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Determining the value of a small business in a Texas divorce

If you, your spouse or both of you in combination own and operate a small business then your divorce will be one where the sometimes-complicated issue of valuing that business will present itself. A small business is likely a part of your community estate, which means that the parts of the business, any income earned, and even the equipment utilized in the performance of that business are eligible to be divided up by a judge.

The number that you, your spouse and your attorneys will need to determine if the fair market value of that business. Any of us who have taken high school economics are probably familiar with this term. In terms of a basic definition, I explain the fair market value to clients as what a willing buyer is prepared to offer to a willing seller in order to purchase that business. However, what often occurs in a divorce is that multiple methods of valuing the business are presented. This can lead to confusing and unreliable information that does not assist in helping to determine the true nature of your community estate's overall value.

What is the book value of your business?

I think it makes the most sense to approach the issue of valuing your small business from the perspective of book value, first and foremost. This is the most straight forward measure for valuing a business and probably the one that will make the most sense to all of us.

The value shown by the “books” of a business is the value that is arrived at when you consider the total value of assets as shown in the financial accounting of business. From there, you subtract any debts/liabilities that the business has. This is similar to how you or I would calculate our personal net worth: assets minus liabilities. The money I have in the bank plus the value of my home, investments and personal property would be subtracted by any debts I have to get a sense of my net worth. The same theory applies to value a business here.

There are limitations, however, to utilizing the book value of a business. First of all, tangible assets would need to be appraised and then reflected at their market value rather than what you and your spouse personally value them at. From there, you could still subtract liabilities in order to produce what is known as adjusted book value. Even an adjusted book value still would produce a deflated value of your business in all likelihood.

What information would a business appraiser need in order to accurately arrive at the value of your business?

If you did not start the business that you and your spouse currently own it is likely that you purchased that business from another person. There were basic documents and information that you likely requested from the sellers of that business before you were willing to make an offer or counteroffer to purchase the business. You will need to prepare a list of that information and assemble those same documents in the context of your divorce.

For starters, you should compile a detailed description of your business: when was it started, when did you purchase it (if you did purchase it), what your business does in the marketplace, who its competitors are, how many employees you have, who your business’ customers are and the names of the vendors that your business uses. This will provide your attorneys, an appraiser, a mediator and potentially a judge with a pretty solid idea of all the inputs and outputs that are relevant to your business

Next, you will need to produce a profit and loss sheet for each of the past three years. Balance sheets for most businesses are broken down into quarters since you probably pay taxes on a quarterly basis. Income and outgo is the name of the game for these balance sheets. If your business has shown an increasing propensity for making money then this is a “soft” factor that will likely drive the value of your business up. However, if your business shows a decreasing profit trend over the past three years this will have the opposite effect.

As far as your employees are concerned I would advise a client to provide a list of all persons under payroll at your business as well as what each earns. Each employee and their function at your business needs to be discussed as well. It could be that your business either needs to let go of some employees in order to become more efficient. Of course, the opposite could be true as well. This analysis may actually help you and your spouse better position yourselves for however you want to operate your business after the divorce.

Something that is of interest to business appraisers is how much you actually work inside the business. How many hours do you work inside the business in any given week? What direct role do you provide to the operation of the business? Are your personal expenses being paid through the business? Are you paying yourself a salary or bonuses? Do you receive health insurance, a company car or other benefits through the business?

Finally, you will need to show an appraiser how quickly customers of yours have paid your business for services rendered. Do you have an accounts receivable list two miles long? Or do your customers pay you within a couple of weeks of your having submitted an invoice? These things matter as far as cash-flow, reserve accounts and overall sustainability of your business is concerned.

Why does all this matter when it comes to valuing a business?

You may be wondering how all of these issues are relevant to your family business. Very small businesses, such as one where only you and your wife are employed, likely would not have many of the documents that I listed above. The reason for this is because it would not be relevant to your business operations. However, for businesses that have more than a couple of employees most, if not all, of these documents will be relevant.

Help your attorney by collecting these documents ahead of time. You and your spouse should not have competing documents- meaning that you all should be able to agree on sending one set of forms to both of your attorneys. It is not uncommon to have you and your spouse each hire an appraiser to arrive at the total value of your business. Keep in mind that doing so will cost money, and agreeing to hire one accountant to perform an analysis is most cost efficient.

What is goodwill and why is it relevant to valuing your small business?

Goodwill is not an easy to define term, although you and I probably have similar ideas about what it means on a practical level. You could build up a reputation as a great small business owner in your community. That your hardware store business has benefited as a result of the goodwill attached to your name and reputation is certainly relevant. On the other hand, your hardware store may be known far and wide in your community and has a reputation as providing customers with great service and low prices. In that case, you or your spouse could be removed from the business and another person could take your place with very little impact on the goodwill that we have just described.

The goodwill built up by your business would continue for a time after the sale to another person as long as the service provided by your business remains consistently good. The new owners would have an opportunity to justify the faith in your business. The bottom line is that goodwill is attached to you or your spouse as individuals, is not divisible in a Texas divorce. On the other hand, if there is goodwill attached to your business as a whole, that contributes to the value of that business and is divisible and counts towards the overall value of the business.

The reason for this is that if the reputation of you or your spouse goes away as a result of your having sold the business, that is not a long-lasting and valuable asset. However, the generally positive reputation that your business has developed over the course of the years that your business has been in operation is an asset and would be attractive to anyone who seeks to purchase your business.

How will a court view this issue if presented to it?

There is a test that a judge would undertake to answer in regard to whether or not the goodwill attached to your business is subject to being divided up in a divorce case. First, a court would look to whether or not the goodwill exists independent of the ability of you and/or your spouse to continue to perform in the business in whatever role you have each played. Next, the judge would consider whether that goodwill has a commercial value that your community estate could take part in.

What if you are a minority owner in a small business? What impact does that have on the value of the business?

Let's take a hypothetical example and examine how it could impact you and your divorce. Say that you own one quarter (25%) of medical practice. You and your husband are getting a divorce and you agree to hire an accountant to come in and appraise the value of that medical practice for the purpose of arriving at the value of the business.

The accountant says that your business is worth $1,000,000 of which your share would be $250,000. Furthermore, your value would have to be reduced because there isn't much of a market out there for selling minority shares in small medical practices. Unfortunately for you, Texas business law does not provide minority shareholders with much in the way of rights. You can inspect the books of your business but are otherwise subject to the wishes of the person who owns a majority stake in the practice. If you own even 51% of the medical practice, we would be having a completely different conversation. You would own a majority of the practice and there would be no reduction in the value of the business as you would have much greater control over the business.

Contingency agreements can have a huge impact on the value of a business

It may be that your business, owned by you, your spouse and perhaps another person, have partnership agreements in place that state if one of you die, quits the business or is fired, your interest stake in the business is brought back into the company at a set price. This is also known as a “buy-sell” agreement. Essentially it keeps your business partner’s spouse, who has had nothing to do with the business to this point, from having to come into the company due to their having inherited the ownership in your business after the death of their spouse.

In tomorrow’s blog post from the Law Office of Bryan Fagan, we will pick up where we left off today by discussing two questions that need to be answered when it comes to buy-sell agreements. This is a subject that is not often discussed in the context of Texas divorces but it is relevant and something I believe you need to be aware of.

Questions about dividing up a business in a Texas divorce? Contact the Law Office of Bryan Fagan

The attorneys with the Law Office of Bryan Fagan appreciate your interest in this topic. If you have any questions about what we discussed or need guidance on any subject in Texas family law please do not hesitate to contact our office. We offer free of charge consultations six days a week here in our office. These consultations are a great opportunity to ask questions and have your issues addressed directly by an attorney with experience helping people in our community just like you.

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