(No) Love in a Cold Climate
Article, New Law Journal – February 2010
Legal / Disputes
Catherine Rawlin, Partner in RGL's London office, examines the links between business valuations & divorce.
- 2008 data reveals number of divorces at lowest rate since 1979.
- Recession has impacted buisness valuations and ability to release funds.
- Essential to understand liquidity of business to fund settlement.
Figures published last month by the Office for National Statistics show divorce rates are at their lowest level since 1979. This flies in the face of expert predictions, which forecast that the recession would drive up divorce rates. Could there be financial reasons for this unexpected result? Areas where the current economic climate is having an impact on divorce include the valuation of businesses, and also the ability to release funds from the business to enable a financial settlement to occur.
Clearly a business that is at the centre of a divorce may belong to the husband, the wife, or both of them. For current purposes, I assume a scenario where the husband owns and runs the business. In the event of a divorce, the business would be treated as the husband’s asset and it would need to be valued, along with other assets, to arrive at the overall matrimonial pot available for the settlement. In preparing such a valuation, recessionary effects must be considered. First, if the business is asset-rich, the value is likely to reflect that of the assets. The current climate has seen the value of many assets, such as property, drop. Therefore the value of a business where its main function is property ownership will in turn be lower now than at the height of a property boom. The parties also need to consider how to fund the settlement. In this example, if the properties were sold, the current value of the assets would be realised. One would have to consider the tax issues resulting from the sale, but at least the parties would have the certainty of the proceeds. However, if the properties continued to be held and the wife’s settlement was agreed based on today’s property values, the husband is likely to benefit from an increased value in the future, so is this a fair settlement?
Future maintainable earnings
Alternatively, the business might be one that, rather than being asset-based, depends on the skill and qualifications of the husband and the market demand for his products or services. Valuations for such businesses are often calculated based on the future maintainable earnings of the business, ie earnings which the business can sustain for the foreseeable future, to which a multiple is applied. The financial downturn can impact both elements of this calculation. In considering the future maintainable earnings of a business, one must gain an understanding of the business and how its profits are derived. Underpinning the profit is, of course, the income earned by the business and the associated costs.
Costs are an area that businesses review in detail during a recession, in order to analyse which costs can be shaved to maintain profit, perhaps in the face of falling income. When considering the future maintainable earnings, it is therefore necessary to consider to what extent the historical earnings will be repeated or whether they have been unduly influenced by other factors—the economic downturn being one of them. In the same way, the multiples being achieved in the market are being affected by the recession and this must also be taken into account in the valuation. One issue to watch out for is the possibility of a business owner using the recession as a means of explaining why the performance of the business has worsened. It is important to ensure that this explanation is supported by reality. This is because it would be possible for the owner to use this as a cover-up for deliberate downward manipulation of the profits to lower the value of the business, and hence the potential settlement.
Another area to consider when looking at the future of a business that is affected by the economic situation is to what extent it is able to survive financially. Sometimes, a combination of low profitability and a scarcity of funding opportunities results in the business failing. When preparing a valuation of a business on the profits basis, where essentially one is valuing the future profit flow from the business, it is important to be as certain as one can be that the business has a future as a “going-concern”. In a divorce case, it is also relevant to understand the liquidity of the business and its ability to help fund the divorce settlement. Again, in difficult economic times, this can cause more of a problem, especially where external finance is needed to enable the settlement to take place.
As appeared in New Law Journal, February 2010.