Michelle O’Neil:
Welcome back to our webinar brought to you by OWLawyers. I’m Michelle
O’Neil. And I am joined by Jere Height and Ryan Segall, who are
both attorneys at my law firm. And we are also honored to have with us
today Robert Bales, who's a CPA, ABV and some other letters behind his
name with Bales & company. And he is a forensic CPA that works in
the divorce industry, specifically on valuations and tracing in divorce
cases. So we're super honored to have Robert with us today. So jumping
right in, I mean this is kind of your specialty, the valuation question.
So we talked into the second section at the end of just kind of how you
get to the valuation. Why is it important in a divorce and so that's because
in order for a divorce court to make a just and right division of the
entire community estate, there has to be dollar figures on each of the
assets. So if there's a corporation or closely held business or even stock
in a not so closely held business, in the marital estate or in the community
estate, there has to be a dollar figure put on that so that the judge
can ultimately decide if a division of the community estate is a just
and right division. So that's where you come in.
Robert Bales:
That's correct.
Michelle O’Neil:
Because I can't value, I mean I'm make figure kind of a rough number that I think it might be, but I can't go in and testify to that. So now kind of laying the groundwork here, a client, an owner of a business can testify to what they think is the value of the business, right?
Robert Bales:
Yeah.
Michelle O’Neil:
So they can offer an opinion and that opinion is valuable evidence, it can be considered.
Ryan Segall:
Valuable evidence? I don’t know, but its evidence.
Robert Bales:
And sometime it’s not contradicted and in this case it's enough.
Michelle O’Neil:
But you still have to show, I think there was a recent case, we'll have to find that and post it in the group. But there was a recent case that talked about even if the client offers evidence of their opinion of value, there still has to be a basis for that opinion. It can't just be, well I think my business is worth $1 million. You know, you to have some basis for why you think that or show some methodology to that approach. But assuming that your client doesn't have that basis of knowledge, then tell us basically what you do for a living.
Robert Bales:
Well, we attempt to come up with the value of these equity interests in
these businesses. And in Texas it's a little bit different than what you
can sell the business for.
Michelle O’Neil:
The valuation for divorce purposes is not the same as a valuation for a sale?
Robert Bales:
Correct, yes.
Michelle O’Neil:
Why is that?
Robert Bales:
Very important because personal Goodwill is not a component of the value of the divorce value or the component of the divorce value. Because the court cannot prevent a party from competing post-divorce. You value the business as if the party is free to compete with a business and not in the business. And most small businesses, this is a very, very, very large reduction in the value. Not so much in a fast food franchise or car dealership or something where it's a little bit, it's known by the business name as opposed to the person. So that to start with, and that's probably the most important thing to know.
Michelle O’Neil:
In the distinction between a sale?
Robert Bales:
Because it's not uncommon for a spouse say I think I can sell my business
for $15 million and the other spouse hears it and then they get a divorce
and then they come back. Now it's $4 million. What happened? Well, the
difference is he's going to stay with the business and make sure the customers
stay with the business. And he's probably going to have a contingent contract
saying, if they don't stay with the business, we're not going to pay you.
So that to begin with and then with that in the background, you look at
the assets of the business. How much are they worth? Are they all part
of the operation of the business? Are there assets in there that have
nothing to do with creating income, like a ski lodge in Colorado or a
bass boat or something. And then how much income does the business make
under this fictitious scenario of the owner not being around? And then
you compare based upon the risk of that income stream, how much would
someone pay to get that income stream versus how much could you liquidate
those assets for? Normally the higher of those two numbers is your value.
Now there's a lot of rigmarole that goes into getting there in determining
what the capitalization rate is you apply, we already talked about what
tax rate do you apply to the income, things of that nature. But once you
determine what the income of the business is, you compute a value of the
income. Another way to go that you don't see quite as much in small businesses
is a market approach where you compare the sale of other businesses, similar
businesses. It works if you're trying to figure out how much your business
can sell for. But most actual transactions don't have the personal Goodwill
limitation built into them. And because of that using, to me some of the
databases with actual sales can be a little bit dangerous with this personal
Goodwill aspect we're required to consider.
Michelle O’Neil:
So tell everybody just kind of basically what his personal Goodwill?
Robert Bales:
Personal Goodwill is what the individual brings as far as relationships,
skills, reputation to the business and what would happen to the business
and whether it's in the form of sales or relationships with suppliers,
what would happen with that person gone? So in most small businesses,
you take that person out and there's nothing left. One thing you have
to look at is what we call the barrier to entry to the business. And if
they don't have enough capital to start over again if they were to leave,
then there's not as much personal Goodwill cause there's less likely they
would be able to step out or how long would it take them to reconstruct
the business. I know we had one we did last year where it would have taken
our guy two years to get the permits and to reconstruct a manufacturing
facility. He was the engineer that designed it, but you got to go build
it again. And so that diminished the amount of personal good will, now
we still had some but his customers would have stayed with the old company
because they needed the product. So you've got to look at all the different
aspects of the business.
Michelle O’Neil:
Yeah. So what's the opposite then of personal Goodwill?
Robert Bales:
Well, I've had that as well, negative personal Goodwill that the business
is worth more without the owner.And I actually had one of those in a bankruptcy
one time and I was fortunate enough that my client had stepped out of
the courtroom to use the restroom while I was explaining why I had applied
this particular factor to the business and I told the judge that I thought
he's the worst business man on the face of the earth and it was worth
more without him in it. That doesn't happen often.
Michelle O’Neil:
Yeah. Then there's also component of Goodwill that is valued in the valuation
of the business. And what component is that?
Robert Bales:
Well, that's your entity Goodwill. And that's the Goodwill associated with
the company name, with the workforce that's in place at the business with
its marketing program, it's intellectual property, it's web presence,
all the infrastructure it has in place to make sales, to manufacture goods,
whatever. That's the entity Goodwill. And in the larger companies, most
of the Goodwill is entity Goodwill because the sales responsibility is
spread amongst a lot of people. The knowledge of the product is spread
around a lot of people. So the larger the company, the more likely the
enterprise or the entity Goodwill is gonna apply more than the personal Goodwill.
Michelle O’Neil:
So how do you go about figuring out what the personal Goodwill factor is
in a business? I mean what kinds of evidence would you be looking for
us to gather or would you be looking for?
Robert Bales:
Well, the first thing you need to know is what's the business worth including
the Goodwill, including all the Goodwill. Then you need to know what are
the assets worth? If your assets less your debt is worth one number. I
mean, that's kind of a lower end. The intangible assets are that the delt
or the difference between that enterprise value and those asset values.
And then you look very subjectively at what drives the difference. Is
it driven by the workforce or is it driven by this person and you have
to make a subjective call on it. And anyone that tells you it's not a
subjective call is lying.
Michelle O’Neil:
And I guess that's kind of my question is how do you get to this subjective,
personal Goodwill? You know I've had times where we have done discovery
on the client list and then maybe had my client, the business owner, contact
those clients and say are you my client because of me or because of the
business and kind of do a survey. Is that helpful information?
Robert Bales:
Well, yes, we've done that as well. I don't think doing it with the clients
is helpful because they're going to lie to the client. But we've done
blind surveys before where I've had staff members who didn't identify
that he gave permission to talk to them to do blind surveys to find out
why are you using this business. We weren't particularly asking is it
because of him or something else, but what do you like about the business?
And we've done that in the past. In most cases it's pretty obvious, Hey
this guy does everything. All the sales come from his buddies that he
plays golf with. Normally it's pretty straight forward.
Michelle O’Neil:
So maybe tracking lead sources? I mean for a business owner to kind of
track and help provide you information that would be valuable to determining
this subjective number. Lead sources?
Robert Bales:
Yeah. We'll find out who are your top 10 customers? What's your relationship
with each one of them? How long have you had them? What's your involvement
day to day with each of those customers? We'll ask those kinds of questions.
Another one is suppliers. People don't think about suppliers, but I did
a bit a valuation not long ago of a company that makes pine bark mulch
and one of the owners had a relationship with a sawmill that they got
all their pine bark from. And but for that sawmill being available, they
would be out of business. So that’s personal Goodwill, there were
two owners and one of the owners without his relationship with the owner
of that saw mill, they would have been out of business. So you've got
to look at more than just the sales side.
Michelle O’Neil:
Okay. So there's what basically two approaches to valuation in a divorce context.
Robert Bales:
Yeah. The three, the income market and asset market is not as common. You
do see people using it some and I would just say look real hard at how
they applied those factors and where they got their data.
Michelle O’Neil:
Yeah. So then the difference between the asset and the income. When would
you use an asset approach versus when would you use an income approach?
Robert Bales:
When the asset approach generates a larger value. Seriously, I mean, if
you've got no assets, the floor assets floor and argue lower than asset.
Robert Bales:
If you can go liquidate those assets and get X number of dollars, it's
not going to be less than that, but if the income streams worth more than
those asset values, then you would apply that.
Michelle O’Neil:
Alright. So what are some things you look for in coming up with that value?
Robert Bales:
Well, in a small business the primary thing we look for other than just
basic data is how much personal stuff is run through the business. And
it is almost every one of them and it's almost always material. So that's
very important. There are sometimes a little resistant to provide that
information.
Michelle O’Neil:
So you're saying that personal expenses that are not then counted as their
income or their distribution.
Robert Bales:
I try to explain it to them as expenses a third party might not have to
have and were they to buy the business as opposed to tax fraud. So you
try to identify that and then the second thing in a small business is
what's it going to cost you to replace this person and we talked about
that a little bit earlier. We were talking about salaries and distributions.
Sometimes that's a difficult number because these people will need two
or three people to replace them because they work 16 hours a day and do
three jobs. So you've got to define what they're doing, what would it
cost to replace them and with those things determined you can normally
come up with a cashflow stream that you can put a capitalization rate
on in value or multiplier.
Michelle O’Neil:
So what about like loans to shareholder? How do you handle those when you're
evaluating a corporation?
Robert Bales:
Well, that's a great question because they show up all the time and most
loans to shareholders, quite frankly, are entries made by accountants
to make the books balance. There's never was a loan made, there never
a check written. Most of them are not real loans. And quite frankly, I
go back to the party and say, is this ever going to get paid? Is this
ever going to be collected? And deal with it that way. If it's a legit
loan, then I treat it as a legit loan, but it needs to be shown on the
inventory as receivable from the corporation or the partnership. It needs
to be consistent in the inventory., but if not I just wipe it out and
I'll let the attorneys know or I'll put in my report this has been eliminated
and should be considered eliminated.
Michelle O’Neil:
What about retained earnings?
Robert Bales:
Well retained earnings are really just an accounting term. It’s just
the difference between assets and liabilities and it's gonna be part of
the asset approach. Now, one thing, when you mentioned cash sometimes
you have excess cash or not enough cash. So if the company's operating
too lean or too rich, you can adjust the value downward or upward, if
you do an income approach. The income approach, it seems it's got enough
assets to operate. So it's got receivable, its got inventory, got some
cash. But a lot of people hoard cash in their companies and if they have
excess cash you need to add that on.
Michelle O’Neil:
Especially when going through a divorce and it's your job to identify that.
Robert Bales:
We have noticed sometimes the cash grows a little bit, but excess cash yet on top of the income approach to allay fears. I mean it's not like the cash goes anywhere. I mean you see it and it's part of the value. Correct. Yeah, part of the value of the company.
Michelle O’Neil:
What about I've heard of some lawyers that advise their clients to prepay
taxes for future years to hide money within the business. Is that something
that you can find and determine in valuation?
Robert Bales:
Theoretically, you can find it. I would not say you can always find it,
but it does. I know prepaid expenses happen. Now, one thing we look at
when we're analyzing a business is we'll take a look at the elements of
their P and L and see where there's a big fluctuation. If we notice something's
unusually large, we'll go drill down into it and ask about it and sometimes
that pops out, not always.
Michelle O’Neil:
So whenever you're doing an income valuation, there's sometimes discounts
and so besides personal goodwill, what are some of the other discounts
that reduce the value?
Robert Bales:
That's a very important question. When you're valuing a controlling interest
in business, it's not marketable. It's not a public company. You can't
call your broker up and sell it tomorrow. So you put a marketability discount
to take into consideration the time you have to expose it to the market
cause you can't turn it into instant cash. The 100% interest in the business,
those discounts are less, a fractional interest, 20%, 30%, much greater
and then you deal with control as if you're buying non-voting stock. A
limited partner interest that doesn't have the ability to change the general
partner or something else that clearly cannot control. And on top of that,
you take a discount for not being able to control the activities of the
company. That varies and these are fairly subjective. There's ranges that
we have empirical studies give us some ranges. With the control discount,
the more money the company pays out, the less the discount. The less money
it pays out, the more the discount. That is a simplistic approach.
Michelle O’Neil:
So as attorneys, when we're reading evaluation report, what are some things,
depending on which client we are representing or whatever, what are some
things that we should be looking for in looking at a report that somebody
like you drafts to decide or help us determine is this a fair evaluation
or are there places where I need to question this expert witness about it?
Robert Bales:
Well, the discounts is a very important area. Take a look and see how did
they apply them, how much were they? You are probably going to need evaluation
expert of your own to run this by to see how reasonable that is. The biggest
one is what adjustments did they make to the income? What replacement
salary did they use? What did they assume the capital expenditures were
going to be every year? So if you've got a company that's going to have
to spend 500 grand a year to stay in business on new equipment and they
only used 50 grand, then they substantially understated the value of that
company. The capitalization rate in very important, most of us use what's
called a buildup rate and it will have different elements of the rate
and you'll get down to a deal called specific company risk. You want to
look to see how the two valuation experts compare on their cap rate. If
one's at a 16 and one's at a 35, there's a big difference. So why the
difference? And this is where you need to go to your expert and go and
what to do. I mean cause you're going to have differences, this is not
an exact science but that's an area where we see a lot of abuse. The replacement
comp is a big one. I had one the other day, actually last week, where
I had a very, very strong disagreement with a replacement comp used in
this valuation because it was they understated about $150,000.
Michelle O’Neil:
And that makes a big swing in the value. So one of the things that always bugs me and I've done it at times, but is the concept of the two parties in the divorce agreeing on one joint valuation expert. Have you ever done that. Ryan?
Ryan Segall:
I've seen it done.
Michelle O’Neil:
Well we talk about things like that and so there's a lot of times where
I might would agree to do that if I have the company owner who's in control
of the information and it's an expert that I am familiar with their methodologies,
where I know kind of generally how that's going to work. But as a general
rule, I just don't really like using one joint valuation expert.
Ryan Segall:
I mean because exactly what Robert said, reasonable minds can differ on
a whole bunch of these things. Especially when you're talking about personal
goodwill, it's a purely subjective number and different experts are going
to have different opinions.
Michelle O’Neil:
And the discounts being subjective and not really having the ability to
hire your own expert to then challenge it because then when you're in
trial and they're parading this person around like you agreed to this
person and now you're attacking them. So it seems to me that the better
strategy is to have one expert perform the valuation for one side. And
usually I assume that if I represent the business owner, that is pretty
much my job to put the dollar value on that asset, on the inventory, so
the judge has that information. So if I represent the business owner,
I pretty much think it's my job to go get the expert and get that valuation
done. I'm in control of the evidence and the information. And then if
I'm representing the non-business owner, I wait and get that report and
then decide, do I need to attack it or am I happy with this value? And
then can decide if we need to spend the money on another expert to look
at it and tell me what's going on.
Robert Bales:
I agree, I will do a joint valuation. They are fraught with problems and
never gonna have a bunch of happy campers when you do one. But I've found
a lot of times, and maybe it's just because I've been around awhile and
people know me, I'll do an evaluation like you say first, other side will
take a look at it, see if they agree with it. Now they don't always agree
with me, trust me, they don’t always agree with me, but I'll do
it first. And if they think it's reasonable, then we just go with it.
And if they want to challenge it, great. But it keeps the cost down, but
I'm still working for one party because inevitably questions come up about
reimbursement claims. Things that are a little bit more difficult to be
in the middle of and it gets uncomfortable. So I prefer to be working
for one side of the other.
Michelle O’Neil:
And I think a lot of times we'll do like the one side gets the valuation
and then you go to mediation and you can try to settle based on the one
valuation. And even at mediation you can kind of make some arguments about,
well now that valuation needs to come down a little bit because this discount
or that discount wasn't where needed to be, but at least then you can
get something and get to mediation. And then if that doesn't work and
you're headed to trial, then you really need to get your own expert. Both
sides really need to have their own expert if a company's involved.
Robert Bales:
And the one where I was disagreeing with a replacement comp was the joint
expert who was a very close friend of mine.
Michelle O’Neil:
Well and joint experts create problems for payment for you for you, it
gets kind of muddy on how you're getting paid.
Robert Bales:
Amen sister.
Michelle O’Neil:
I mean it just does. So you mentioned reimbursement claim. So let's talk about reimbursement claims. What are some of the reimbursement claims that can affect, not necessarily the value but kind of the division issues?
Robert Bales:
Reimbursement claims with companies, there's a little bit of statutory
guidance. You have the time, toil, talent, Jensen that everyone loves
to talk about. No one ever tries a case with it. And if you ask the judges,
they basically just throw them out. I shouldn't say that, but pretty much
what some retired judges tell me.
Michelle O’Neil:
Well there are so hard to prove. I mean so to be clear, what we're talking
about is where the business owners compensation is not sufficient for
the work they're performing.
Robert Bales:
Correct. And unless you have a very extreme set of circumstances, it's
a difficult time to prove but probably the most common claims we see are
separate property put into a community business, community property put
into a separate business. You have to prove enhancement. One that is not
quite as common, but we've done quite a bit of is use of community credit
to benefit the separate property company. And the case on point for that
particular claim lays out exactly what you're supposed to do to prove
it up is the Thomas Case out of Houston. And it's in the footnote because
the people didn't plead it. They said we’d given it to you if you
had pled it. Now, if you had pled it and put on this evidence, we would
have given you that claim. But we've done that some, I know one we had
that that was, and again, it needs to be pretty obvious, where a company
was about to go under. It was a chip maker, I think they made video boards
back when video boards and computers were a hot item. And about to go
under and the guy went and guaranteed the line of credit and without the
line of credit, the company would've gone under. And so he exposed all
the community assets when he signed And because of that, the company ended
up selling for like $20 million and we were able to assert, not a hundred
percent community, but maybe a quarter of the company might be community
because someone would have charged an equity piece to sign that guarantee.
So that's a topic claim. Another claim that has been confused a bit by
recent court case, is if you have a flow through entity that the community
pays tax on the income of and never gets any distributions.
Michelle O’Neil:
So in that case, you're assuming the flow through entity’s separate.
Robert Bales:
The flow through entity separate makes a profit, doesn't pay any money
out, the profit passes through on the tax turn, the community pays the
tax bill, the money stays in the business and enhances its value. So someone
recently with some very large money had their reimbursement claim set
aside saying, you can't get a community reimbursement for community obligation,
the Dire case. Now I'm not a lawyer, I'm not going to argue with the court,
but to me it is an extreme injustice that the community suffers because
the separate property entity made money it didn't pay out. So I think
the question there is what's the proper way to plead that? Probably reconstitution,
but that needs to be pled in some form or fashion. We see a lot of that
in family businesses, Dad doesn't pay the money out, we're going to pay
you a $2 million salary, but we're not going to pay any money out on this business.
Michelle O’Neil:
And then there's also a usurping community opportunity.
Robert Bales:
You do see usurping community opportunity where maybe the community could
have participated in the deal, but he chose the separate entity to do it.
Michelle O’Neil:
So real quick, we got just maybe a minute or two, piercing the corporate
veil. You mentioned that a little bit earlier.
Robert Bales:
Hard to do.
Michelle O’Neil:
And I actually won one! I've done it once and so in our world it's really reverse piercing, not exactly straight piercing, but so what you're trying to do is set aside the legal entity formality so that you can get to the assets of the company to divide in the community estate.
Robert Bales:
Correct.
Michelle O’Neil:
And the most common way that you get that to happen is by the parties ignoring
the formality of the entity and running personal expenses, treating it
like their own personal bank account.
Robert Bales:
Well the guy had the other day that said, well I don't have a personal
bank account, the company account is my only account.
Michelle O’Neil:
So when we're advising and trying to avoid that, what Ryan said I think
in the very beginning of our webinar was making sure that they're kind
of keeping their personal expenses separate, that's where he was headed
with that comment, is am I going to be facing a claim for piercing the
corporate veil?
Ryan Segall:
And there's actually in the TBOC, they have a statute that's kind of addressed
this issue. And the statute is now saying that you can pierce for actual
fraud but not for constructive fraud, which I thought was kind of interesting.
Michelle O’Neil:
Alright, anything to add on any of that? Alright then we are finished with
section three of our Divorcing the Business Owner Entrepreneur webinar.
So the section four, we will start in just a minute on post-divorce issues.
There's a big thing going on right now with some post-divorce issues because
of some of the tax law changes. So you'll want to stay tuned for that.
We’ll be right back. Keep in mind, this is a webinar that's aimed
at attorneys. This is for continuing legal education. If you're out there
watching this webinar and you're not an attorney, we welcome you to watch
it. But remember that we are not giving you any specific legal advice.
We cannot comment on any specific case or situation without knowing all
the facts. So if you need legal advice, this webinar is not a substitute
for legal advice. Please, please seek the advice of a lawyer as to your
specific situation and get specific advice to that. Because if you rely
on just what we're talking about here, we're being general, we're talking
about general legal principles that may not actually apply to your situation.
This is for continuing legal education only, and we cannot create an attorney
client relationship just through the video camera. Okay. Thanks.