Strategic Value in Divorce Settlements

Most divorce cases that involve the ownership of a business, or spousal support in starting a business are often contested. Regardless of whether a business valuation expert represents the plaintiff or the defendant, or is appointed a court “neutral”, he or she must be very careful to apply the appropriate standard of value. There are many different standards of value in use today. This case study will examine the primary differences between fair market value and strategic value, and provide an explanation as to why there are significant material differences between these two standards of value.

Many divorce cases often involve a debate over the value of each spouse’s ownership interest in a business. This occurs quite frequently since more than 95% of all corporations in the United States are private companies. Establishing the value of a business that is not publicly traded requires both technical expertise and subjective judgment on the part of the valuation expert.

A Brief History of Business Valuation in the United States

Business valuation is a process that uses certain analytical procedures to estimate the monetary value of the whole business, along with the monetary value of various ownership interests in the business – when the business is not listed on a public stock exchange. When the 18th Amendment to the U.S. Constitution became effective on January 16, 1920 it required many businesses who sold alcohol to close their doors. The Internal Revenue Service subsequently issued Appeals and Review Memorandum (ARM) 34 to provide guidance on how to determine the value of distillers and related businesses that were being put out of business by Prohibition.

“ARM 34 provided a formula for valuing a business: Capitalize the excess earnings to arrive at the value of intangible assets and then add that to the value of tangible assets.”[footnoteRef:1] Business valuation methods varied somewhat from the 1930’s through the 1950’s, but for the most part, generally followed this format. [1: Valuing Professional Practices and Licenses – A Guide for the Matrimonial Practitoner, 3rd edition, 2011-2 Supplement, Wolters Kluwer Law & Business, p. 8-3.]

This changed in January of 1959 when the Internal Revenue Service issued Revenue Ruling (Rev. Rul.) 59-60. It stated that no single formula should be used to value all businesses. This Revenue Ruling has been used to outline the general approach, methods and factors to be considered when valuing the shares of stock in a closely held corporation for a variety of purposes. This Revenue Ruling is widely used today. It is used for a variety of purposes, including estate and gift tax, matrimonial disputes, and other situations where the actual ownership of the stock being valued does not change hands.

Standards of Business Value in Divorce Settings

At the present time, there appears to be quite a bit of confusion regarding what standard of value should be used in marital dissolution cases. Valuation experts rely on the attorney who hires them to provide guidance on the applicable standard of value to use. The standards of value used in various states’ statutes, and the case law which interprets those standards differ from state to state.

In many states, commonly accepted standards of value are defined as: Fair market value, Fair value, Investment value, and Intrinsic value. Given the present state of confusion surrounding what the correct standard to be used for divorce proceedings is, I have decided to focus on the difference between Fair market value and Strategic value.[footnoteRef:2] While it should be noted that a great deal of controversy surrounds the issue of Personal Goodwill under the standard of Fair market value (especially when valuing professional service entities), I will avoid this issue by illustrating a hypothetical divorce settlement appeal based on an actual matter where I was chosen as the valuation expert, and Personal Goodwill was not an issue. [2: It should be noted that both standards of value are applied under the premise of value being, going concern – which assumes that the entity will continue to operate in its current form after the valuation date. A liquidation or break-up premise of value would assume that the entity would cease operations after the valuation date.]

Fair market value as defined in Rev. Rul. 59-60 is:

“… the price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” Section 20.2031-1(b) of the Estate Tax Regulations.

Strategic value as defined in the Lawyer’s Business Valuation Handbook is:

“A strategic or synergistic value reflects added benefits to a particular acquirer because of synergies with the acquirer. That is, it is a price or potential price reflecting all or some portion of the value of synergistic benefits created through the combination of the respective entities for which a buyer might be willing to pay. Such benefits include, for example, increasing market share, reducing costs by combining operations, and/or raising prices by eliminating a competitor….Synergistic value generally reflects some added value above fair market value. Because it reflects the value of benefits available to a particular buyer, it is usually considered to fall within the concept of investment value…”[footnoteRef:3] [3: The Lawyer’s Business Valuation Handbook, Shannon Pratt, 2000, ©2000, The American Bar Association, p. 14.]

Maryland’s Jane A. Doe v. John B. Doe

Jane and John Doe met while they were undergraduate students at the University of Maryland. They were married in June 1977, one month after graduation. John had been accepted into the PhD program in Computer Science at College Park, and was planned to attend graduate school full-time. Jane obtained a job with the federal government in Washington, DC and planned to pay all of the bills, and provide the majority of financial support for John. (John had received a scholarship to cover tuition costs, and was paid a small stipend of approximately $6,000 per semester for providing research assistance to the faculty.)

John completed his studies after six years in the graduate program, and was subsequently hired by the Raytheon Company, a major Department of Defense contractor, as a software engineer in 1983. John and Jane subsequently started a family, having a son and daughter, while John rose through the ranks at Raytheon. Eventually, however, John became disenchanted with the large, bureaucratic organization where he worked, and began to search for more creative challenges.

The internet boom was just taking off, so John wanted to capitalize on the skills and knowledge that he had obtained over the last 12 years at Raytheon. He wanted to start his own business. He spent long hours talking with Jane, trying to explain to her the boundless opportunities which the internet presented. Finally, with her permission, he presented his business plan to the Center for Innovative Technology, located in Herndon, VA.

John opened the doors to his internet start-up (hereinafter referred to as Company Dotcom) in the fall of 1995. He relied on Jane’s income and support in order to maintain the family’s standard of living, as he set out on his venture. (Jane had obtained a job with a major federal agency when graduating from the University of Maryland back in 1977. She had risen to a managerial level by 1993.) John and Jane gradually drifted apart, as financial strains and long periods of separation (due to John’s long hours at the business) began to magnify.

Finally, after 3 years of increasing anxiety and loneliness, Jane filed for divorce. John did not contest the divorce, and their marriage was dissolved by the Circuit Court for Prince George’s County Maryland in June, 1998. The Court ruled that the stock in Company Dotcom was to be valued by an independent expert (me) and that Jane was to receive a cash settlement for her one half interest in the business.

Internet Stock Valuation

Company Dotcom was a fairly typical internet start-up. Its initial funding had not been too difficult, as venture capitalists and angel investors were plentiful during the late 1990’s. Basically, all you needed was a sound business plan and a good idea, and venture capitalists would be interested in funding you.

As with many internet companies, Dotcom was valued based on a multiple of revenue basis. The three traditional approaches to value a business were not very effective measures at the time. Under the Asset Approach, there were few tangible, or physical assets, so there was very little value to be found. Under the Market Approach, there were few, if any publicly traded firms to use for comparison purposes to Dotcom, so this method could not be used. Finally, under the Income Approach, Dotcom had not shown any profits to date, so it was also useless.

The most widely-used approach to value used for this brand new industry had become a multiple of revenues approach. Hambrecht & Quist, an investment bank based in San Francisco was the co-lead underwriter (along with Morgan Stanley) for the Initial Public Offering (IPO) of Netscape Communications on August 9, 1995. They reasoned that since there were no earnings yet for the first widely popular internet browser, let’s just use revenue as our basis to value, for it reflects how much or how large Netscape’s ownership portion of the internet is. Earnings and profits were to be worried about later. Right now, it is market share that counts.

Standard of Business Value in Divorce Proceedings: Fair Market vs. Strategic Value

The judge in the matter of Jane A. Doe v. John B. Doe had directed the independent business valuation expert to use Fair market value as the Standard of Business Value when valuing the outstanding common shares owned by the Does in Company Dotcom. The expert then applied a multiple of revenue (5 times) to determine the fair market value of a 100% interest in Company Dotcom. This value, $10 million, was then allocated among the common shareholders, with Mr. and Mrs. Doe owning approximately 40% of the Company Dotcom’s outstanding common shares.

The Does’ were minority shareholders in Company Dotcom, owning a 40% interest, while the venture capitalists who had funded the operation from its start, owned the majority 60% interest. A discount for both a lack of marketability and a lack of control were then applied to the Does’ stock – combined, the discounts equaled 35% – to arrive at a fair market value of $2,600,000 (65% of $4 million). Mrs. Doe owned 50% of the 40% interest, so her cash settlement equaled $1,300,000.

Mrs. Doe did not contest this value, and the divorce agreement was finalized.

Three years later, however, things changed. One of the major players in the development of the internet, located in Loudon County, Virginia acquired Company Dotcom for $28.2 million in the summer of 2001. Mrs. Doe read this in the paper shortly after the acquisition, and contacted her attorney. She felt that Company Dotcom had been undervalued when she signed the divorce decree back in 1998.

Mrs. Doe’s attorney then set about trying to determine whether to file a motion to amend the Divorce Judgment in 1998, and asked for a new trial with the Court of Special Appeals in Prince George’s County. The attorney decided to contact the business valuation expert in the hopes of finding out how this discrepancy in the value of the business could have happened.

The valuation expert met with Mrs. Doe and her attorney to explain how the difference between the divorce settlement value and the subsequent value used to sell the Company Dotcom happened. The expert explained that the acquirer simply found Company Dotcom to be a great strategic fit for them. The reason for the discrepancy in values lie in the fact that under the standard of Fair market value, Mrs. Doe’s interest was worth considerably less, for it had been appraised from the perspective of a “willing buyer and willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

Strategic value, which the acquirer used to determine the price they ultimately paid to buy the business, looked at Dotcom from the perspective of the synergies which Dotcom Company had with them. More specifically, they looked at how the acquisition would allow them to expand their revenues more rapidly than they would by trying to create the technology owned by Dotcom Company themselves. Hence, a 100% ownership stake in Dotcom Company was worth 2.8 times more to the acquirer than it was to the existing stockholder.

In closing, the business valuation expert explained that the standard of Strategic value does not include discounts for lack of marketability and control – which the standard of Fair market value includes. This is due to the fact that the owner of the shares in a privately held company must have a majority and marketable controlling interest in the business in order to realize the business’s strategic value. Mr. and Mrs. Doe’s interests were minority interests, so on the date of their divorce settlement, it would have been impossible to apply the standard of Strategic Value.

You Need a Professional Writer To Work On Your Paper?