Divorcing the self-employed spouse: Getting what you are entitled to

Determining how much the damages are in cases involving self employed professionals is difficult. In a lot of situations, the difficulty arises because the self employed individual's actual tax reported income does not reflect how much he or she is bringing into the household. In divorce cases the problem can be amplified because the analyst is not only trying to figure out how much the individual makes or could make, but the value of a income stream into the (post-divorce) future.

Below is an example of the problem and a number of suggested solutions. The problem is based on posting to a popular forensic economics bulletin board.

The setting
Beavis Matfry (age 50) owns a highly successful local chain of hair salons, Beavis Matfry Styles. He has won national and international styling awards, has his own line of hair care products, and his is THE salon in town for anybody important. He still cuts hair personally, and his operators are trained by him and sign non-compete contracts.

Now comes the divorce and the non-working spouse wants half the business.

The Problem
A "standard" business valuation, that uses generally accepted valuation methods such as the Discounted Cash Flow Method, places the value of his business at $1.2 - $1.5 million. However, his personal tax returns show that his personal income from the salons is about $600,000 per year.

In the real world, it is hard for anyone to believe that anyone would give up $600,000 a year for a one-time upfront payment of $1.2 - $1.5 million.

The solutions

1. The analyst may want to value the service business as the capitalized value of the stream of income above that portion that is compensation to the owner/manager in his role as manager. To do this you may want to use a methodology based such as "Sellers Discretionary Earnings" methodology instead of approaches such as the 'Excess Earning method' that in part value on parts of a company that are not really applicable to a service business.

The SDE method incorporates personal earnings and adds back the non-cash stuff like deprecation and interest expense. The Business Reference Guide -2004 edition by Tom West does a good job of explaining this method and also states that it is becoming the most popular method for business valuation (page 294).

2. It may be ok to use the standard approaches such as the 'Excess Earnings' approach but the analyst may need to 'add back' certain expenses to get a more accurate picture of the company's worth. For example, adding back all non operating expenses (cell phone, personal vehicle, professional fees not specific to the business, non working relatives on payroll, etc.), as well as any other expenses an arm's length buyer would not expect to incur as a normal operating expense may produce a more realistic assessment.