When divorcing spouses own a private business interest, it complicates the settlement process. The value of a business isn’t necessarily as straightforward as the values of other marital assets. And it’s often impractical to sell the business and split the proceeds, because there may be other owners who aren’t interested in selling and it takes time to sell a business.

Plus, the business’s value might be partially excluded from the marital estate, depending on state law, legal precedent and prenuptial agreements between the spouses. Fortunately, a business valuation professional can help you sort through the issues.

Tangible vs. intangible value

The value of a business can be broken down into two pieces. First up are tangible (or hard) assets, which include such items as cash, receivables and equipment. Most of these items are recorded on a company’s balance sheet. The difference between the combined market values of tangible assets and liabilities (such as payables and bank debt) is called net tangible value.

The second component is intangible value. Most intangible assets aren’t reported on the balance sheet because they’re generated internally. Moreover, any book values of intangible assets that are reported on the balance sheet are typically from a former purchase. Sometimes estimates used to allocate the purchase price to intangibles vary from the assets’ current fair market values, especially if the purchase occurred many years ago.

In general, intangible value equals the difference between the business’s fair market value and its net tangible value. It’s important to allocate value to identifiable intangible assets, such as patents, customer lists, brands, leases and proprietary software. What’s leftover is called “goodwill.”

Treatment of goodwill

How goodwill is handled in a divorce depends on case facts, state law and relevant legal precedent. Some judges may look to other jurisdictions for guidance. State laws and legal precedent vary, but courts generally have three choices when divvying up goodwill:

1. Exclude all goodwill from the marital estate. Here, the expert separates the value of goodwill from the rest of the business’s value and excludes all goodwill from the marital estate. 
2. Include all business value in the marital estate. The business valuation expert makes no distinction between tangible and intangible assets or between personal (or professional) and enterprise (or business) goodwill. 
3. Differentiate between enterprise and personal goodwill. Personal goodwill is specifically excluded from the marital estate, but enterprise goodwill is included.

Although goodwill is generally associated with professional practices, some states have ruled that other types of businesses — including retailers, manufacturers and construction contractors — also may possess goodwill.

2 types of goodwill

In more than half the states, goodwill is broken into enterprise and personal goodwill. The former is linked to the business itself. Companies with established brand names, accessible locations and an assembled workforce likely possess enterprise goodwill.

Conversely, personal goodwill is inextricably linked to the business owner and can’t easily be transferred to a buyer. Personal goodwill is a function of an owner’s reputation, skills and personal efforts.

The logic behind excluding personal goodwill from the marital estate is that it represents a spouse’s future earnings capacity. Some courts have determined that it’s unfair to credit a spouse who’s not active in the business for a company’s personal goodwill and also award maintenance payments based on the former spouse’s future earnings.

In conclusion

To reach an equitable settlement in a divorce that involves a closely held business, both spouses must have a clear understanding of the relevant legal precedent and the theory underlying goodwill allocations.

(This is Blog Post #1173)