Valuation experts are frequently asked to determine the fair market value of business interests as of various dates in order to determine if any appreciation in value occurred during the marriage from either the date of marriage, gift or inheritance. Additionally, we may be asked to render our opinion as to the active or passive nature of such appreciation as well as the reasonableness of owner’s compensation paid.

Valuations typically consider the impact of a key employee, depth of management, reasonableness of owner compensation and a variety of other issues. A frequently raised question is whether or not the marital estate fairly received the benefit of a spouse’s efforts.

The trier of fact must determine if the appreciation of an interest in a closely-held business is either active (due to the efforts of the spouse) or passive (the efforts of others and/or market factors). The Herron (Herron v. Herron 2004 - Ohio - 5765) case in Allen County (Case No. CA2004-0023) presents an interesting result addressing this issue.

Other conclusions reached in this matter are the consideration of buy-sell agreements, how these were treated and the differing concepts of value by the Trial Court.

A review of the Herron case is as follows:

Facts:

1. Plaintiff – Wife – Appellant

Defendant – Husband – Appellee

2. Robinson Fin Machines, Inc. (Robinson Fin) was solely owned by Wife’s mother, who, on June 16, 1995, began gifting an equal number of shares to her daughter (wife) and her two brothers as part of her estate plan.

3. Mother and her three children each worked at Robinson Fin in the following capacities:

· Mother – President

· Wife – Vice President of Administration

· Brother – Vice President of Engineering and Manufacturing

· Brother – Vice President of Sales and Marketing

4. Wife and her two brothers each owned 217 shares out of the 1,000 total outstanding shares.

5. The stockholders entered into a buy-sell agreement at book value on June 16, 1995. The Trial Court found that a hypothetical buyer would consider the terms of the buy-sell agreement and thus valued Robinson Fin at book value rather than fair market value. In fact, all valuation experts opined that book value and fair market value were different concepts.

6. In order to determine the appreciation in value, the Trial Court compared the value as of the date of gift (fair market value pursuant to IRS regulations) to the book value.

7. Testimony at trial indicated that mother served as the figure head of the Company and primarily dealt with community relations. Wife was responsible for human resources and administration. Brothers were in charge of engineering, manufacturing, new product development, sales and marketing.

8. Prior to Wife’s employment, such duties were shared by her brothers, who, upon her hiring, focused on their respective positions.

9. Robinson Fin experienced tremendous growth during the marriage. The complexity of Wife’s job also increased as the size of the Company grew.

10. Trial Court did not attribute all of the growth to Wife and found that the four executives were part of a team effort, each contributing to the success of the Company.

11. Trial Court found that Wife contributed to the overall growth of Robinson Fin during the marriage and thus 25% of the appreciation in value was found to be marital property. 75% was deemed passive appreciation.

12. Wife and brothers formed an investment holding company (Haushalter Group) to provide funds to be available in the event of a product liability suit and to maintain their lifestyle.

13. Haushalter Group invested in loans, stocks and mutual funds which decreased in value.

14. Contributions to Haushalter were made equally by Wife and her brothers during the marriage from Robinson Fin bonuses and the marital nature of contributions during the marriage was not disputed.

15. The operating agreement provided that a withdrawing member would receive the Liquid Asset Value that would be converted to cash. In essence, this is a prorata value of the underlying investments at market value.

16. The Trial Court concluded that, regardless of the nature of the underlying investments, the brothers would insure that Wife received the entire amount of her initial investment, not the Liquid Asset Value, relying on the goodwill of her brothers.

17. Trial Court also found that post-separation contributions to Haushalter Group resulted from bonuses earned during the marriage and were deemed marital property.

Appellant’s (Wife’s) Arguments

1. Appreciation in Robinson Fin’s value should not be a marital asset.

2. Increase in Robinson Fin’s value was due solely to market conditions and the efforts of her brothers.

3. Increase in value should thus have been deemed passive.

4. Haushalter’s operating agreement calls for the Liquid Asset Value to be paid a departing member not the original investment. Thus, the value of Haushalter was artificially inflated by relying upon the goodwill of the brothers to repay the original investment and ignored the market value of assets held.

Appellee’s (Husband’s) Arguments

1. Wife’s mother was not responsible for the increase in Robinson Fin’s value, as she did not contribute as much as her daughter and sons. Thus 33 1/3% of the appreciation should have been deemed a marital asset.

2. Wife’s interest in Robinson Fin should have been valued at fair market value not book value.

3. Wife’s bonus was earned by her efforts expended during the marriage but paid after separation. Therefore, such post-separation contribution to the Haushalter Group should be deemed a marital asset.

Court of Appeals Conclusion

1. Wife was one of four key executives managing Robinson Fin and, thus, she contributed to its increase in value. The Trial Court’s decision was upheld that 25% of the appreciation in value was properly deemed a marital asset.

2. Trial Court was correct in determining Wife’s post-separation contribution to Haushalter was marital property, as such bonuses were earned during the marriage.

3. The valuation of Robinson Fin and Haushalter were based upon competent and credible evidence and, thus, upheld.

Analysis From a Valuer’s Prospective

The appreciation in value of many businesses is frequently not the result of one individual’s efforts, but of several, functioning as a management team. When management contributes to the appreciation in value, especially if members of the management team are also owners of the business, not an uncommon event, it may be difficult to ascribe the growth and/or appreciation in value solely to the efforts of one select individual. Rather, it is typically the collective effort of all members, working in unison, each concentrating on their respective duties and responsibilities. Thus, it appears that the determination by the court in this particular matter followed this logic.

However, in computing the marital appreciation, the Trial Court compared the gift tax value (fair market value per IRS regulations) to book value. All experts testifying in this case admitted that book value and fair market value are different concepts. Thus, an apples-to-oranges valuation comparison was utilized in arriving at the conclusion.

Pratt’s “Valuing A Business” Fourth Edition (page 308) states that “Under any standard of value, the true economic value of a business enterprise equals book value only by coincidence.” He further states that the term “book value” is merely accounting jargon. Tax courts have consistently disregarded buy-sell agreements in family businesses that do not reflect economic reality and may contain provisions that serve alternative motives. Marketability discounts certainly take into consideration not only liquidity but many other factors such as restrictive stock and buy-sell agreements.

The employment of the buy-sell provisions and the valuation methodology appears contradictory. The court upheld the Agreement utilizing book value in Robinson Fin but disregarded the Liquid Cash Value language in Haushalter and relied upon the goodwill of the brothers to restore Wife’s voluntary investments. Why wouldn’t the same logic employed for Haushalter apply to Robinson Fin whereby the brothers’ goodwill would pay a departing family member their fair value?

Wife’s investment in Haushalter was voluntary. The nature of Haushalter’s underlying assets (marketable securities) is no different than personal investments in similar securities, which would have been valued at fair market value. Why the goodwill of the brothers would have resulted in them buying marketable securities above fair market value seems illogical since securities would need to be liquidated in the open market to redeem a departing partner. Thus, the remaining partners would incur all of the historical investment risk and transaction losses.

Regardless of the valuation results, the recognition by the Trial Court that not all the appreciation in value may be considered a marital asset is worthy of note, as this is a common occurrence in businesses where there are multiple owners. Naturally, every case is fact specific.

Robert G. Turner, Jr. is the Managing Principal of the Business Valuation and Litigation Department for Moore Stephens Apple. He has performed valuations in a number of industries for estate, gift tax, mergers and acquisitions, domestic relations and litigation support services and has served as a court-appointed expert, Special Master and Receiver. Numerous State, Civil, Probate and Domestic Relations Courts, as well as Federal Courts, have qualified Bob as a valuation and economic damages expert. He is a Certified Public Accountant (CPA), licensed to practice in Ohio and South Carolina, a Certified Valuation Analyst (CVA) and is Accredited in Business Valuations (ABV).

Questions regarding this article or other valuation issues can be addressed to Robert G. Turner, Jr., CPA/ABV, CVA or other members of the Valuation/Litigation Services team at Moore Stephens Apple at (440) 460-1980.

Moore Stephens Apple is a customer-focused, regional business advisory firm of certified public accountants and industry experts serving privately owned businesses in Northeast Ohio. MSA blends accounting services with human resource consulting, business valuation and litigation services, information technology consulting and employee benefit planning. Based in Akron, Ohio, the firm also has offices in Westlake and Mayfield Village, Ohio. For more information, visit www.msapple.com.

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