Court Rejects Valuation Based on Unsustainable Past Earnings
In a recent divorce case, In re Riddle, the Court of Appeals of Arizona, Division 1, vacated the trial court’s ruling regarding the value of a business interest owned by the wife. Why? In a nutshell, the husband’s expert valued the business based on past earnings, but “there was no evidence that similar earnings would continue” in the future.
The parties separated in 2008 and began divorce proceedings in 2017. Their marital estate included an ownership interest in a company that the wife, along with her business partner, continued to operate after the separation date. The company coordinated medical care for clients referred by personal injury attorneys, collecting its fees when the litigation ended — up to two years after it began providing services.
At trial, the parties disputed the size of the wife’s ownership interest in the business. The company’s operating agreement stated that the wife owned 25% and her partner owned 75%. However, the husband argued that the wife owned the entire business, based on the company’s tax returns. According to the wife, she listed herself as the sole owner on the tax returns to distinguish that the business was her property, and the husband owed no taxes for the company. The trial court sided with the wife, ruling that she owned a 25% interest.
In October 2015 — before divorce proceedings began — the wife sold her interest in the business to her partner for $60,000. At the same time, the partner started a new company under a different name that performed the same types of services as the original business. The wife didn’t have an ownership interest in the new venture.
The husband hired a business valuation expert who assumed the company was a viable going concern that would continue to earn new revenue through new referrals. He valued the interest at $905,000, using two valuation methods:
- The capitalization of earnings method, using projected cash flow based on prior years ending in 2016, and
- The guideline transaction method, applying a pricing multiple from sales of comparable businesses to projected earnings based on prior years ending in 2016.
The wife hired her own expert, who estimated a range of value between $42,000 and $112,000 for the entire company. This valuation was prepared under the assumption that the business wouldn’t continue after the wife sold her interest, except to collect any outstanding fees under existing contracts.
The trial court accepted the valuation by the husband’s expert, based on the significant profit the original company was generating. It ordered the wife to pay the husband $113,125 (half of 25% of $905,000).
Appellate Court Findings
On appeal, the court deferred to the lower court’s decision regarding the size of the interest. The appellate court further noted that the sale of the wife’s 25% interest to her partner for $60,000 implied a value of $240,000 for the entire business ($60,000 divided by 25%).
After the husband’s expert conducted his initial valuation, the expert learned that the wife’s partner had been conducting business under a new name. The husband’s expert wasn’t asked to update his valuation based on that information. However, the valuation prepared by the wife’s expert recognized that the original company generated no new revenue after October 2015.
According to the appellate court, the undisputed evidence showed that, after October 2015, while the business continued to collect substantial fees from existing clients, it added no new clients to produce any future earnings. Because one of the “basic foundations” of the trial court’s valuation was incorrect, the case was remanded to the trial court to determine the value of the wife’s interest.
Sidebar: Court Accepts Calculation of Value in Divorce Case
In another Arizona divorce case — Mikalacki v. Rubezic — the parties were equal partners in a law firm. The trial court adopted a value of $269,000 for the firm, based on a calculation of value prepared by the wife’s expert. The court awarded the husband sole ownership of the firm and ordered him to compensate the wife for her 50% interest. The expert valued the business using financial information provided by the wife and an independent analysis of comparable businesses.
On appeal, the husband challenged the valuation, because it was a calculation of value rather than a full opinion of value. However, the husband never presented opposing valuation evidence to the trial court. He also failed to meaningfully contest the expert’s testimony that the business goodwill associated with the husband’s name had considerable value.
The Court of Appeals of Arizona, Division 1, acknowledged that although a calculation of value falls short of the “gold standard . . . a fact-finder need not discount an expert’s opinion solely because the expert did not consider every single process and procedure that would be included had he conducted a fuller valuation.” (Internal quotations omitted.)
Back to the Future
As Riddle demonstrates, valuing a business based on only its earnings history is insufficient. There also must be evidence that those earnings are sustainable in the future.