Family Law: Understanding the Hypothetical Seller and Buyer

FACT: The emotions of spouses involved in a divorce often obscure the value of a company (or ownership interest), one of their most important marital assets. The spouse keeping the company (in-spouse) often argues that the company is less valuable. On the other hand, the spouse leaving the company behind (out-spouse) often argues that the company is more valuable. The company is less valuable because:

  • The in-spouse can open-up next door and compete
  • The in-spouse can close-up shop and walk away
  • The employees will not work for anyone else but the in-spouse
  • Nobody else but the in-spouse knows how to run the business

The out-spouse argues the company is more valuable because:

  • The next owner could improve the business
  • The in-spouse could improve the business
  • Some of the business contacts could become customers
  • The business would be doing better but for the divorce
  • The economy will improve and so will the business

While the spouses may believe their emotional arguments have merit, California family law courts base a company’s value on either the fair market value (FMV) or the fair value standard. The FMV standard uses the hypothetical financial buyer and the fair value standard uses the specific investment buyer (in-spouse). Unlike the FMV standard, the California courts have disallowed discounts for lack of control and marketability when using the fair value standard resulting in company values higher than FMV, which may become a factor of contention between the spouses.

True FMV is determined by the actual sale of a company on the open market. Since the actual sale of a company is not contemplated in divorce cases (and other legal cases), the FMV standard requires that a company’s value be determined by considering the hypothetical willing and able seller and buyer. FMV is defined as:

The price, expressed in terms of cash equivalents, at which a property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy nor to sell, and when both have reasonable knowledge of the relevant facts.

The FMV standard uses a price range concept with the fair market value falling within a range of prices. The bottom of the range is the lowest price a hypothetical willing seller seeking the highest price would accept and still sell the company. Whereas the top of the range is the highest price a hypothetical willing buyer seeking the lowest price would accept and still buy the company. An actual (and therefore hypothetical) sale cannot be completed if the seller’s lowest price is higher than the buyer’s highest price. Therefore, a valuation analyst must always think about what a ‘hypothetically’ real buyer and seller would think and do under similar circumstances. A real buyer will not often pay a premium for what he brings to the table; instead, he will pay for the FMV of the future performance that a company has proven. The real world and divorce courts lean more toward the buyer’s perspective. The following are a few examples of what a real seller and buyer would consider in valuing a company. A real seller would:

  • Not threaten to compete with the buyer
  • Keep the workforce intact for a new owner
  • Not give the company away
  • Train the new owners how to operate the business
  • Not close the business when there is potential to sell it
  • Seek the highest possible price for the business

A real buyer would:

  • Consider the ability of the company to meet owner salary requirements (market)
  • Generally rely on past and recent operating history
  • Consider how a sale might affect relationships with existing customers
  • Consider the capital outlay and cost requirements to make improvements
  • Consider the economy, industry and market
  • Seek the lowest possible price for the business

Regardless of the emotional arguments by each spouse, a valuation analyst must adhere to the basic willing and able seller and buyer requirements of the FMV standard for determining the FMV of a company. A valuation analyst should bring reason into divorce business valuation situations, which can often assist the parties in settling property division issues rather than depending upon the courts. In the event that a trier of fact (judge or jury) is involved, a valuation analyst can provide great assistance in determining if the FMV requirements have been met.

Other than in divorce, valuations by a business valuation analyst are important in financial, tax and litigation matters.

Important Notice
The preceding article is intended as general information and should not be considered legal, tax, accounting or other expert advice. As the author, I represent that neither the information nor its impact is comprehensive. If legal, tax, accounting or other expert advice is required, please use a qualified and competent professional.

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