(973) 403-9200
Editor-in-Chief’s Column
Fairness and Economic Reality in Business Valuation
By Charles F. Vuotto, Jr.
It is widely accepted that fairness is the polestar[1] for those entrusted with the resolution of all issues that arise in a family law matter. That concept is no less applicable in the area of business valuation. This column submits the proposition that one can only achieve fairness in business valuation incident to the dissolution of a marriage or other family-type partnership when conclusions are reached based upon economic reality. That economic reality requires a conclusion of value that is based upon concepts of cash equivalency. Therefore, the valuation expert’s opinion and the court’s ultimate decision, in order to be fair,[2] must result in a ‘value’ that is the cash equivalent of what the business owner could receive as of the date of the filing of the complaint for divorce or other agreed upon cut-off date for purposes of equitable distribution. The true issue has been obscured by the debate over the standard of value[3] after the appellate court’s decision in Brown v. Brown,[4] where the court concluded that the appropriate standard was “fair value”[5] as opposed to “fair market value.”[6] Instead, the focus should be on fairness and economic reality.
The inescapable truth is that the value resulting from a strict adherence to a “fair value” standard in accordance with Brown v. Brown does not represent economic reality. Since it does not represent economic reality, it is not fair. Since it is not fair, it should not be the basis for business valuation in the state of New Jersey. Fixing business valuation based upon fairness and economic reality implements the public policy of the statutory scheme of equitable distribution in the state of New Jersey. Clearly, valuing the economic benefits the owner of a personal services business may receive in the future does not accurately implement equitable distribution policy as opposed to valuing the asset as though it is being sold (even though it is not actually being sold).
Fair market value appears to be the closest standard of value that is available to determine the cash equivalent that may be obtained by the business owner. However, we should not allow the label to control. In other words, we should not raise form over substance. The ultimate goal in determining the appropriate equitable distribution of a business is to determine the cash equivalent of the business owner’s interest as of the valuation date. If this goal can be achieved by applying “fair market value”, then the standard of value should be fair market value. If some other standard of value can better achieve this goal, then it should be that standard of value.
If a new standard of value needs to be adopted or developed to get to that end result, then that’s what should be done. Therefore, if it is necessary to arrive at the cash equivalent by applying a marketability discount,[7] then the marketability discount must be applied. Similarly, if it is necessary to arrive at a true cash equivalent by applying a minority interest discount,[8] that discount should be applied. Conversely, if it is critical to obtaining the cash equivalent by applying a control premium,[9] then that control premium should be applied to increase the value.
The fact that the business may not actually be in the process of being sold, does not change the fact that the ability of the business owner to achieve that cash equivalent would trigger the application of the aforementioned discounts or premiums in order to achieve that cash equivalent. In other words, these discounts and premiums are necessary to translate the value conclusion to a cash equivalent. Although typically applied to real estate, perhaps the more appropriate standard of value to achieve a cash equivalent, rather than fair market value, fair value, orvalue to the holder, is something akin to value in exchange. Value in exchange is the value of the business or business interest changing hands, in a real or hypothetical sale. Accordingly, discounts, including those for lack of control and lack of marketability, are considered in order to estimate the value of the property in exchange.
The fair market value standard, and to some extent the fair value standard, fall under the value in exchange premise.[10] It may very well be that the value to the holder is greater than the value in exchange or cash equivalent, but it is only the value in exchange or cash equivalent that should be subject to an equitable distribution award. The additional ‘value’ (if any) to the holder should be compensated by way of spousal support if compensation is fair and equitable under the applicable law.
Many of us may have attended the 2015 Family Law Symposium and heard our esteemed colleague, Frank A. Louis, espouse his view that basing a business valuation on a hypothetical sale is wrong since it does not represent the reality (in those cases where there is no present or contemplated sale). Interestingly, that argument fails to recognize the inconsistency in valuation approaches between a business and other assets. For example, when valuing the commercial property, the appraiser will utilize average rates of collectability when determining cash flow for purposes of the property valuation. If a commercial property owner getting divorced is able to achieve collection rates in excess of the average rates in the locality, why should the lower collection rates drive the value when the commercial property owner is not going to sell the property? Nevertheless, it is the average collection rates that are used rather than the actual ones. This is inconsistent with Louis’ view that the facts should dictate the valuation approach based on “economic reality.”
The first question is why doesn’t fair value result in a value conclusion that represents economic reality? The simple fact is that in many situations, the business owner will not be able to realize the cash equivalent of the value resulting from a fair value standard of value. This is due to various reasons including:
The reason is that in a sale a potential investor or pool of investors would not benefit from these types of transactions. The buyers would adjust the subject company’s results to reflect economic realty and would, therefore, only determine the value (purchase price) of the company after it has adjusted its financial results to reflect the market.
As Louis noted, our Supreme Court and Appellate Division have repeatedly reaffirmed these fundamental principles, but have never analyzed whether a standard predicated on a sale is the optimum approach to implement this broad policy and fairly divide, in an economically realistic fashion, the fruits of the marital partnership. Where this author differs with Louis’s conclusions, is that the standard should not be some esoteric value to the holder but rather should be guided by the economic reality of what the business owner can achieve in cash equivalent, perhaps best represented by the value in exchange concept(s). By focusing on what the business owner can achieve by way of cash equivalency, it realistically quantifies what an owner could expect to receive from market participants. It, therefore, permits a fair division of the value of that asset to both the owner and non-business owner. It does not, as Louis warns, relegate the non-owning spouse’s interest on a value to some hypothetical third party.
The underlying public policy for equitable distribution is recognition that a marriage is a partnership whose assets should be shared in an equitable fashion. It is statutorily presumed that each party made contributions to the marital enterprise, some of which may be economic in nature and some of which may be noneconomic.[11]
Therefore, with all of the foregoing considered, the appropriate standard that will implement the state’s public policy of fairness in rendering equitable distribution based on economic reality should be as follows:
***
A non-titled spouse should be entitled to fairly share in the economic value of a business legally or beneficially acquired during the marriage. This value shall be defined as that which the owner could receive at a point in time from market participants (potential willing buyers) after both parties have considered and analyzed all of the relevant facts. This amount would be the cash equivalent subject to equitable distribution at the appropriate termination date.
***
The goal of this standard is to fairly compensate the non-titled spouse and not put an undue burden on the non-titled spouse. It is intended to reflect economic reality. It is based on the assumption that the cash equivalent of the asset reflects the value of the titled spouse’s interest in the business and will require distribution of nothing more than what the owner could expect to receive from market participants.
Therefore, based upon the foregoing, it is clear that those entrusted with the resolution of business valuations incident to the dissolution of marriage or other family-type relationships, must be guided by concepts of economic reality and cash equivalency. In so doing, matrimonial disputes will be resolved with adherence to the most important concept, (i.e.fairness to all).
The author wishes to thank Leslie M. Solomon, CPA, ABV, ASA of Rotenberg Meril Solomon Bertiger & Gutilla, P.A. for his invaluable assistance with this column.
[1] Reference is made to Justice Pashman’s observation in Kikkert v. Kikkert, 88 N.J. 4, 10 (1981) that “fairness after all, is the prime concern of equitable distribution.”
[2] Reference is made to Justice Rivera-Soto’s statement in Steneken v. Steneken, 183 N.J. 290 (2005) wherein His Honor emphasized that, “we start from the bedrock proposition that all alimony awards and equitable distribution determinations must – both jointly and severally – satisfy basic concepts of fairness.” Id. at 298.
[3] Standard of Value sets the criteria upon which valuation analysts rely. An essential step in valuing a business is selecting and then applying the appropriate standard of value. Applying the standard including: fair market value, fair value, intrinsic value, value to the holder, equitable distribution value or some other standard involves an assumption as to who will be the buyer and who will be the seller in the hypothetical or actual sales transaction regarding the assets at issue.
[4]Brown v. Brown, 348 N.J. Super (App. Div. 2002). In Brown, the Appellate Division adopted Fair Value, a corporate law principle under N.J. S.A. 14A:11-1 and N.J.S.A. 14A:12-7(1)(c) utilized in shareholder dissenting oppression cases. As recently noted by Frank Louis, Esquire in his article entitled, “Value to the Holder, Not Fair Market Value, is the correct standard to value a professional practice in New Jersey,” (as originally published in the materials made available at the 2015 Family Law Symposium), Brown adopted Fair Value notwithstanding the Supreme Court’s admonition, albeit in a footnote, that using corporate statutory remedies may not be applicable in a divorce. See Balsamides v. Protameen Chemicals, 160 N.J. 352, 375 (1999), fn. 9.
[5]Fair Value is defined as a legislatively determined valuation standard applied under N.J.S.A. 14A:11-3(2).
[6]Fair Market Value is defined as the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. (IRS Regulation 20.2031-1).
[7] A “marketability discount” reduces the value of the business by recognizing the time that it would take to effectuate a sale.
[8] A “minority interest discount” recognizes that there is an impact on one’s income (and therefore value of one’s interest) in a business when that owner does not have a controlling interest.
[9] A “control premium” is the converse of a minority interest, and increases value to the owner due to that person’s ability to control the entity.
[10] Fishman, Pratt & Morrison, A Consensus View, Q&A Guide to Financial Valuation at 178 (2016).
[11] See N.J.S.A. 2A:34-23.1.