Valuation in a Business Divorce

THE LEGAL INTELLIGENCER BLOG
Valuation in a Business Divorce
Terry Silver, The Legal Intelligencer
March 19, 2015

My advice to lawyers and CPAs is to prepare your clients for the prospect of a business divorce. A business relationship is no different than a marital one; people change, circumstances change, and people grow (and don’t grow) in different directions. And by “preparing for a business divorce,” I am referring to the need to create an operating agreement from the outset of a business relationship to address the following issues, if and when they arise:

Death of an equity owner;
Disability of an equity owner;
Sale of an equity interest to a third party;
Termination of an equity owner’s employment; and
The subject of this article: the predetermined steps to value an equity interest.

When a new business begins, financial resources are usually devoted to its tangible needs, while intangible needs are usually delayed. An operating agreement is typically recognized as an intangible need that can wait until cash flow improves. I, however, advise both new and newer business owners to negotiate the terms of an operating agreement as early in the business life cycle as possible, as once issues develop, it will be too late to negotiate a mutually acceptable operating agreement.

To address valuation, an operating agreement typically will either provide a specific method to value the business, or will designate the means by which to value the business. For example, the operating agreement can specify a methodology such as 5 x EBITDA or 1.5 x revenue. I strongly advise against this approach for two reasons: (1) The person selecting the valuation approach is most likely not qualified in business valuation, so the method selected may be flawed; and (2) there is no one correct way to value a business. As time and circumstances change, so too may the appropriate method to value a business change.

For these reasons, a fixed valuation method, to be used for all time, is ill-advised. I recommend the operating agreement specify the business be contemporaneously and independently valued, and the valuation be binding, as to avoid time-consuming and costly litigation. I further advise the operating agreement specify the credentials of the business valuator chosen to insure a credible valuation product. Commonly accepted valuation credentials include ASA, CVA, ABV and CFA.

Lastly, there may be a dispute between owners in the selection of the business valuator. This can be avoided by incorporating a provision in the operating agreement that enables each owner to select a business valuator. These two business valuators, in turn, jointly select the final business valuator, whose valuation opinion will be binding. This is a lesser used provision, as it is almost always preferable for the parties in dispute to choose a mutually acceptable valuator.

Taking the time in the early stage of a business to address potential adversarial issues via the operating agreement will save a great deal of time, anxiety and money once problems develop between owners.

Terry Silver is a partner at Citrin Cooperman, a full-service accounting, tax, and consulting firm with offices located throughout the Northeast. Based in Citrin Cooperman’s Philadelphia office, Silver focuses his attention on business valuation services and mergers and acquisitions. To learn more, visit www.citrincooperman.com.

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