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Articles From Brisbane Consulting Group

Harvey v. Harvey - Buy-sell provision Applies to Divorce Valuation

The Fifth District Court of Appeals of California recently addressed the valuation of a closely held business in connection with a divorce. Notably, the court valued the wife’s 50% interest pursuant to the valuation provisions of a buy-sell agreement rather than the state’s family code.

Background

The couple in this case jointly owned nearly 70% of the stock of a chemical manufacturing company that was founded by the husband. They also signed a buy-sell agreement that included a provision that specifically addressed the issue of a sale related to the marital dissolution or separation of a shareholder.

Under that provision, the husband was deemed to be the owner of the stock. It also outlined several ways in which the disposition of the stock could be handled in a divorce decree, separation maintenance agreement or property settlement. The method that the trial court ultimately followed gave the wife’s interest in the company to the husband as a part of the division of community property.

The buy-sell agreement also included a valuation provision. It set the stock price at its fair market value (FMV) as agreed to by the parties. In the event that the parties couldn’t agree, the provision required each party to appoint an appraiser to value the business. If the valuations were too far apart, the appraisers would appoint a third appraiser as the “final arbitrator of value.”

Trial Court Decision

In an earlier proceeding, the wife requested that her interest be appraised in accordance with the state’s family code, rather than under the valuation provision of the buy-sell agreement. The trial court denied this request, finding that, for purposes of a shareholder’s divorce or separation, FMV was set by the agreement’s valuation provision.

At trial, the husband’s valuation expert valued the wife’s interest at approximately $21.3 million, applying two valuation discounts for 1) a $2.5 million deferred tax liability and 2) a 22.72% discount for lack of marketability (DLOM).

The wife’s expert valued her interest at approximately $40 million. He didn’t adjust his conclusion for the deferred tax liability because it wasn’t “immediate and specific.” And he declined to apply a DLOM, finding that the buy-sell agreement “created a market for the shares” and that the company’s stock was “highly marketable.”

Given the disparity between the two appraisals, a third expert was brought in. He concluded that the valuation by the husband’s expert “most closely approximated the actual value of the shares.” The trial court accepted the $21.3 million valuation and ordered the husband to pay the wife that amount to “equalize” their marital assets.

On Appeal

The appellate court agreed that, for divorce purposes, FMV was set by the agreement’s valuation provision. The court also upheld the DLOM. It ruled that any criticism of the expert’s methodology went to the weight of his testimony, which was strictly within the trial court’s purview.

However, the appellate court rejected the adjustment for the deferred tax liability because it was attributable primarily to depreciation deductions that would later be reversed. The court noted that under California law, it’s “improper to take into consideration the tax consequences of an order dividing a community asset unless the tax liability is immediate and specific.”

Sidebar: Does Your Buy-Sell Cover All the Valuation Bases?

A comprehensive buy-sell addresses value-related matters to help ensure that all parties are treated equitably. You can hit a “home run” by addressing these four elements of value:

1. Definition of value. A valuation expert can provide definitions for a variety of relevant standards. Examples include the book value as listed on the company’s balance sheet, fair value in accordance with the state’s appraisal rights statute or fair market value as defined in Revenue Ruling 59-60. It’s also critical to specify the valuation date in advance. For instance, that might be the date of the triggering event or the most recent fiscal year end.

2. Application of discounts. The parties should address if and when discounts for lack of control and marketability apply. Quantifying any applicable discounts in advance can also help facilitate the buyout process.

3. Valuation process. Some agreements base value on a fixed amount or a prescribed formula (such as a multiple of earnings or revenue). However, those methods are oversimplified and can become outdated. Instead, the parties could agree to hire one or more valuation professionals to determine value. The agreement should specify a process for selecting experts and a timeline for completing the valuation.  

4. Payment of fees. Last, but not least, the agreement should specify who’s required to pay the valuation fees (the buyer, the seller or the company).

Draft Buy-Sells Carefully

This case illustrates the importance of drafting buy-sell agreements carefully. Although the trial court allowed a DLOM in this case, it’s conceivable that some courts would accept the argument that a buy-sell agreement creates a market for the stock, decreasing or even eliminating the discount. To avoid these issues, a business valuation professional can help the parties draft agreements that cover all the value-related bases.

Harvey v. Harvey - Buy-sell provision Applies to Divorce Valuation

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John is a manager responsible for valuation, forensic accounting, and litigation support services for Brisbane Consulting Group, a wholly-owned subsidiary of Lumsden McCormick. He has prior public accounting experience working in the tax department of a Syracuse CPA firm and has commercial sales experience working for an automotive firm for more than five years.

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