What Happens to the Business When Spouses Divorce in California?
Divorce can be daunting enough without the added complication of owning or running a business with your spouse. When spouses have mixed business with pleasure during the marriage, the separation and divorce can create unique issues related to the division, management, and future of the business.
Spouses commonly ask their divorce attorneys if the other spouse will get half of the business, how the court will determine how much the business is worth, whether they will have to pay spousal support on top of dividing the business, and whether the business will make it out of the divorce unscathed.
3 Steps to a Dividing a Business in Divorce
The truth is that not every divorce that involves a business has to be messy, expensive, and complicated. There are three steps every spouse considering divorce or going through a divorce involving a business should take.
1) Characterize the Business – Is the Business Involved in the Divorce Community Property, Separate Property, or a Mixed Asset?
Did one spouse start the business prior to the marriage? Did the spouses start the business together during the marriage? What funds were used to acquire the business initially?
Like any other asset, a divorce with a business involved begins with determining the date of acquisition and the source of the acquisition. (For more information, see our How to Divide Assets in California Divorce page).
If the business was started prior to the marriage, then the asset is most likely mixed. This means that a portion of the value of the business is separate property of the spouse who initially started the business, but if the business grew in value during the marriage, then the community likely has an interest as well.
The factors that may impact the characterization of the business are:
- The value of the business at the time of the marriage,
- The contribution of time and money to the business during the marriage by the operating spouse,
- The value of the business on the date of separation and/or later at the time of the trial or final resolution.
When the business was started prior to marriage, California family courts have developed two different methods of allocating earnings and profits of a business between separate and community property in a divorce.
The first method is the Pereira formula. Pereira is typically used when the business is spousal labor-intensive and the increase in value of a separate property business during marriage was primarily the result of community labor and not outside market forces. The court first determines the value of the business at the time of marriage and then add that value to a reasonable rate of return, which is allocated as the business owner spouse’s separate property. The remaining value is community property.
The second method of allocating earnings and profits of a business in divorce is utilized when the nature of the business itself or outside market are primarily responsible for the increased value of the separate property business during marriage. This is known as the Van Camp formula. Under Van Camp, the court will first fix a fair, reasonable salary for the community labor the spouse contributed to the business during the marriage, and subtract community expenses from that amount. The result is considered community property. Whatever amount remains is separate property.
California family courts are free to choose the approach that is most appropriate and equitable in a particular case, and each spouse will most often prefer application of a different formula.
2) Value the Business – What is the Business Involved in the Divorce Worth?
It is important to know the value of the business so that spouses can decide if litigating the issue makes sense. If the business is worth $30,000, spending $5,000 on a forensic accountant and $15,000 in attorney’s fees is probably unreasonable. If the business is worth $300,000, however, the litigation budget is likely higher because the potential return is higher.
Family law attorneys are generally experts in family law, not business valuations. The same can be said of family law judges. For this reason, valuing any given business without the use of an expert in the field is tricky.
For many businesses, the real value of the business may be its “goodwill.” A business’ goodwill refers to the expectation of continued public patronage, or the business’ reputation, which is often part of its brand and recognition.
Forensic accountants and experts specific to a business’ industry help determine a business’ goodwill. The more established a business is and the more it relies on its brand or reputation, the greater the goodwill.
The court has the power to appoint a forensic accountant who will act as the court’s expert to prepare a report on issues such as income available for support (i.e. controllable cash flow) and business valuation. If the court makes such an order, it is most often the result of one spouse’s request for such an order. The court does not have to make such an order and a spouse (especially the business operator) can and sometimes should resist the court appointing its own expert.
Such experts, often appointed as experts pursuant to Evidence Code section 730, look at the following:
- The longevity of the business. The longer the business has been around and has been successful, the more likely that success will continue.
- The location of the business. A busy urban or metropolitan location may have different demands for a business than a remote or suburban location. A business that operates exclusively online has an entirely different business model than a business with a physical location.
- The past and ongoing profits and earnings of the business. Some businesses have nice profit margins and keep more of the money they earn. Others have tighter margins. This may also be impacted by soft and hard costs of the business.
- The amount of patronage (customers) the business receives. The volume of business is often directly related to its popularity and patronage.
- The loyalty of the customers and whether there is repeat business. Is this a business to which customers return?
Naturally, if the parties and/or forensic accountant(s) agree on the value of the business, the issue is not the value, but how the spouses will divide the community property portion of the business through a buyout. This can be accomplished through a cash payment, an installment plan, or even an offset against other community property assets.
Some spouses hire their own forensic accountant to conduct the business valuation. This is especially true when the parties have substantially differing views on the likely value of the business.
In many cases, it is important to start the valuation process early, so that negotiations and settlement discussions can be conducted with a working knowledge of the value of the assets to be divided. Arguing over a business neither party genuinely knows the value of is a waste of time and money.
Methods for valuing a business include:
- Capitalized earnings
This is the most common method for valuing businesses used in California because courts find it to be most reliable. If a spouse wants to use a different method, they will need to justify why that method is fairer to the out-spouse. This method requires expensive forensics. It is not uncommon to bifurcate the question of business valuations to try them separately because often this is the thorniest issue to be decided in a dissolution or legal separation proceeding.
- Evaluating Sales Proceeds
When a business is actually being sold in an arm’s length transaction to a third party, the price that a willing buyer will pay and a willing seller accept determines value. This is rare in the case of business valuations, but more common with respect to the sale of real property.
The specific asset is valued based upon the actual sales of similar assets or properties with actual sales that can be tracked. With professional practices, this is common with dental businesses which are commonly bought and sold, and so numbers from the sales of other dental practices may be persuasive to a court. Whether this method is useful depends very much on the nature of the business – sometimes there is nothing comparable or little published information about comparable sales.
- Liquidation Value
Sometimes businesses will be cut up into parts that are sold separately. Sometimes the business is valued in terms of what these parts would sell for. It is rarely used except when the parties intend to actually liquidate the company. Liquidation value does not generally include valuing goodwill (because the assumption is there will be no on-going concern). Goodwill is the nightmare component to valuing businesses. Many people in divorce who manage the business believe strongly this is how businesses should be valued (in part because in the absence of an actual sale, it is a fiction to say what a buyer might pay when no such buyers as a practical matter exist).
- Book Value / Adjusted Book Value
This relies upon the company records to determine what ‘retained value’ is. It is rarely used, because it is more a statement of how the company perceives itself, or structured (or even ‘cooked’) its books, than any objective indication of value. Adjusted book value is performed through a forensic audit. Usually it is performed on a cash basis, and accounts receivable and much more must be analyzed.
- Going Concern Value
This describes a method that includes valuing the business as greater than the sum of its parts. There are a number of factors that are used.
3) Divide the Community Property Value of the Business in the Divorce
Once the value of the business is known or agreed upon, it is time to have a conversation about the options regarding division of the community property value of the business.
There are generally only three options regarding division of the business:
- One spouse may buy out the other spouse’s interest in the business;
- The spouses may sell the business and divide the proceeds; or
- The spouses may choose to continue to operate the business together.
The spouses and attorneys should collaborate to determine the best options for each spouse in a particular case.
Spouses should seriously consider whether a compromise would be preferable if neither can withstand the potential for the court to order their worst-case scenario at trial. Trial is always a risk, and is in and of itself expensive. You take control out of your mutual hands and give it to a judge to make the decision.