Double-dipping in Divorce Valuations

MARCH 29, 2012 BY ROBERT J. RIVERS, JR., ESQUIRE

Among the issues frequently considered in divorce cases is the value to be assigned to a spouse’s business interest for asset division purposes pursuant to M.G.L. c. 208, §34. While business valuation experts often value such interests for asset division purposes, the “double dipping” concept that necessarily flows from such valuation methodologies can sometimes create inequities when addressing the separate yet interrelated issues of alimony and child support. The concept of “double-dipping” is not an insignificant issue to be addressed by the Court; rather, avoidance of the potential inequities resulting from the “double dip” can significantly alter the value of a spouse’s business interest and can lead to dramatically different results.

The concept of “double-dipping” refers to the double counting of a marital asset, once in the property division and again in the support award. This theory is premised upon the fact that the same cash flows capitalized to determine the present overall value of a spouse’s business (an asset subject to equitable distribution pursuant to M.G.L. c. 208, §34) are also considered a component of that spouse’s total income for support calculation purposes. More specifically in the context of divorce proceedings, where the Court uses a business owner’s “excess earnings” to value the business, and also fixes support based upon that spouse’s total income (inclusive of the “excess earnings” used to value the business), a “double-dip” can occur. In order to fully understand the “double-dip” issue, an understanding of basic business valuation theory and methodology is required.

It is basic valuation theory that the value of a business is equal to the present worth of the future benefits of ownership. Fishman, Pratt, Griffith, Wilson, et. al., Guide to Business Valuations, Vol. 1, page 2-4 (PPC Publishers, February, 1999). This statement is a fundamental principle of business valuation. This is bolstered by the fact that, “a rational buyer normally will invest in a company only if the present value of the expected benefits of ownership are at least equal to the purchase price. Likewise, a rational seller normally will not sell if the present value of those expected benefits is more than the selling price. Thus, a sale generally will occur only at an amount equal to the benefits of ownership.”  Id.

This fundamental theory of business valuation is sometimes misinterpreted by Courts due to the misconception that business valuation is based upon an averaging of past income, rather than a projection as to what the future income will be based upon a review of the historical earnings of the company. However, whether one is applying a “capitalization of earnings” valuation methodology or an “excess earnings” valuation methodology, the earnings to be capitalized are indicative of the beginning point of future earnings. A future earnings growth rate is then subtracted from a discount rate to yield a capitalization rate. Thus, the role of past earnings is simply to provide an indication as to projected future earnings. Accordingly, the result of a business valuation is the present value of future, not past, income.  See Vuotto and Steirman, Double Trouble, New Jersey Divorce Article (www.vuotto.com/double-trouble.htm).

When valuing a business using either the capitalization of earnings method or an excess earnings method, the role of the business valuation expert is to determine the value of two separate components of value, namely “tangible” and “intangible” assets. While tangible assets, such as equipment, inventory, and accounts receivable, are easily identifiable, intangible assets are much more subtle.  Among the principal intangible assets that are analyzed in the context of business valuation is business “goodwill.”  The term “goodwill” is commonly defined as the “expectation of continued public patronage.”  Miod, The Double-Dip in Valuing Goodwill in Divorce, Miod & Co. LLP (1999). This definition leads to the logical conclusion that business “goodwill” is essentially the ability of an owner to enjoy future benefits from the business. See Pratt, Reilly & Schweihs, Valuing Small Businesses and Professional Practices, 2d. ed., p. 410-411 (Irwin Professional Publishing 1993) (among the biggest factors contributing to goodwill value in a professional practice is the projected level of economic earnings).

As has been noted, “[i]n valuation theory, these [“goodwill”] benefits an owner receives are represented by the net cash flows the owner receives from operating the business through dividends, withdrawals and/or salary and benefits beyond a normal level.” Fishman, Pratt, Griffith, Wilson, et. al., Guide to Business Valuations, Vol. 1, page 2-5 (PPC Publishers, February, 1999). It is the process of converting these future benefits above normal levels to a present value for purposes of determining business “goodwill” in quantifying the total value of tangible and intangible assets of a business that gives rise to the potential for “double-dipping.” If these future benefits are also utilized by the Court in order to determine a spouse’s future support obligations, these future benefits have been counted twice, hence the “double-dip.”

Among the leading cases addressing the concept of “double-dipping” is Grunfeld v. Grunfeld, 94 N.Y.2d 696 (2000). In Grunfeld, the New York Court of Appeals succinctly identified this concept by stating:

We agree with the defendant that the Supreme Court [the trial court in New York state] impermissibly engaged in the “double-counting” of income in valuing [the husband’s] business, which was equitably distributed as marital property, and in awarding maintenance to the [wife]. . . Here, the valuation of the [husband’s] business involved calculating the [husband’s] projected future excess earnings. Thus, in valuing and distributing the value of the [husband’s] business, the Supreme Court converted a certain amount of the [husband’s] projected future income stream into an asset. However, the Supreme Court also calculated the amount of maintenance to which the [wife] was entitled based on the [husband’s] total income, which must have included the excess earnings produced by his business. This was improper. ‘Once a court converts a specific stream of income to an asset, that income may no longer be calculated into the maintenance formula and payout.’

Grunfeld, 94 N.Y.2d at 705, citing McSparron v. McSparron, 87 N.Y.2d 275 (1993).  See also Rattee v. Rattee, 767 A.2d 415 (N.H. 2001) (business income exceeding “reasonable compensation” that was utilized to calculate value of business was properly disregarded for support calculation purposes, thus avoiding “double-dip”).

While the concept of “double-dipping” is widely recognized, not all jurisdictions have embraced its theories.  For example, in the recent case of Steneken v. Steneken, 873 A.2d 501 (N.J. 2005), the New Jersey Supreme Court specifically rejected the concept of “double-dipping” in the context of business valuation for divorce purposes.  In determining that such an issue is subject to an overriding concept of fairness, the Court stated that:

Because we embrace the premise that alimony and equitable distribution calculations, albeit interrelated, are separate, distinct, and not entirely compatible financial exercises, and because asset valuation methodologies applied in the equitable distribution setting are not congruent with the factors relevant to alimony considerations, we conclude that the circumstances here present a fair and proper method of both awarding alimony and determining equitable distribution. We find no inequity in the use of the individually fair results obtained due to the use of an asset valuation methodology normalizing salary in an on-going close corporation for equitable division purposes, and the use of actual salary received in the calculus of alimony.  The interplay of those calculations does not constitute ‘double-counting.’

Steneken v. Steneken, 873 A.2d 501, 507 (N.J. 2005) (emphasis supplied).

Our appellate courts have recognized and addressed the concept of “double-dipping” in the context of divorce proceedings on more than one occasion. For example, in Dalessio v. Dalessio, 409 Mass. 821 (1991), the Appeals Court found that there had not been any double-counting of the proceeds of a large tort settlement arising from the husband’s industrial accident. Id. at 827-828.  In so finding, however, the Appeals Court specifically instructed that:

So long as it is possible to identify separate portions of a given asset of a divorcing spouse as the separate bases of the property assignment and any alimony or support obligations (thus avoiding redistribution by an alimony or support order of specific assets that already have been equitably assigned), there is nothing improper about including a particular asset within a spouse’s assignable estate, assigning part of it, and then counting its remainder for alimony and child support purposes.”

Dalessio, 409 Mass. at 828 (emphasis supplied).

As the Appeals Court noted in Dalessio, the key concept when addressing whether an impermissible double-dip has occurred is whether it is possible to identify separate portions of an asset as forming separate bases for a division of property and a support obligation. Unless these separate components can be identified, quantified and separated from the Court’s decision-making process for property division and support calculation purposes, an impermissible double-dip has occurred. In Dalessio, the future income to be derived from the asset formed no part of the determination of the value of that asset; hence, no impermissible “double-dip” had occurred.

In Champion v. Champion, 54 Mass. App. Ct. 215 (2002), the Appeals Court

again considered the concept of “double-dipping” in the context of the valuation of a husband’s telecommunications equipment business. In holding that there had been no double-counting in the trial judge’s assignment of property and determination of support, the Appeals Courtnoted that the value for the husband’s business had been determined using a “net asset” valuation methodology which did not include any quantifiable “goodwill” value. Id. at 217. Because this valuation methodology does not consider future, excess earnings as part of the calculation of the value of the business, the Appeals Court found that the corresponding support order had not double-counted the husband’s future earnings from the business. Id. at 221.

Most recently, in Sampson v. Sampson, 62 Mass. App. Ct. 366 (2004), the Appeals Court determined that there appeared to have been impermissible “double-dipping” with respect to the trial judge’s divorce judgment, thus requiring a remand for further consideration of the apparent inequities that existed. The Appeals Court noted in Sampson that, unlike the “net asset” valuation method that had been utilized in Champion, a “capitalized income” valuation methodology had been used by both parties’ experts in valuing the wife’s business. Id. at 375. The Appeals Court further noted that “a [capitalized income] method requires subtraction from business income of a reasonable salary expense for the operator of the business [citations omitted].  Without subtraction of a sum representing a reasonable salary, there is significant concern that the business may be overvalued. Moreover, where such a salary is subtracted, it facilitates the identification of those portions of a given asset providing separate bases of property assignment and alimony as articulated by Dalessio v. Dalessio.”  Id. at 375-376.

In finding that “double-dipping” may have occurred in Sampson, the Appeals Court went on to state that:

When considering the wife’s income for the purposes of determining her need for support, the judge made no adjustments, concluding that she would earn $41,912 a year. The $41,912 was based on what she was earning from the business without recognizing that some of that income had been attributed to the value of the business itself. For that additional income, the husband had already been compensated by providing him with an otherwise disproportionate share of the proceeds from the sale of the house [citations omitted]. Concerns are thereby raised that either the value of the business was inflated by artificially deflating the salary of the owner-operator or, conversely, that the wife’s income was inflated when determining her need for support [citations omitted].  In sum, there appear to be some ‘double counting’ and other inequities present.

Sampson, 62 Mass. App. Ct. at 377 (emphasis supplied); see also Adlakha v. Adlakha, 65 Mass. App. Ct. 860, 866-867 (2006) (trial judge did not engage in “double-dipping” where alimony and property division awards were based upon consideration of separate components of spouse’s overall income from medical practice).

In appropriate circumstances where it would be inequitable to disregard the “double dip,” there are two alternatives whereby a Court may avoid this concept.  Specifically, the Court could order an equitable division of the marital estate based upon a value for the spouse’s business interest according to recognized valuation methodologies which utilize “excess earnings” as part of the valuation analysis, with a corresponding calculation of that spouse’s support obligations based upon the fair market “reasonable compensation” of the business owner (as considered and determined as part of the valuation methodologies that were utilized).

Alternatively, the Court could order an equitable division of the marital estate based upon a value for the spouse’s business without consideration of the “excess earnings” of the business, with a corresponding calculation of that spouse’s support obligations based upon the spouse’s actual total net earnings from the business (including therein any “excess earnings” above “reasonable compensation”). See generally Kristal, The Double-Dipping Consideration in Marital Dissolution Valuations, American Journal of Family Law, Vol. 19, No. 2, p. 71 (Summer 2005) (using valuations premised upon different bases for owner’s compensation properly separates owner-operator’s compensation into two parts: (1) what he or she earns from managing the business; and (2) what he or she earns from owning (investing in) it); In re Marriage of Schneider, 824 N.E.2d 177, 185-186 (Ill. 2005) (“goodwill” value of dental practice improperly double-counted in both division of assets and in the level of maintenance and support awarded).

The potential inequities that may result by failing to eliminate the “double-dip” are not limited to those mentioned above. In light of the fact that a significant portion of the value of a spouse’s business is often comprised of “goodwill” value, this goodwill value is directly tied to, and dependent upon, the projected future earnings of the business. Because the goodwill value of the business is based upon projections only, many unforeseen and/or uncontrollable circumstances could significantly diminish, or even eliminate, these projected future earnings. For example, the business could experience a significant financial downturn, material changes in the way in which revenues are generated within a particular industry could occur, the owner-spouse could become disabled and incapable of working to his/her projected full capacity, or the owner-spouse could die prematurely.

Notwithstanding the myriad potential changes in circumstances, the non-owner spouse would presumably immediately receive his/her equitable share of the total value of the owner spouse’s business (including “goodwill”) via an offsetting assignment of other, presently existing (and perhaps liquid) assets. As a result, although the owner-spouse would retain his/her business as part of the overall asset division, he/she would not be able to immediately reap the financial benefit of the inherent future benefits (the “excess earnings” of the business) that comprise the total value of the business for many years to come. In addition, it is quite possible that the future benefits that are essentially “built-in” to the value of the owner spouse’s business may never materialize. Such events could result in an inequitable division of property in the non-owner spouse’s favor.

Unfortunately, the above-referenced material changes in circumstances could not be addressed by the Court in the future, as it is well-settled that an equitable division of marital assets cannot be modified in the future.  Dumont v. Godbey, 382 Mass. 234, 238 (1981). By comparison, however, if the Court considered the excess earnings of the business only for purposes of determining an appropriate level of support, the Court (and the parties) would remain in a position to revisit the issue of support via a complaint for modification in the event that future, unforeseen and/or uncontrollable circumstances were to occur. Such an approach may provide the parties, and the Court, with more flexibility to properly address changes in circumstances which may adversely affect the fundamental earnings projections that are inherent in the valuation methodologies of the business. See Drapek v. Drapek, 399 Mass. 240, 244 (1987) (present valuing future earned income for equitable assignment under G.L. c. 208, §34 forecloses consideration of the effect of future events on an individual’s earning capacity, as property settlements are not subject to modification).

Another potential factor that might be relevant concerns the tax consequences associated with essentially awarding a portion of the owner-spouse’s future business earnings to the non-owner spouse by means of an offsetting, tax-free assignment of property.  By making an offsetting, tax-free property assignment to the non-owner spouse, the owner spouse will effectively receive the “goodwill” value of his/her business subject to the inherent income taxes that will be due on these future excess earnings as they are earned.  Specifically, since the future excess earnings received by the owner-spouse will be subject to federal, state and FICA/Medicare self-employment taxes potentially totaling in a range of forty (40%) percent or more in the aggregate (if, as and when received), the actual net benefit to the owner-spouse may be significantly impacted upon and reduced by future income taxes.

While the concept of “double-dipping” in business valuation for divorce purposes is a recognized theory, the particular facts and circumstances of each case must be thoroughly analyzed in order to fully understand the potential inequities that may exist. In this regard, counsel must have a thorough understanding of the valuation methodologies that have been utilized by the expert witnesses who have participated in the valuation process, including the particular aspects of the business enterprise that have been considered for asset valuation purposes. Counsel who wish to have the Court consider the “double-dipping” issue should also be prepared to introduce expert testimony regarding this concept in order to specifically show the extent, if any, that this concept impacts upon the inherent value of the business enterprise and the interrelated issues of alimony and child support. Only after a thorough review of these factors has been undertaken can an appropriate analysis of the “double-dipping” issue be considered.

Mr. Rivers is a partner in the Boston law firm of Lee, Rivers & Corr LLP where he concentrates his practice in the areas of domestic relations and civil litigation.

Source

IP Valuation Overview

Intellectual capital is recognized as the most important asset of many of the world’s largest and most powerful companies; it is the foundation for the market dominance and continuing profitability of leading corporations. It is often the key objective in mergers and acquisitions and knowledgeable companies are increasingly using licensing routes to transfer these assets to low tax jurisdictions.

Nevertheless, the role of intellectual property rights ( IPRs) and intangible assets in business is insufficiently understood.  Accounting standards are generally not helpful in representing the worth of IPRs in company accounts and IPRs are often under-valued, under-managed or under-exploited.  Despite the importance and complexity of IPRs, there is generally little co-ordination between the different professionals dealing with an organization’s IPR.  For a better understanding of the IPRs of a company, some of the questions to be answered should often be:

What are the IPRs used in the business?
What is their value (and hence level of risk)?
Who owns it (could I sue or could someone sue me)?
How may it be better exploited (e.g. licensing in or out of technology)?
At what level do I need to insure the IPR risk?
One of the key factors affecting a company’s success or failure is the degree to which it effectively exploits intellectual capital and values risk. Management obviously need to know the value of the IPR and those risks for the same reason that they need to know the underlying value of their tangible assets; because business managers should know the value of all assets and liabilities under their stewardship and control, to make sure that values are maintained. Exploitation of IPRs can take many forms, ranging from outright sale of an asset, a joint venture or a licensing agreement. Inevitably, exploitation increases the risk assessment.

Valuation is, essentially, a bringing together of the economic concept of value and the legal concept of property. The presence of an asset is a function of its ability to generate a return and the discount rate applied to that return. The cardinal rule of commercial valuation is: the value of something cannot be stated in the abstract; all that can be stated is the value of a thing in a particular place, at a particular time, in particular circumstances. I adhere to this and the questions ‘to whom?’ and ‘for what purpose?’ must always be asked before a valuation can be carried out.

This rule is particularly significant as far as the valuation of intellectual property rights is concerned. More often than not, there will only be one or two interested parties, and the value to each of them will depend upon their circumstances. Failure to take these circumstances, and those of the owner, into account will result in a meaningless valuation.

For the value of intangible assets, calculating the value of intangible assets is not usually a major problem when they have been formally protected through trademarks, patents or copyright. This is not the case with intangibles such as know how, (which can include the talents, skill and knowledge of the workforce), training systems and methods, technical processes, customer lists, distribution networks, etc. These assets may be equally valuable but more difficult to identify in terms of the earnings and profits they generate. With many intangibles, a very careful initial due diligence analysis needs to be undertaken together with IP lawyers and in-house accountants.

There are four main value concepts, namely, owner value, market value, fair value and tax value. Owner value often determines the price in negotiated deals and is often led by a proprietor’s view of value if he were deprived of the property. The basis of market value is the assumption that if comparable property has fetched a certain price, then the subject property will realize a price something near to it. The fair value concept, in its essence, is the desire to be equitable to both parties. It recognizes that the transaction is not in the open market and that vendor and purchaser have been brought together in a legally binding manner. Tax value has been the subject of case law worldwide since the turn of the century and is an esoteric practice. There are quasi-concepts of value which impinge upon each of these main areas, namely, investment value, liquidation value, and going concern value.

Methods for the Valuation of Intangibles

Acceptable methods for the valuation of identifiable intangible assets and intellectual property fall into three broad categories. They are market based, cost based, or based on estimates of past and future economic benefits.

In an ideal situation, an independent expert will always prefer to determine a market value by reference to comparable market transactions. This is difficult enough when valuing assets such as bricks and mortar because it is never possible to find a transaction that is exactly comparable. In valuing an item of intellectual property, the search for a comparable market transaction becomes almost futile. This is not only due to lack of compatibility, but also because intellectual property is generally not developed to be sold and many sales are usually only a small part of a larger transaction and details are kept extremely confidential. There are other impediments that limit the usefulness of this method, namely, special purchasers, different negotiating skills, and the distorting effects of the peaks and troughs of economic cycles. In a nutshell, this summarizes my objection to such statements as ‘this is rule of thumb in the sector’.

Cost-based methodologies, such as the “cost to create” or the “cost to replace” a given asset, assume that there is some relationship between cost and value and the approach has very little to commend itself other than ease of use. The method ignores changes in the time value of money and ignores maintenance.

The methods of valuation flowing from an estimate of past and future economic benefits (also referred to as the income methods) can be broken down in to four limbs; 1) capitalization of historic profits, 2) gross profit differential methods, 3) excess profits methods, and 4) the relief from royalty method.

1. The capitalization of historic profits arrives at the value of IPR’s by multiplying the maintainable historic profitability of the asset by a multiple that has been assessed after scoring the relative strength of the IPR. For example, a multiple is arrived at after assessing a brand in the light of factors such as leadership, stability, market share, internationality, trend of profitability, marketing and advertising support and protection. While this capitalization process recognizes some of the factors which should be considered, it has major shortcomings, mostly associated with historic earning capability. The method pays little regard to the future.

2. Gross profit differential methods are often associated with trade mark and brand valuation. These methods look at the differences in sale prices, adjusted for differences in marketing costs. That is the difference between the margin of the branded and/or patented product and an unbranded or generic product. This formula is used to drive out cashflows and calculate value. Finding generic equivalents for a patent and identifiable price differences is far more difficult than for a retail brand.

3. The excess profits method looks at the current value of the net tangible assets employed as the benchmark for an estimated rate of return. This is used to calculate the profits that are required in order to induce investors to invest into those net tangible assets. Any return over and above those profits required in order to induce investment is considered to be the excess return attributable to the IPRs. While theoretically relying upon future economic benefits from the use of the asset, the method has difficulty in adjusting to alternative uses of the asset.

4. Relief from royalty considers what the purchaser could afford, or would be willing to pay, for a licence of similar IPR. The royalty stream is then capitalized reflecting the risk and return relationship of investing in the asset.

Discounted cash flow (“DCF”) analysis sits across the last three methodologies and is probably the most comprehensive of appraisal techniques. Potential profits and cash flows need to be assessed carefully and then restated to present value through use of a discount rate, or rates. DCF mathematical modelling allows for the fact that 1 Euro in your pocket today is worth more than 1 Euro next year or 1 Euro the year after. The time value of money is calculated by adjusting expected future returns to today’s monetary values using a discount rate. The discount rate is used to calculate economic value and includes compensation for risk and for expected rates of inflation.

With the asset you are considering, the valuer will need to consider the operating environment of the asset to determine the potential for market revenue growth. The projection of market revenues will be a critical step in the valuation. The potential will need to be assessed by reference to the enduring nature of the asset, and its marketability, and this must subsume consideration of expenses together with an estimate of residual value or terminal value, if any. This method recognizes market conditions, likely performance and potential, and the time value of money. It is illustrative, demonstrating the cash flow potential, or not, of the property and is highly regarded and widely used in the financial community.

The discount rate to be applied to the cashflows can be derived from a number of different models, including common sense, build-up method, dividend growth models and the Capital Asset Pricing Model utilising a weighted average cost of capital. The latter will probably be the preferred option.

These processes lead one nowhere unless due diligence and the valuation process quantifies remaining useful life and decay rates. This will quantify the shortest of the following lives: physical, functional, technological, economic and legal. This process is necessary because, just like any other asset, IPRs have a varying ability to generate economic returns dependant upon these main lives. For example, in the discounted cashflow model, it would not be correct to drive out cashflows for the entire legal length of copyright protection, which may be 70 plus years, when a valuation concerns computer software with only a short economic life span of 1 to 2 years. However, the fact that the legal life of a patent is 20 years may be very important for valuation purposes, as often illustrated in the pharmaceutical sector with generic competitors entering the marketplace at speed to dilute a monopoly position when protection ceases. The message is that when undertaking a valuation using the discounted cashflow modelling, the valuer should never project longer than what is realistic by testing against these major lives.

It must also be acknowledged that in many situations after examining these lives carefully, to produce cashflow forecasts, it is often not credible to forecast beyond say 4 to 5 years. The mathematical modelling allows for this in that at the end of the period when forecasting becomes futile, but clearly the cashflows will not fall ‘off of a cliff’, by a terminal value that is calculated using a modest growth rate, (say inflation) at the steady state year but also discounting this forecast to the valuation date.

While some of the above methods are widely used by the financial community, it is important to note that valuation is an art more than a science and is an interdisciplinary study drawing upon law, economics, finance, accounting, and investment. It is rash to attempt any valuation adopting so-called industry/sector norms in ignorance of the fundamental theoretical framework of valuation. When undertaking an IPR valuation, the context is all-important, and the valuer will need to take it into consideration to assign a realistic value to the asset

Source Kelvin King, founding partner of Valuation Consulting