During an economic recession, the best tool for valuing a business is a discounted cash flow (DCF) analysis. A DCF analysis is the only valuation method that allows a financial expert to develop customized financial projections for the business that account for both the economic downturn and the eventual recovery. This article describes the DCF analysis. I also address a common misunderstanding about whether it is legally permissible to use financial projections to value a business in an equitable distribution case. As I explain, using financial projections to value a business does not run afoul of the directive found in Poore to value business goodwill “by taking into account past results, and not the postmarital efforts of the professional spouse[.]” Poore v. Poore, 75 N.C.App. 414, 421 (1985). Using a DCF analysis to value a business on the basis of its projected income is perfectly consistent with North Carolina law, as long as the projections account for a reasonable compensation for the business owner spouse.
Basic Valuation Concepts
Valuing Business Ownership as a Property Interest. N.C. Gen. Stat. § 50-20 requires the trial court to classify, value, and distribute marital and divisible property. An ownership interest in a business is personal property. From a financial standpoint, that personal property only has value when it can deliver a stream of future profits to a passive owner who holds it. A passive owner does not work in the business. Instead, the passive owner simply waits by the mailbox to receive a profit distribution check from the business. That check represents purely a return on the owner’s capital investment in the business.
In many small businesses, the owner is not a passive owner. He or she is also the manager of the operation. In those situations, the check in the mailbox sometimes represents both a return on the owner/operator’s capital and a return on the owner/operator’s labor. If so, the expert must make an adjustment to that profit check to properly value the ownership in the business as a property interest for purposes of § 50-20. Because a property interest in a business is valued based on a return on capital profit stream, the value of the owner/operator’s labor must be subtracted out when the profit represents both a return on capital and labor. For example, if an owner/operator makes $100,000 per year, and $60,000 per year is reasonable compensation for his or her labor in managing the business, the passive owner profit would be $40,000 per year. The $40,000 annual profit is a return on capital, and it is the figure used by the expert to value the owner/operator’s ownership in the business as a property interest. The other $60,000 received annually by the owner/operator is the value of his or her labor in managing the business. Although relevant for alimony, that $60,000 amount is irrelevant in valuing the owner/operator’s property interest in the business. As a further example, let’s assume the expert determines this future $40,000 annual profit stream is worth $120,000 today. Stated another way, the expert is saying an investor would be willing to pay $120,000 today for the right to receive the $40,000 annual profit stream from the business in the future. That $120,000 represents the value of the owner/operator’s ownership in the business as a property interest for purposes of § 50-20.
Concept of Present Value. The concept of present value is the foundation of all financial asset valuation. Present value concepts are what the expert uses above to determine that a business generating $40,000 of profit each year in the future is worth $120,000 today. Present value can be understood by thinking about interest earned in a savings account. Believe it or not, there was a time when you could actually earn 5% interest in a bank account. When 5% is paid, if you deposit $95 today and wait one year, you will have $100 in your account. You will have earned $5 of interest on your $95 over a one-year period. If you understand that example, you understand present value, which simply accounts for the investment return that can be earned through the passage of time. Stated another way, $100 a year from now has a present value today of $95 based on a 5% investment rate of return assumption. Using a different rate of return assumption yields a different present value. For example, $100 a year from now has a present value of $91 using a 10% rate of return assumption.
Discounted Cash Flow Analysis. A discounted cash flow (DCF) analysis is the primary method of valuing a business. The theory is simple. A business is worth the present value of all future profits expected to be generated by the business over its assumed life. A DCF analysis involves three steps. First, the expert develops yearly projections of the future cash flows (future profits) expected to be generated by the business over its life. Most of the time, a business is assumed to exist forever. Second, each yearly projection of future profit is individually discounted to present value at an assumed investment rate of return. In the case of a business that is assumed to exist forever, there will be an infinite number of yearly profit numbers to discount to present value. Third, all of those present value numbers are added together to arrive at today’s present value of the business.
Despite assuming businesses have infinite lives, experts do not develop profit projections over an infinite number of years. That would be too cumbersome. Instead, they typically develop projections over a five-year period and make simplifying assumptions about years six through infinity. During this five-year projection period, an expert can account for a recession by projecting revenues and profits based on expectations for the timing of the economic downturn and recovery. It is important to understand that the value generated by a DCF analysis only has meaning when the projections are founded on realistic assumptions about the business. Thorough due diligence by the expert is essential to developing those assumptions. This is particularly true with projections that span an economic downturn and recovery, as those projections are more complex to develop.
Goodwill. Goodwill is an accounting concept that represents the intangible value of a business. It refers to the amount of business value that is not reflected in the company’s tangible assets. Tangible assets are items we can see listed on the balance sheet such as real estate, equipment, accounts receivable, bank accounts, etc. Goodwill is a residual number. It is calculated by first determining the value of the business using an income method like a DCF analysis. Goodwill is equal to the value of the business minus the value of the tangible assets. In our example above, the business value is $120,000, which was computed based on the business earning $40,000 per year forever. If the value of the company’s tangible assets is $30,000, then goodwill (intangible value) is equal to $90,000. Computing goodwill is therefore essentially an exercise in valuing the overall business based on its capacity to generate future income. The computation of the $120,000 overall business value is the critical part of the goodwill calculation.
Legal Aspects of Using Projected Income in Business Valuation
In Poore, the Court of Appeals stated there is no particular valuation methodology that must be used when valuing a business for purposes of equitable distribution. See Poore at 419. Value is a question of fact that must be resolved on a case-by-case basis. Id. Therefore, trial courts have a wide range of flexibility in selecting a valuation methodology that is appropriate for the situation. Whichever methodology is used, care must be taken to avoid valuing postmarital efforts. The Poore court stated that goodwill is properly valued by “[a]ny legitimate method of valuation that measures the present value of goodwill by taking into account past results, and not the postmarital efforts of the professional spouse[.]” Id. at 421. Some observers argue the prohibition against valuing postmarital efforts means a business valuation method that uses projections of future business income, such as a DCF analysis, is legally impermissible. I believe this view is incorrect for three reasons.
First, as a matter of financial theory and real-world experience, a business valuation can only be made using projections of future business income. Investors value businesses by looking through the windshield and not the rearview mirror. They do this because they pay money for a business based on future profits they hope to receive. Past profits are sometimes a useful guide, but the price an investor is willing to pay for a business is based entirely on expectations of future profits.
Second, calculating the present value of projected future business income is legally permissible because business income projections, when properly developed, represent only a return on capital and contain no trace of postmarital spousal efforts. The rationale of the rule against valuing postmarital efforts is rooted in the definition of separate property. The term “efforts” logically means labor. After the marital partnership ends, which in North Carolina is after separation, the fruits of each spouse’s labor accrue as separate property. It would therefore be improper to use a valuation methodology that calculates a present value of a spouse’s postseparation labor and then incorporates that number into the business value. Doing so would transform separate property into marital property. This is the rationale behind the prohibition on valuing postmarital efforts described in Poore. The prohibition on valuing postmarital efforts is designed to make sure postseparation labor remains separate property.
Properly developed business income projections contain no postmarital spousal labor because of the assumed compensation figure embedded in the projections. We see this in our example above with the $60,000 of labor compensation that was assumed in the projections. As described above, the $40,000 of annual business profit is purely a return on the spouse’s capital. It does not represent a return on the spouse’s labor. The spouse’s labor is accounted for in the $60,000 compensation assumption. Therefore, even though the $40,000 projection extends beyond the date of separation, it does not run afoul of the prohibition on valuing postmarital spousal efforts because the $40,000 profit figure contains no postmarital spousal labor. It is only a return on capital, which represents the benefit of owning the property. The present value developed from a return on capital profit stream represents the value of a property interest in the business.
Third, the Court of Appeals has rejected the argument that a DCF analysis improperly values postmarital efforts when the projections underlying the analysis reflect purely a return on capital. In Poore, the court established the legitimacy of a forward-looking valuation methodology by stating that a business can be valued based upon “the price which an outside buyer would pay for it taking into account its future earning capacity[.]” Poore at 420. In Pellom v. Pellom, 194 N.C.App. 57 (2008), the court concluded a DCF analysis used by the expert in the case was a proper application of valuing a business based on its future earnings capacity. See Pellom at 64-65. Furthermore, the court rejected the business owner’s argument that postmarital efforts were valued in the DCF’s projections of business income, which extended beyond the date of separation. As argued in the non-business owner’s brief, the expert subtracted out the business owner’s reasonable compensation in developing those projections. See Pellom, Def. Br. at 15. This meant the projections represented only a return on capital, and therefore what was being valued was the property interest and not the business owner’s future labor. In my view, Pellom established that a DCF analysis with properly developed projections does not value postmarital efforts.
A DCF analysis is the best choice for capturing the impact of a recession when developing a business valuation. North Carolina law supports the use of a DCF analysis in equitable distribution cases. The use of business income projections that extend beyond the date of separation does not improperly value postmarital efforts, provided the value of the business owner’s labor is accounted for in those projections by a reasonable compensation assumption.
Russel B. Duckworth, CFA, JD is a financial expert with Piedmont Valuation Advisors, LLC in Charlotte. He works throughout North Carolina on family law financial issues, including business valuation, tracing, and separate/marital allocation calculations.
https://ncbarblog.com/wp-content/uploads/2018/06/Blog-Header-1-1030x530.png00FamilyLawhttps://ncbarblog.com/wp-content/uploads/2018/06/Blog-Header-1-1030x530.pngFamilyLaw2020-09-16 13:59:372020-09-16 13:59:37Valuing a Business During a Recession: Using Projected Business Income Without Valuing Postmarital Efforts