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Profession: Expert Witness

Date:6 MAY 2021

The value of a family business or business interest is treated as an asset and therefore part of the matrimonial pot to be distributed when it comes to negotiating a financial settlement on divorce or in dissolution settlements. Since the business valuation may be the most significant component of the total matrimonial assets, it needs to be ascertained with care, normally with expert assistance, in order to achieve a fair division of family wealth on divorce.

Why are business valuations important?

Business valuations are important for a number of reasons, including the following:

  • Proper account needs to be taken of a number of aspects which can affect the valuation, including whether both parties are involved, whether the business owner is a sole trader, a partner or a shareholder, whether one or both parties own all or only a percentage of the shares, whether the business owns property and whether the business is merely an income-producing vehicle. For instance, a business which is just an income-producing vehicle reliant upon one or two individuals may have little value as a going concern.

  • Consideration needs to be taken of agreements between shareholders or partners which may impose conditions on the transfer of interests in the business or the way in which shares or goodwill are to be valued.

  • If the valuation of a partnership interest or shareholding is a relatively significant proportion of the overall amount attributed to the family assets owned by the parties, it may be necessary for value to be realised from the business. It may be appropriate for a partner or shareholder to divest a proportion of his or her interest or to release funds from the business.

  • As the principle of sharing has evolved, the courts are now more likely to make an order which requires a business to be restructured or possibly sold to implement the terms of any settlement. As an example of restructuring, a family court may order a transfer of shares to the other spouse so that a financial settlement can be arranged in a tax-efficient way. It is vital therefore that the valuation of the business represents a true reflection of its worth!

  • A clean break terminating the financial obligations of the husband and wife to each other may need to be deferred if the business is either too difficult to value or in such a state of flux that justice can only be done by allowing each party to retain a stake. Postponement may also be necessary if assets are illiquid or the husband's borrowing power is limited.

  • If a relatively low value is 'incorrectly' attributed to a business, important implications may include the business being deemed to have insufficient assets for use in any settlement proposals and the business being considered to have inadequate profits to provide a healthy income stream for the party continuing to be involved in the business.

  • If a business is valued at a relatively high amount not justified by its future earnings and assets, it may be concluded incorrectly that the business has sufficient assets to assist in settlement proposals and/or that it can sustain a very healthy income stream for the party who continues in the business. Proposals effected on the basis of such conclusions may jeopardise the future of the business as a going concern.

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What needs to be valued?

In order to value a shareholder's stake in a company or a partner's share of a partnership, it is necessary in the first instance to value the company or business as a whole. A business with a consistent history of profits expected to continue as a going concern is generally valued on the basis of its maintainable earnings stream or on the basis of its discounted future cash flows. In order to evaluate its maintainable earnings stream, it is often necessary to make adjustments to the past profits of the business so as to be able to estimate the 'future' earnings stream to be sold to a prospective buyer. Such adjustments would include the exclusion of one-off sources of income or expenditure incurred in the past not likely to be applicable in the future and the need to take account of the cost of full-time management of the business.

In order to determine the value to be attributed to the maintainable annual earnings of a business, it is normal practice to apply a 'price' to such earnings, ie the amount payable in the market for buying an earnings stream either by reference to 'Price/Earnings' ratios as applicable to actual transactions or by reference to the average ratio applicable to the industry sector concerned in relation to companies quoted on the Stock Exchange.

For a business with a patchy history of profits and with an uncertain future, albeit with a relatively healthy asset base, it may be more appropriate to consider the net assets rather than the earnings stream in valuing the business. It may also be appropriate to consider net assets for sectors in which assets can be realised with relative ease and within which earnings may be less of a driving force than asset appreciation, eg the property sector.

Divorce settlements

A family company's funds can primarily be used to provide a capital sum or to increase the income of one or both of the shareholders/ directors. It will often be important to take into account the views of other shareholders and directors on the proposals, particularly if the divorcing party is not the majority or largest shareholder.

Providing a capital sum

Capital sums from a family company may be realised in a number of ways including the following:

  • Repayment of loans made by a shareholder/director to the company or of a directors' current account is potentially a tax-effective way of making funds available.
  • Shareholders/directors may realise cash by selling assets to the company which are owned by them but which have been used by it.
  • A shareholder can sell shares to a third party. Important financial considerations include the ease with which a buyer can be found, the terms of any potential sale, eg whether any payments are to be deferred, and the continuing role of the shareholder in the company. Alternatively, the shareholding may be used as security for increased borrowings by the shareholder.
  • The company may be able to release funds by re-purchasing shares owned by a shareholder.
  • Increased pension contributions by a company on a director's behalf can increase the value of his or her pension fund. The contributions will increase the director's pension rights after retirement so that the amount which can potentially be drawn down as a lump sum may increase in the foreseeable future.

Increasing income

The income of one or both of the shareholders/directors of a family company may be increased in a number of ways, including the following:

  • A straightforward way of releasing funds to a director is to increase his or her salary or pay a bonus. An important factor, however, is that employer's National Insurance contributions will normally be payable on the full amount of the salary and bonus.
  • The company must have adequate distributable profits to fund increased dividend payments. The dividend will be taxable income in the hands of the shareholder. A potential drawback is that the company will also have to pay dividends to other holders of the same class of share.
  • If a shareholder/director has made a loan to the company, or has a credit balance on his or her current account with it, the company can be charged interest on a commercial basis for the use of these funds. The interest will represent taxable income in the hands of the shareholder/director.
  • A shareholder/director may own some or all of the company's trading premises and may not charge rent on an arm's-length basis. Any increased rents charged to the company will be paid gross to the shareholder/director, who will be liable for income tax on the rents.

Conclusions

As all businesses differ and valuations are critical for the reasons noted in this article, it is important to avoid an over-simplistic or mechanistic approach to work on valuations and to ensure that they are independent, based on the best available information and prepared on the basis of the most appropriate methodology.

The resources which are potentially available to a controlling shareholder/director of a family company include its readily realisable assets, primarily cash. Although funds cannot be removed at will, as businesses need to retain assets to continue trading, there may be scope for raising funds through borrowing against revalued assets and/or the sale of surplus or under-utilised assets. If funds are extracted from a company, the directors will need to consider whether the business can generate the income to service any additional indebtedness. In addition, it is necessary to establish as exactly as possible the overall financial and tax situation of the individual and the business when considering the best way of funding a divorce settlement.

This article was first published in New Law Journal, 171 NLJ 7921, p20, and is reproduced with permission.

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