Business Valuation in Divorce

Part One of a Two-Part Article

The question of how to value private companies in marital dissolution proceedings has been wrestled with for many years. Several valuation methods have been used, although some that are commonly used, and perhaps favored, for other valuation purposes are effectively banned from use in divorce cases due to interpretations of existing case law. Two significant valuation methods, the Guideline Public Company Method (GPC method) and the Discounted Cash Flow Method (DCF method), have been largely excluded from use in divorce cases in some states. This article addresses the GPC method, and when it would be appropriate to use. At a later date, Part Two of this article will address the DCF method.

Cases in Point

The two early court cases frequently cited for the proposition that the GPC method is not applicable in marital dissolutions are In re Marriage of Hewitson 142 Cal.App.3d 874 (1983), and In re Marriage of Lotz 120 Cal.App.3d 379 (1981). Hewitson and Lotz are two influential California family law cases that were appealed and decided in 1983 and 1981, respectively. Several more recent court cases also address the GPC method: Hamby v Hamby, No. COA00-151 (N.C. App. (2001), Guill v Guill, No A-00-357, Neb. App. unpublished (2001), In re the Marriage of Schlief, No. C2-02-493, Minn. App. (2002) and In re the Marriage of Sims, No. 20238-6-III, Wash. App. (2003). Below are brief summaries of the six cases noted.

In re Marriage of Lotz

During the marriage, the parties formed Your Own Things, Inc. (YOTI), a privately held company that manufactured women's clothing. At trial, the wife's expert used a multiplier of 7 times pretax earnings (a price/earnings multiple of 7) and valued YOTI at $595,000. He derived this multiple from an analysis of over 5100 public companies as published in Standard & Poors, concentrating on public companies that manufactured women's clothing. The method of valuation used by the husband was not disclosed. The trial court found in favor of the wife.

The case was appealed and the appellate court stated that publicly traded corporations have little relevance when valuing a closely held corporation because sales volume of publicly traded corporations is much higher, liquidity is much greater, and public companies are less risky because they can “miss on two or three lines” without being hurt too much. The court also cited that the cost of going public is high. The lower court decision was reversed.

Marriage of Hewitson

During the marriage, the parties formed Ronan, a privately held company that designed and manufactured monitoring devices. At trial in 1981, the wife's expert used a price/earnings ratio and valued Ronan at $9.6 million. The price/earnings ratio was derived from acquisitions of two public corporations. Although several valuation methods were used, each method used the same two public corporate acquisitions as a basis for these methods. The husband's expert used similar methodology and valued Ronan at $6 million. The trial court found in favor of the wife.

The case was appealed, and the appellate court held that the trial court's reliance solely on the price/earnings ratio approach to determine the value of Ronan was in error. The appellate court held further that the trial court improperly applied the price/earnings multiple approach by basing the multiples on the prices paid in acquisitions rather than market prices of stock listed on an exchange or over-the-counter. The Hewitson court cited the Lotz appellate decision, noting that before Lotz, the GPC method was approved under both statutory and decisional federal law. However, the Hewitson court, stating that the Lotz case was applicable and controlling, ruled that the GPC method was unreliable, primarily due to the lack of a ready market for the privately held shares.

Additional Cases

Hamby v Hamby

This case involved the valuation of a captive insurance agency. The trial court rejected the testimony of the husband's expert, who relied partially on a capitalization of income approach, but primarily on the adjusted book value of the agency. The lower court criticized this expert for failing to consider the GPC method “which … would seem to the Court to have analytical value and which [the opposing expert] testified should have been used.” The appellate court affirmed the valuation of the business based on the wife's expert's testimony — which, while not explicitly stated, may be inferred from the above quote — considered the GPC method. The appellate court affirmed the decision of the lower court with respect to the valuation of the agency. Of all the cases discussed above, only the Hamby court (again, by inference) allowed the GPC method, and in fact, chastised the opposing appraiser for not using it. The statements of the court do not explain why the method was allowed in this case, compared to other cases that disallowed the method.

Guill v Guill

This case involved the valuation of a majority interest in a closely held business operating two business segments: temporary professional staffing and ATM kiosks. The wife's expert valued each business segment using only a GPC method that included Xerox, Pitney Bowes, and Manpower. The trial court was not persuaded by this expert, and the opinion of the husband's expert was accepted by the trial court almost unchanged. The appellate court upheld the decision of the lower court.

In re the Marriage of Schlief

This case involved the valuation of a minority interest in a large, private financial planning business. One party's expert relied solely on the market approach, which utilized comparable public company data. The lower court rejected this expert's testimony stating, this expert ” … should have relied on more than one valuation approach, and found that … [he] had used improper data in his appraisal and unconventional valuation techniques.” The appellate court affirmed the lower court's valuation of the business, which was based on the opposing expert's valuation that relied on the income approach, the guideline transactions method, and past company transactions.

Interestingly, Schlief quotes from an earlier case, Nardini (414 N.W.2d 184, 188, Minn. 1987), which quoted Revenue Ruling 59-60. In fact, both appraisers considered the RR 59-60 factors in their analysis. However, the court found using only public company data was not appropriate, and upheld the lower court's ruling.

In re the Marriage of Sims

In this case, a minority interest in a printer manufacturer was valued. One expert valued the business solely by reference to the market approach, using the premise that this company would likely be acquired by a public company. The competing expert did not give the market approach any weight because no comparable public companies could be identified. Neither experts' value was accepted, but rather the court assigned a value to the stock. The appellate court upheld the decision of the lower court.

Revenue Ruling 59-60

Several courts noted that Revenue Ruling 59-60, which lists eight factors that should be considered in any business valuation, should have been followed. All factors are important, but the eighth is the most relevant to the GPC method. Factor 8 of RR 59-60 states that when valuing a business, “The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over the counter … ” should be considered.

The difference between public acquisitions and actively traded public stock is an important distinction. Publicly traded stock may trade millions of shares on a daily basis, thus, the published price of the stock is deemed one of the best indications of fair market value. On the other hand, acquisitions of public or private companies involve a one-time transaction that may be affected by factors specific to the transaction that may influence the resulting value to be higher or lower than fair market value. The factors set out in RR 59-60 should be considered in any business valuation, including those pertaining to family law matters. The Hewitson court's opinion was conflicting, saying both that RR 59-60 should be followed, yet disallowing the valuation method based on factor 8 of RR 59-60.

Pratt Responds to Lotz

The Lotz appellate court did not allow the GPC method. Not knowing today the full rationale of the judges, it is difficult to say that this was an improper decision at that time. However, today there are so much more data available regarding publicly traded companies, and access to these data is so much easier, that the method can be done quite accurately. This point is well made in Valuing a Business, Fourth Edition, by Shannon Pratt, Robert Reilly and Robert Schweihs.

The Lotz case cited several reasons that explain why public companies are not comparable to private companies.

• Size: Public companies are larger in revenues and assets.
• Liquidity: Public companies have greater liquidity or marketability.
• Risk: Public companies are more diversified.
• Cost to go public: Going public is expensive for private companies.

Size

Pratt explains that this generalization, that public companies have greater revenues and assets, is “no longer valid.” There are thousands of public companies with equity values under $10 million. Today it is easier to find publicly traded guideline companies that are comparable in size and operations to the private companies that one has to value.

Liquidity

Pratt says that the generalization that public companies have liquidity and private companies do not is also no longer valid. It is now easier for small companies both to go public and to find private equity investors.

Risk

Pratt explains that the diversification that may have existed in most public companies 20 years ago is much less a limiting factor now. Many public companies today have only one or a few lines, and are not highly diversified.

Cost to Go Public

According to Pratt, the cost to go public (the cost of flotation) is significantly less today than 20 years ago. We can see this by the large number of companies under $10 million in equity value.

Bad Facts May Make Bad Law

The Hewitson court was correct to exclude the acquisition method as the sole method for appraising Ronan, particularly because the appraiser used only two acquisitions. In reality, the appraiser in the Hewitson case used one method in three different ways, based on only two acquisitions. This is not proper valuation practice, even outside of the marital courts. Further, it appears that on appeal, the Hewitson court disallowed the price/earnings method (a subset of the GPC method) primarily due to the decision in the Lotz case.

In Lotz, the appellate court refused to allow the valuation of a small clothing manufacturer based on the application of a price-to-earnings multiple derived from what appears to be a simple analysis of public price-to-earnings ratios. The use of a single multiple based on an inadequate sample of guideline companies is not proper valuation practice and the court was correct in its refusal to allow this valuation method alone.

In both of these cases, the courts were almost certainly correct to exclude the use of the GPC method in the way that it was used. Many attorneys and judges in California, however, have broadened the meaning of these two very influential cases to imply that the GPC method is never allowable in divorce cases. This is not only what I believe to be an incorrect interpretation of case law, but has fostered the widely held belief that the GPC method is never appropriate, and this is harmful to the practice of business valuation in divorce cases.

When Should Appraisers Use the GPC Method?

Initially, it is easier to determine when the GPC Method should not be used. An appraiser should not use the GPC method when he or she is certain that there is no reasonably similar public counterpart. A solo practitioner, ie, a doctor, dentist or lawyer, does not have a public company counterpart. In these cases, the appraiser would not even consider the GPC method.

However, if the business is a very large, highly diversified, 2000-employee manufacturing firm with professional management, the appraiser would almost certainly find publicly traded companies with which to compare it. In this case, the appraiser would almost always use the GPC method as one of the approaches (but never as the only approach).

Between these two extremes, some businesses, although small, have many publicly traded counterparts. The software industry is replete with small software development companies, many of which are public. In fact, in a recent valuation, one appraiser found over 100 public software companies, most of which were small companies, which were very similar to the subject company. These situations clearly demand the inclusion of the GPC method as one of the several appropriate methods.

Conclusion

The six cases discussed above illustrate several common themes: 1) Courts do not like valuations using only one method; 2) Courts place weight on the credibility and credentials of experts; 3) Courts generally do not accept the GPC method, but not always for the same reason; and 4) Courts generally affirm the use of the RR 59-60 factors.

As one of several standard business valuation methods, the GPC method is appropriate for appraising certain privately held companies. The method is frequently used in areas other than family law, such as for gift and estate tax calculations, or partnership dissolutions. Not all, but some family law cases merit the use of the GPC method. If the valuation analyst believes that a private company may have public company counterparts, the GPC method should be considered. Furthermore, if the initial search and analysis of the public companies yield positively correlated characteristics, this method should be used as one of the several methods to establish value.

Vanita M. Spaulding, CFA, ASA, is a Business Valuation Partner at Gursey, Schneider & Co. LLP, Los Angeles. A Chartered Financial Analyst, she is also an Accredited Senior Appraiser with the American Society of Appraisers, has practiced business appraisal for 22 years, and has taught the ASA courses for 12 years. The author wishes to thank Michael Rabe, CFA, Gursey Schneider & Co., LLP; and John Stockdale, Jr., Valuation Information, Inc., for their invaluable research and assistance.

Part One of a Two-Part Article

The question of how to value private companies in marital dissolution proceedings has been wrestled with for many years. Several valuation methods have been used, although some that are commonly used, and perhaps favored, for other valuation purposes are effectively banned from use in divorce cases due to interpretations of existing case law. Two significant valuation methods, the Guideline Public Company Method (GPC method) and the Discounted Cash Flow Method (DCF method), have been largely excluded from use in divorce cases in some states. This article addresses the GPC method, and when it would be appropriate to use. At a later date, Part Two of this article will address the DCF method.

Cases in Point

The two early court cases frequently cited for the proposition that the GPC method is not applicable in marital dissolutions are In re Marriage of Hewitson 142 Cal.App.3d 874 (1983), and In re Marriage of Lotz 120 Cal.App.3d 379 (1981). Hewitson and Lotz are two influential California family law cases that were appealed and decided in 1983 and 1981, respectively. Several more recent court cases also address the GPC method: Hamby v Hamby, No. COA00-151 (N.C. App. (2001), Guill v Guill, No A-00-357, Neb. App. unpublished (2001), In re the Marriage of Schlief, No. C2-02-493, Minn. App. (2002) and In re the Marriage of Sims, No. 20238-6-III, Wash. App. (2003). Below are brief summaries of the six cases noted.

In re Marriage of Lotz

During the marriage, the parties formed Your Own Things, Inc. (YOTI), a privately held company that manufactured women's clothing. At trial, the wife's expert used a multiplier of 7 times pretax earnings (a price/earnings multiple of 7) and valued YOTI at $595,000. He derived this multiple from an analysis of over 5100 public companies as published in Standard & Poors, concentrating on public companies that manufactured women's clothing. The method of valuation used by the husband was not disclosed. The trial court found in favor of the wife.

The case was appealed and the appellate court stated that publicly traded corporations have little relevance when valuing a closely held corporation because sales volume of publicly traded corporations is much higher, liquidity is much greater, and public companies are less risky because they can “miss on two or three lines” without being hurt too much. The court also cited that the cost of going public is high. The lower court decision was reversed.

Marriage of Hewitson

During the marriage, the parties formed Ronan, a privately held company that designed and manufactured monitoring devices. At trial in 1981, the wife's expert used a price/earnings ratio and valued Ronan at $9.6 million. The price/earnings ratio was derived from acquisitions of two public corporations. Although several valuation methods were used, each method used the same two public corporate acquisitions as a basis for these methods. The husband's expert used similar methodology and valued Ronan at $6 million. The trial court found in favor of the wife.

The case was appealed, and the appellate court held that the trial court's reliance solely on the price/earnings ratio approach to determine the value of Ronan was in error. The appellate court held further that the trial court improperly applied the price/earnings multiple approach by basing the multiples on the prices paid in acquisitions rather than market prices of stock listed on an exchange or over-the-counter. The Hewitson court cited the Lotz appellate decision, noting that before Lotz, the GPC method was approved under both statutory and decisional federal law. However, the Hewitson court, stating that the Lotz case was applicable and controlling, ruled that the GPC method was unreliable, primarily due to the lack of a ready market for the privately held shares.

Additional Cases

Hamby v Hamby

This case involved the valuation of a captive insurance agency. The trial court rejected the testimony of the husband's expert, who relied partially on a capitalization of income approach, but primarily on the adjusted book value of the agency. The lower court criticized this expert for failing to consider the GPC method “which … would seem to the Court to have analytical value and which [the opposing expert] testified should have been used.” The appellate court affirmed the valuation of the business based on the wife's expert's testimony — which, while not explicitly stated, may be inferred from the above quote — considered the GPC method. The appellate court affirmed the decision of the lower court with respect to the valuation of the agency. Of all the cases discussed above, only the Hamby court (again, by inference) allowed the GPC method, and in fact, chastised the opposing appraiser for not using it. The statements of the court do not explain why the method was allowed in this case, compared to other cases that disallowed the method.

Guill v Guill

This case involved the valuation of a majority interest in a closely held business operating two business segments: temporary professional staffing and ATM kiosks. The wife's expert valued each business segment using only a GPC method that included Xerox, Pitney Bowes, and Manpower. The trial court was not persuaded by this expert, and the opinion of the husband's expert was accepted by the trial court almost unchanged. The appellate court upheld the decision of the lower court.

In re the Marriage of Schlief

This case involved the valuation of a minority interest in a large, private financial planning business. One party's expert relied solely on the market approach, which utilized comparable public company data. The lower court rejected this expert's testimony stating, this expert ” … should have relied on more than one valuation approach, and found that … [he] had used improper data in his appraisal and unconventional valuation techniques.” The appellate court affirmed the lower court's valuation of the business, which was based on the opposing expert's valuation that relied on the income approach, the guideline transactions method, and past company transactions.

Interestingly, Schlief quotes from an earlier case, Nardini (414 N.W.2d 184, 188, Minn. 1987), which quoted Revenue Ruling 59-60. In fact, both appraisers considered the RR 59-60 factors in their analysis. However, the court found using only public company data was not appropriate, and upheld the lower court's ruling.

In re the Marriage of Sims

In this case, a minority interest in a printer manufacturer was valued. One expert valued the business solely by reference to the market approach, using the premise that this company would likely be acquired by a public company. The competing expert did not give the market approach any weight because no comparable public companies could be identified. Neither experts' value was accepted, but rather the court assigned a value to the stock. The appellate court upheld the decision of the lower court.

Revenue Ruling 59-60

Several courts noted that Revenue Ruling 59-60, which lists eight factors that should be considered in any business valuation, should have been followed. All factors are important, but the eighth is the most relevant to the GPC method. Factor 8 of RR 59-60 states that when valuing a business, “The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over the counter … ” should be considered.

The difference between public acquisitions and actively traded public stock is an important distinction. Publicly traded stock may trade millions of shares on a daily basis, thus, the published price of the stock is deemed one of the best indications of fair market value. On the other hand, acquisitions of public or private companies involve a one-time transaction that may be affected by factors specific to the transaction that may influence the resulting value to be higher or lower than fair market value. The factors set out in RR 59-60 should be considered in any business valuation, including those pertaining to family law matters. The Hewitson court's opinion was conflicting, saying both that RR 59-60 should be followed, yet disallowing the valuation method based on factor 8 of RR 59-60.

Pratt Responds to Lotz

The Lotz appellate court did not allow the GPC method. Not knowing today the full rationale of the judges, it is difficult to say that this was an improper decision at that time. However, today there are so much more data available regarding publicly traded companies, and access to these data is so much easier, that the method can be done quite accurately. This point is well made in Valuing a Business, Fourth Edition, by Shannon Pratt, Robert Reilly and Robert Schweihs.

The Lotz case cited several reasons that explain why public companies are not comparable to private companies.

• Size: Public companies are larger in revenues and assets.
• Liquidity: Public companies have greater liquidity or marketability.
• Risk: Public companies are more diversified.
• Cost to go public: Going public is expensive for private companies.

Size

Pratt explains that this generalization, that public companies have greater revenues and assets, is “no longer valid.” There are thousands of public companies with equity values under $10 million. Today it is easier to find publicly traded guideline companies that are comparable in size and operations to the private companies that one has to value.

Liquidity

Pratt says that the generalization that public companies have liquidity and private companies do not is also no longer valid. It is now easier for small companies both to go public and to find private equity investors.

Risk

Pratt explains that the diversification that may have existed in most public companies 20 years ago is much less a limiting factor now. Many public companies today have only one or a few lines, and are not highly diversified.

Cost to Go Public

According to Pratt, the cost to go public (the cost of flotation) is significantly less today than 20 years ago. We can see this by the large number of companies under $10 million in equity value.

Bad Facts May Make Bad Law

The Hewitson court was correct to exclude the acquisition method as the sole method for appraising Ronan, particularly because the appraiser used only two acquisitions. In reality, the appraiser in the Hewitson case used one method in three different ways, based on only two acquisitions. This is not proper valuation practice, even outside of the marital courts. Further, it appears that on appeal, the Hewitson court disallowed the price/earnings method (a subset of the GPC method) primarily due to the decision in the Lotz case.

In Lotz, the appellate court refused to allow the valuation of a small clothing manufacturer based on the application of a price-to-earnings multiple derived from what appears to be a simple analysis of public price-to-earnings ratios. The use of a single multiple based on an inadequate sample of guideline companies is not proper valuation practice and the court was correct in its refusal to allow this valuation method alone.

In both of these cases, the courts were almost certainly correct to exclude the use of the GPC method in the way that it was used. Many attorneys and judges in California, however, have broadened the meaning of these two very influential cases to imply that the GPC method is never allowable in divorce cases. This is not only what I believe to be an incorrect interpretation of case law, but has fostered the widely held belief that the GPC method is never appropriate, and this is harmful to the practice of business valuation in divorce cases.

When Should Appraisers Use the GPC Method?

Initially, it is easier to determine when the GPC Method should not be used. An appraiser should not use the GPC method when he or she is certain that there is no reasonably similar public counterpart. A solo practitioner, ie, a doctor, dentist or lawyer, does not have a public company counterpart. In these cases, the appraiser would not even consider the GPC method.

However, if the business is a very large, highly diversified, 2000-employee manufacturing firm with professional management, the appraiser would almost certainly find publicly traded companies with which to compare it. In this case, the appraiser would almost always use the GPC method as one of the approaches (but never as the only approach).

Between these two extremes, some businesses, although small, have many publicly traded counterparts. The software industry is replete with small software development companies, many of which are public. In fact, in a recent valuation, one appraiser found over 100 public software companies, most of which were small companies, which were very similar to the subject company. These situations clearly demand the inclusion of the GPC method as one of the several appropriate methods.

Conclusion

The six cases discussed above illustrate several common themes: 1) Courts do not like valuations using only one method; 2) Courts place weight on the credibility and credentials of experts; 3) Courts generally do not accept the GPC method, but not always for the same reason; and 4) Courts generally affirm the use of the RR 59-60 factors.

As one of several standard business valuation methods, the GPC method is appropriate for appraising certain privately held companies. The method is frequently used in areas other than family law, such as for gift and estate tax calculations, or partnership dissolutions. Not all, but some family law cases merit the use of the GPC method. If the valuation analyst believes that a private company may have public company counterparts, the GPC method should be considered. Furthermore, if the initial search and analysis of the public companies yield positively correlated characteristics, this method should be used as one of the several methods to establish value.

Vanita M. Spaulding, CFA, ASA, is a Business Valuation Partner at Gursey, Schneider & Co. LLP, Los Angeles. A Chartered Financial Analyst, she is also an Accredited Senior Appraiser with the American Society of Appraisers, has practiced business appraisal for 22 years, and has taught the ASA courses for 12 years. The author wishes to thank Michael Rabe, CFA, Gursey Schneider & Co., LLP; and John Stockdale, Jr., Valuation Information, Inc., for their invaluable research and assistance.