale of a medical practice. There are primarily three potential buying groups for medical practices:

  • Another physician,
  • A physician group, or
  • A hospital.

To determine fair market value, a valuator would consider potential transactions to purchase the practice by all three of these groups, under the cost, market and income approaches. But in the real world, only one specific buyer would make an offer. So, for example, the analyses involving a physician or physician group wouldn’t be relevant if a hospital is buying the practice.

Price and Value Aren’t Synonymous

It’s critical for buyers and sellers to understand that the appraised value of a business interest may not reflect its future selling price. Value can vary substantially, depending on the effective date and the purpose(s) specified in the appraiser’s report.

When the purpose of a valuation is to establish an asking (or offer) price, valuators may provide a range of values that considers various buyers and transaction scenarios. This range can help a buyer and seller arrive at a reasonable selling price that’s based on the individual parties’ expectations of risk and return.

If you’re planning to buy or sell a business interest, the professionals at Advent Valuation Advisors are here to help.

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