Business Valuation

Fair Market Value in Pennsylvania Divorce

“Fair market value” is defined as the price that a hypothetical buyer would pay to purchase the business from its owner in an arms length transaction. While Pennsylvania law does not mandate fair market value in divorce litigation, that standard has prevailed over other standards, such as “fair value.”

The fair market value standard incorporates certain assumptions, including the assumptions that the hypothetical purchaser is not motivated by any synergistic or strategic influences; that the business will continue as a going concern and not be liquidated; that the hypothetical sale will be conducted in cash or equivalents; and that the parties are willing and able to consummate the transaction. These conditions are assumed because they allow a meaningful comparison between businesses that are similarly situated.

What is Business Valuation or Company Appraisal?

Business valuation is a process applied by qualified valuation experts to determine the fair market value of an owner’s interest in a business. Three different approaches are commonly used in business valuation: the income approach, the asset-based approach, and the market approach. Within each of these approaches, there are various techniques for determining the fair market value of a business.

  • The asset-based approach is perhaps the simplest method. By adding up the values of the assets, the expert may determine the book value or net asset value of a business. It may be necessary to adjust the historical cost value of the assets shown on a balance sheet to their fair market value.
  • The income approach determines value by calculating the net present value of the benefit stream generated by the business. The appraiser might adjust the company’s cash flow statement before applying an appropriate capitalization or discount rate.
  • The market approaches determine value by comparing the subject company to other companies in the same industry, of the same size, and/or within the same region.

Most treatises and court decisions encourage the valuator to consider more than one technique, which must be reconciled with each other to arrive at a value conclusion.

Normalization of Financial Statements

Generally, the first step in business valuation is called “normalization” of the company’s financial statements. Normalizing the company’s financial statements permits the valuation expert to compare the subject company to other businesses and detect trends and irregularities. Appraisers adjust the owner’s compensation and benefits to reasonable levels, add back non-cash expenses like depreciation, and adjust non-recurring income and expenses.

Capitalization of Net Income or Cash Flows

In Pennsylvania divorce litigation, most business valuations are based on a variation of the capitalization-of-earnings method. The capitalization-of-earnings method calculates fair market value by first normalizing the profit-and-loss statement to determine the profit that a hypothetical buyer would generate after the sale. Next, the appraiser determines what level of investment return the hypothetical buyer would demand for this type of business. Since private businesses are more risky than government bonds, or blue chip stocks, or even most penny stocks, investors generally demand a higher return for private companies than any of these other investments. With these two criteria (normalized earnings and capitalization rate), the appraiser can predict the price that a hypothetical buyer would pay to buy the business. Often, the appraiser applies valuation discounts because there is no ready market (such as NYSE or NASDAQ) for private company stocks and/or because the owner holds a minority interest in the business.

Articles on Business Valuation

The following links contain information about business valuation:

Eight Landmines to Watch Out for in Divorce Valuations

Fundamentals of Business Valuation in PA: Glosser Bros

Glosser Bros Part II”

Medical Practices, Law Practices, Dental Practices

The following links contain information relevant to the valuation of professional practices in divorce:

Three Signs of Enterprise Goodwill in Professional Practices

Quantifying Personal Goodwill – Smith v. Smith

More Personal Goodwill: Baker