While doing research on corporate control issues recently, I came across the following article, published by The Wilmington Trust, a venerable private wealth management firm:

Imagine attending the next board meeting of your venerable family firm, only to be seated across from your former spouse’s new partner, who is 15 years your junior. With the divorce rate high, the liklihood of these situations occurring is increasing. But when it comes to protecting your family business from such potentially disagreeable divorce fallout, it’s important to take some precautionary steps:

• Develop a corporate culture that separates ownership from authority and control.
• Employ legal tactics and structures to prevent a divorce from deadlocking the business.
• Establish mechanisms (including participation in family business associations) to keep the channels of communication open and prevent small conflicts from becoming big.

Corporate Culture
Too many families confuse a stake in the business with authority and control. Here is one textbook example from Paul Karofsky, director of the Northeastern University Center for Family Business: “A century-old company, in which ownership was diluted among 18 grandchildren, gave everyone an identical salary, private office and luxury car regardless of their job with the now-defunct company. It would have been much more appropriate to provide salaries and benefits commensurate with their job descriptions and to distribute dividends based on their ownership and profits.”

The model for separating ownership from control in a mature family company, such as the one with 18 owners, is akin to a public company. At Staples®, where just about everyone owns stock — from truck drivers to senior management — no one has grounds to complain when a truck driver, who bought Staples stock 20 years ago, owns a bigger stake in the company and has a higher net worth than his newly hired, better-paid branch manager.

Legal Tactics
When children marry and their spouses enter the family with a presumption of status in the company, the stresses can severely impede business success. Add divorce, and the business could be doomed. As the founder, or senior family member, you have a responsibility to protect the company from being deadlocked by an irate ex-spouse following a child’s divorce. When the children are young and unmarried, it is relatively easy to insist on prenuptial agreements to prohibit spouses from owning stock. To encourage acceptance among the adult children and their betrothed, make it clear that the lack of stock ownership bears no relationship to a financial settlement in the event of divorce.

Obviously, prenuptial agreements cannot be required if marriages have already taken place or in situations where spouses feel justified in owning part of the business. For example, two sisters started a small, mail-order company to sell gardening tools. One sister’s husband offered to set up and run the website, which became hugely profitable. Meanwhile, the other sister’s husband helped out with the books and eventually joined the burgeoning company as CFO. The small business grew into a sophisticated corporation, with no one addressing any of the tough issues such as divorce, death, succession, and so forth.

In an emerging business, such as the gardening tool company, the owners and their spouses must recognize that their obligation to the business far outweighs their individual need for control. Since the spouses are already active in the company, one solution is to create a trust which will own and control all of the stock. In addition to family members, the trust should have one or more outside trustees, preferably a corporate trustee, to break any deadlock. Without a trust in place, shareholders can seek, and will likely receive, a remedy from the courts if a deadlock threatens the business. Unfortunately, having the courts make business decisions is costly and cumbersome, and everyone can wind up with bruised feelings. Trust documents should be re-examined and revised periodically to make sure they continue to serve business and family interests.

Family Business Associations
Family Business Associations can assist in facilitating communication, resolving conflict, and providing management, legal, and other insights. In addition, these organizations offer family business owners, including spouses and children, an opportunity to share their problems and solutions in a non-threatening, peer-to-peer forum.

In a Nutshell

• The divorce rate is high, but the probability of divorce increases when the number of family members involved in the business grows.
• Disputes over power, money, and control at home will be played out in the business.
• Be alert to status issues, both within the company and community.
• Clearly distinguish between ownership and jobs, but do not go overboard by being unduly tough on an heir apparent.
• Communicate and revise the trust and other agreements to cope with advancing age, marital status, involvement, health, and the like.
• Establish an exit strategy, such as a Texas Shootout, which allows one partner to set the price for his or her half of the business and the other partner to either buy or sell at that price.
• Employing spouses offers substantial benefits, including participation in business travel, the company pension plan, health plan, and Social Security. But roles and compensation for spouses must be well defined, recognizing that other family members and employees will notice every scintilla of preferential treatment.
• Assess your strengths as the business grows; if running the business day-to-day is not your forte, consider hiring an outside CEO or general manager.

Developing an ongoing relationship with your financial institution and a family business forum is well worth the effort. No corporate job can compare to a well-run family business when it comes to flexibility, financial reward, and an opportunity to work with people whom you know, love, and trust.

Source: The Wilmington Trust

Texas has once again proven itself to be a haven for the affluent divorcee. In Mandell v. Mandell, 2010 WL 1006406 (March 18, 2010), the Texas Court of Appeals held that a professional spouse’s 25% interest in a medical corporation was limited under the terms of a buy-sell agreement to a nominal fixed price payable to shareholders upon divorce. The decision was summarized at BVLaw Blog as follows:

In a case of first impression, the Texas Court of Appeals considered a buy-sell agreement that purported to bind shareholders and their spouses in the event of divorce. As a further complication, the husband had signed an employment agreement with the private medical association—but neither he nor his wife had signed the shareholders’ agreement.  This unsigned agreement limited the value of a divorcing shareholder’s interest to the equity buy-in price (in this instance, a mere $11,000 for a 25% share in a business with an estimated $3 million to $5 million book value).

I share BVLaw Blog’s incredulity, but my analysis is somewhat different.

In the opinion, the Texas appeals court emphasized that the doctor, who signed the stock purchase agreement during the marriage three years before separation, tendered a check for his buy-in but never signed the shareholders agreement (which was referenced in the stock purchase agreement); and his shares were never issued. After separation, the corporation returned the shareholder’s fixed buy-in payment. At that point, the trial court  might have held that the shares were never acquired, and only the buy-in payment itself was community property.

Yet, during the pendency of the divorce litigation, the wife filed motions compelling her husband and the corporation to complete the transaction. The doctor returned the fixed sum to the corporation, and the corporation issued the shares. When the wife attempted to introduce expert testimony to prove the fair market value of the shares, she was met with a motion in limine, which was granted. The trial court held that the wife was bound by the terms of the agreements.

In Texas, the fair market value of a business is presumed to be zero if the shareholders are contractually obligated to sell back their shares upon retirement, death or divorce. A divorcing spouse may present evidence of book value or comparable sales to rebut the presumption, but in this case, the court held that the net asset value was the property of the corporation, not the shareholders.

It might be signficant that Texas is a community property jurisdiction. Since the marital community exists throughout the marriage in those jurisdictions, it could be said that the doctor’s wife was in privity with her contracting husband when he signed the stock purchase agreement. Furthermore, property in Texas apparently cannot be owned simultaneously by one legal entity (a corporation) and another legal entity (the marital community). These principles might not apply in common law (marital property) states, such as Pennsylvania, where it might be argued that the spouses were neither in privity nor intended third party beneficiaries of such contracts, and where marital property is merely a fictitious estate rather than a legal entity.

Two articles from BV Wire recently caught my attention. Both deal with business valuation in divorce cases where personal goodwill was an issue. I will post my own analysis soon. Meanwhile, here are excerpts from BV Wire’s blast email, published by BV Resources.

Med practice valuations still plague appraisers—and the courts

A trio of new divorce cases highlights the constant challenge of appraising medical practices, everything from doctors who won’t disclose their finances to those who insist their opinions should determine value. In Garcia v. Garcia (Fla. App., Jan. 20, 2010), the husband’s expert argued for a strict application of the buy-sell agreement, which would have limited his share in a successful hematology practice to a mere $45,000—compared to the wife’s expert, who used a net asset value to appraise it at $900,000. At the very least, the husband argued, the restrictive buy-sell should considerably discount the NAV (but he lost both arguments on appeal).

Or consider Amaraneni v. Amaraneni, (La. App., Feb. 12, 2010), in which the doctor claimed his interest in an urgent care clinic had no value apart from goodwill attributable to his professional qualities. But he failed to provide any financial documentation to the court-appointed expert; at deposition, he was similarly “vague” and un-responsive. His name was on the wall but the clinic wasn’t named after him. A manager supervised all the operations and staff—and the expert apportioned all goodwill to the enterprise, also confirmed on appeal.

Finally, in Dickert v.Dickert, (S.C., Jan. 11, 2010), the trial court valued the husband’s successful dental practice at $360,000, including over $255,000 of “enterprise goodwill.” In an expedited appeal to the S.C. Supreme Court, the husband argued that state law precluded any consideration of goodwill in a professional practice, due to its speculative nature. The wife claimed the current majority rule on enterprise values was the better law, but the court disagreed, finding the goodwill asset “too intangible” to support an accurate valuation.  (All three case digests will appear in the April 2010 Business Valuation Update™.)

Is this recession enough reason to devalue assets in divorce?

In Mistretta v.Mistretta (Fla. App., Feb. 18, 2010), the trial court valued the husband’s restaurant at $854,000, based on a valuation report prepared nearly a year earlier. The husband moved for reconsideration, claiming the recession caused the restaurant to lose value. The trial court agreed, finding that no one could have foreseen the severity of the economic crisis—but the wife successfully appealed. “Economic recessions, like other vagaries in the business cycle, are contingencies appraisers must take into account in valuing a business,” the appellate court held, despite a strong dissent which likened the recession to a global economic “tsunami.” The wife’s expert, Gary Trugman, obviously agrees with the majority. “The truth is, we did consider the economic downturn, because we used dual valuation dates,” he tells the BVWire™. The husband also lost on his expert’s claim that 50% of the restaurant’s value was personal goodwill. “As I said to the judge, ‘Your Honor, when was the last time you went to a restaurant if the food was lousy, the service was terrible, but the owner was a really nice guy?’ I think that got my point across, that there was very little personal goodwill,” Trugman says. “I used Pratt’s Stats data for restaurants to demonstrate what portion of the purchase price was protected by a covenant not to compete, and used that percentage to allocate some personal goodwill—but it was a relatively small figure.”

An issue that befuddles some business owners during the course of their divorce litigation is how to regulate the operation and management of their businesses. In cases where both spouses own interests in the business, they may struggle for control of important business and financial decisions.

Some issues may be resolved under the company’s partnership agreement, shareholders’ agreement, limited liability company (LLC) agreement, or corporate by-laws. Yet, these agreements are often too vague to deal effectively with disputes between divorcing spouses who own businesses together.

Early in the evolution of the Divorce Code, the Superior Court of Pennsylvania authorized the Courts to appoint receivers or trustees to prevent the dissipation of an ongoing business concern. Mayhue v. Mayhue, 485 A.2d 494 (Pa.Super.1984). The Superior Court in Mayhue held that 23 Pa.C.S. § 3505(a) and 23 Pa.C.S. § 3323(f) authorized the Courts to enter an injunction to prevent a spouse from continuing a course of conduct calculated to defeat his wife’s property rights in the business. The Superior Court in Mayhue approved the trustee’s powers to liquidate assets to pay business debts, pay delinquent taxes, and satisfy intercompany debts.

The appointment of a receiver is not practical in every case because the expense of paying a receiver may not be justified. Still, there are some cases in which third party supervision of the business might be the only practical way t0 ensure continued smooth operation of a business caught in the middle.

The California Court of Appeal’s decision in Marriage of Blazer (2009) dealt not only with double dipping, but also with the exclusion of a company’s retained earnings when determining the owner’s income subject to an alimony obligation. After a 20 year marriage, Husband and Wife divorced, the husband retaining ownership of a berry distribution business. At trial, the husband’s expert testified that the berry company was thinly capitalized for its gross revenue. Wife’s expert agreed (if not grudgingly) that some earnings must be retained for capital reserves. The trial court excluded these retained earnings from the husband’s income for alimony purposes.

The husband’s expert also testified that retailers were seeking to eliminate middlemen, forcing the business to integrate vertically. The capital expenditures to purchase a growing farm and expand distribution were not added back to the company’s income, despite wife’s argument that husband “chose” to incur those expenses and would benefit from the enhancement in the company’s value. Again, the trial court adopted the position of the husband’s expert, over the opposition of wife’s expert.

On appeal, the California Court of Appeals affirmed the trial court’s decision under an “abuse of discretion” standard. The Court noted that there is no statutory definition of “income” for alimony cases in California, and it was unclear whether retained earnings could be properly categorized as “income” for alimony purposes. Case law held that the child support definition of “income” did not apply to alimony cases.

The Tennessee Court of Appeals recently held that a business owner’s spouse who signed a buy-sell agreement was bound by the value in a divorce action. In Inzer (2009), the husband and wife both signed a buy-sell agreement when they formed an LLC to purchase a Sonic Drive-In franchise. The buy-sell agreement granted other partners a right of first refusal to buy the interests of a withdrawing partner for the lesser of book value or the offer procured by the withdrawing partner. The owner’s expert presented evidence that the owner’s 24% interest in the franchise was worth $120,000 to $135,000 using capitalized cash flow or market methods, but only $16,000 net book value after discounts. Wife’s expert testified to a value of more than $500,000 after making adjustments to the owners’ compensation and ignoring discounts for lack of marketability, lack of control or the restrictive operating agreement.

The trial court valued the owner’s interest at $200,000 without much explanation. The Tennessee Court reversed, holding that the franchise was worth $33,000 book value without consideration of intangible value or discounts (as specified in the buy-sell agreement). The appellate court distinguished cases in which buy-sell agreements were not controlling, since the non-owner spouse in those cases did not sign the buy-sell.

Consider whether it was appropriate for Wife’s expert to perform  Type I adjustments in his normalization of the income statement, i.e., adjusting the owners’ compensation. Could a purchaser of a 24% interest compel the other owners to reduce their compensation? Even if the Court had not held the buy-sell to be controlling, it seems unlikely that Wife’s expert would have prevailed.

In divorce litigation where one of the spouses owns a professional practice, such as a medical practice, dental practice, law firm or accounting firm, the lawyers and their experts have to determine whether the business has value. Their determination depends upon whether the professional practice is believed to have enterprise goodwill.

Briefly, enterprise goodwill is the price that a buyer would pay for a professional practice over and above the value of its hard assets like equipment and supplies. In theoretical terms, enterprise goodwill is the reputation of the business that is not closely associated with a particular owner or professional. The opposite of enterprise goodwill is personal goodwill, which is the reputation and skill of the professional. Enterprise goodwill has value because it is transferrable but personal goodwill is not. Someone might be willing to pay for a name like Aspen Dental Systems, but what about Jane Doe, PC?

Increasingly, there is a market for professional practices that are not part of a regional or national chain. Dental practices, even those with a single location and single dentist, are bought and sold frequently. The same is true for specialty medical practics. Yet, primary care medical practices and legal practices are rarely bought or sold. So, how does a lawyer decide whether a professional practice should be evaluated by a business valuation specialist? Here are three signs that a professional practice might have value:

1. Actual transactions. If a professional or his/her partners have bought or sold their practices, it is more likely that there is transferrable enterprise goodwill. However, you must distinguish market transactions from succession planning. If the only transactions are between retiring partners and advancing associates, then there may not be much enterprise goodwill.

2.  Subordinates and equipment.  One reason why dental practices are increasingly transferrable is that dental procedures are performed by hygenists and associate dentists. If the owner of the practice is earning profit from other professionals and paraprofessionals, then a buyer might be willing to pay something to step into those shoes.

3.  Excess compensation. If a professional is earning substantially more than industry standards, then the professional’s practice might have enterprise goodwill. No buyer would pay to assume an existing practice if he or she could start a new practice for free – except if the existing practice were more profitable than a new practice would be. This criteria is based on the principle of substitution.

The U.S. Court of Appeals for the Seventh Circuit recently took up the case of Menard v. Commissioner, 560 F.3d 620 (2009), considering whether the CEO of a privately-held company was receiving a dividend disguised as salary from the business he controlled. The CEO whose salary was questioned was John Menard, founder and controlling shareholder of Menards, a chain of retail hardware and building supply stores. The Tax Court took the position that John Menard’s $20 million salary was really a disguised dividend because it was much greater than the salaries of the Home Depot and Lowe’s CEOs, who earned $2.8 million and $6.1 million respectively.

The appellate court’s opinion in this case is so well-researched that I cannot help but include large blocks of text, starting with its introduction to the subject:

The Internal Revenue Code allows a business to deduct from its taxable income a “reasonable allowance for salaries or other compensation for personal services actually rendered,”[or] “payments purely for services.” Occasionally the Internal Revenue Service challenges the deduction of a corporate salary on the ground that it’s really a dividend. A dividend, like salary, is taxable to the recipient, but unlike salary is not deductible from the corporation’s taxable income. So by treating a dividend as salary, a corporation can reduce its income tax liability without increasing the income tax of the recipient. . . As a result of a change in law in 2003, dividends are now taxed at a lower maximum rate than salaries—15 percent, versus 35 percent for salary. 26 U.S.C. § 1(h)(11). This makes the tradeoff more complex; although the corporation avoids tax by treating the dividend as a salary, which is deductible, the employee pays a higher tax. But depending on its tax bracket, the corporation may still save more in tax than the employee pays, and in that event, if the employee owns stock in the corporation, he may, depending on how much of the stock he owns, prefer dividends to be treated as salary. . . . Even before the change in the Internal Revenue Code, treating a dividend as salary was less likely to be attempted in a publicly held corporation, because if the CEO or other officers or employees receive dividends called salary beyond what they are entitled to by virtue of owning stock in the corporation, the other shareholders suffer. But in a closely held corporation, the owners might decide to take their dividends in the form of salary in order to beat the corporate income tax, and there would be no one to complain—except the Internal Revenue Service.

The usual case for forbidding the reclassification (for tax purposes) of dividends as salary is thus that “of a corporation having few shareholders, practically all of whom draw salaries,” Treas. Reg. § 1.162-7(b)(1), especially if the corporation does not pay dividends (as such) and some of the shareholders do no work for the corporation but merely cash a “salary” check. A difficult case—which is this case—is thus that of a corporation that pays a high salary to its CEO who works full time but is also the controlling shareholder. The Treasury regulation defines a “reasonable” salary as the amount that “would ordinarily be paid for like services by like enterprises under like circumstances,” § 1.162-7(b)(3), but that is not an operational standard. No two enterprises are alike and no two chief executive officers are alike, and anyway the comparison should be between the total compensation package of the CEOs being compared, and that requires consideration of deferred compensation, including severance packages, the amount of risk in the executives’ compensation, and perks.

Courts have attempted to operationalize the Treasury’s standard by considering multiple factors that relate to optimal compensation. [Citations omitted.] We reviewed a number of these attempts in Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir.1999), and concluded that they were too vague, and too difficult to operationalize, to be of much utility. Multifactor tests with no weight assigned to any factor are bad enough from the standpoint of providing an objective basis for a judicial decision [citations omitted]; multifactor tests when none of the factors is concrete are worse, and that is the character of most of the multifactor tests of excessive compensation. . . . All businesses are different, all CEOs are different, and all compensation packages for CEOs are different.

In Exacto, in an effort to bring a modicum of objectivity to the determination of whether a corporate owner/employee’s compensation is “reasonable,” we created the presumption that “when . . . the investors in his company are obtaining a far higher return than they had any reason to expect, [the owner/employee’s] salary is presumptively reasonable.” But we added that the presumption could be rebutted by evidence that the company’s success was the result of extraneous factors, such as an unexpected discovery of oil under the company’s land, or that the company intended to pay the owner/employee a disguised dividend rather than salary. 196 F.3d at 839.

The strongest ground for rebuttal, which brings us back to the basic purpose of disallowing “unreasonable” compensation, is that the employee does no work for the corporation; he is merely a shareholder. [Citations omitted.] Comparison with the compensation of executives of other companies can be helpful if—but it is a big if—the comparison takes into account the details of the compensation package of each of the compared executives, and not just the bottom-line salary. This qualification will turn out to be critical in this case.

Having explained the context of this case, the Circuit Court next explained why the Tax Court’s analysis was wrong, especially its comparison of John Menard’s salary to the salaries earned by the Home Depot and Lowe’s CEOs in that year. The appellate court first rejected the notion that the taxpayer’s $17 million bonus, which was equal to 5% of the company’s net income before taxes, was more likely to be a dividend than salary because it was paid at year’s end; was approved by a board that the CEO controlled without outside directors; must be returned if the IRS should disallow the company’s tax deduction as salary; and exceeded the salaries earned by the CEOs of publicly-traded competitors (Home Depot and Lowe’s). The appellate court noted that the managers of privately-held companies often face greater risk than public companies, warranting greater reward for success:

Of particular importance to this case is the amount of risk in the compensation structure. Risk in corporate compensation is significant in two respects. First, most people are risk averse, and the scholarly literature on corporate compensation suggests that risk aversion is actually an obstacle to efficient corporate management because managers tend to be more risk averse than shareholders. Shareholders can diversify the risk of a particular company by owning a diversified portfolio, but a manager tends to have most of his financial, reputational, and “specific human” capital tied up in his job. [Citations omitted.] So the riskier the compensation structure, other things being equal, the higher the executive’s salary must be to compensate him for bearing the additional risk.

That is not a critical consideration in this case because, as we said, management and ownership in Menards are not divorced. But a second significance of risk in a compensation structure is fully applicable to this case. A risky compensation structure implies that the executive’s salary is likely to vary substantially from year to year—high when the company has a good year, low when it has a bad one. Mr. Menard’s average annual income may thus have been considerably less than $20 million—a possibility the Tax Court ignored. Had the corporation lost money in 1998, Menard’s total compensation would have been only $157,500—less than the salary of a federal judge—even if the loss had not been his fault. The 5 percent bonus plan was in effect for a quarter of a century before the IRS pounced; was it just waiting for Menard to have such a great year that the IRS would
have a great-looking case?

The appellate court also noted that the Tax Court had not considered the total compensation packages of the CEOs from the public companies, such as equity compensation, severance packages, retirement plans, and perks. The appellate court noted that the CEO of Home Depot, whose salary was used as a benchmark, actually earned $124 million over six years, and a $210 million severance package when he was forced out. The Court of Appeals also noted that the Tax Court had not considered the salaries of other senior managers, both of Menards and of the benchmark public companies, which may have indicated that this CEO was more productive and delegated less than average. The Court observed that John Menard worked 14 to 16 hours per day, six to seven days per week.

The Seventh Circuit adopted a skeptical, even sarcastic, tone toward the Tax Court’s remark that the owner of a business has no need for incentive compensation because ownership is incentive enough. The Court of Appeals held that owners should not be treated differently from other managers.

Having concluded that John Menard’s $20 million salary was not excessive, the Court of Appeals reversed.

Gallows humor is intended to comfort us in troubling times, I suppose. An article in the New York Times offered a new definition of “goodwill” appropriate to the ongoing economic recession. In “Losses in Goodwill Values Dog Bank Deals,” the NYT defined goodwill as “the amount they overpaid for a business compared with the sum of its parts.”

Goodwill appears on the balance sheet of a business when it purchases other businesses. In that context, goodwill is equal to the price paid for the acquisition target in excess of its book value. Every good joke contains a kernel of truth.

BVWire recently published a follow-up to its teleconference, Valuing Dental Practices, by raising a question about business valuation using the excess earnings method (also known as Treasury Method).

Where do you get your cap rates under an excess earnings method? It’s a question that came up at the recent BVR teleconference, Valuing Dental Practices, featuring BV experts James Andersen, Ron Seigneur, and Stephen Persichetti, a practicing dentist and professor of dental practice management. In answer to the query, one panelist explained, “When you’re using excess earnings, it’s appraiser’s judgment. I’ve seen reports that use Ibbotson or D&P. But your cap rate has to be larger, and sometimes significantly higher, as much as 40% and 60%.”

The BVWire™put the question to Seigneur, who cautioned, “There is no holy grail for developing the capitalization rate under the excess earnings method.” That said, he offered the following insights as a “reality check” for BV experts:

When breaking the economic returns of an enterprise out between the returns on tangible assets and the returns on the intangible assets, it is commonly accepted theory that the returns on the tangible asset base is less risky, and therefore, require a lower economic return to justify the risks associated with the tangible assets. On the other hand, the rates of return required for each class of assets (be they tangible, like cash, inventory, fixed assets, etc., or intangible, such as the reputation of the business, the customer base, etc.) must collectively reconcile to the overall economic return (e.g. capitalization rate) on the overall, all in, benefit stream of the entity.

For example:

If the enterprise is assumed to justify a 30% overall capitalization rate, the returns on the various categories of tangible assets will likely each be below this 30% combined return. The returns required to capture the risks of the various intangibles will likely each be above 30%, with the overall weighted or blended rates tying back to the 30% overall risk adjusted rate associated with the entity take as a whole.

I’m not sure I know the answer to this one, so I’m throwing it out there for comments.