Minority Discount in a Business Valuation in an Arizona Divorce
The Arizona Court of Appeals delivered an opinion on the subject of valuing business interests and how they should be dispersed between the parties in a dissolution of marriage.
The parties married in 1998. During their marriage, they acquired a 50% community interest in two businesses, where Husband operated his professional practice.
At trial, the primary contested issues were the calculations surrounding the two businesses to determine the amounts Husband owed to Wife for acquiring her community property interest in the two companies. Through Husband’s experts, John Pinto and Stephen Koons, Husband presented several valuations for the parties’ business interests.
For their interest in one company, he presented: $475,000 (Pinto – applying minority share and marketability discounts), $620,000 (Koons – applying minority share and marketability discounts), and $830,000 (Koons – not using minority share and marketability discounts).
Husband’s experts also presented valuations for the parties interests in the second business: $580,000 (Pinto – applying minority share and marketability discounts), $490,000 (Koons – using minority share and marketability discounts), and $540,000 (Koons – not applying minority share and marketability discounts).
Through Wife’s expert, Calvin Swartley, she presented a valuation of $1,617,000 for the first business and a valuation of $1,052,000 for the second business. Each of the experts prepared written reports and testified to the complexity of the valuations. They explained that factors such as assets, liabilities, taxes, liquidity, depreciation, interest expenses, revenue, cash flow, rents, goodwill, operating expenses, management agreements, operating agreements, market size and share, capitalization rates, marketability, and control were considered in reaching their final calculations.
Husband disputed Swartley’s valuation, arguing, among other things, that Swartley applied a capitalization rate that was too high and didn’t include a discount for lack of marketability and lack of control for both businesses.
Wife countered that Husband’s experts incorrectly assessed the marketable value of his interests by evaluating them as if he were being sold to a third party. She asserted that discounts for lack of marketability and lack of control were only considerations if an outside buyer is buying into a practice, and irrelevant when calculating the value of a present owner “buying out” the interest of another current owner.
The court found Pinto’s business valuation approach in the divorce case disconcerting but noted his credibility was bolstered because he and Koons reached similar calculations. The court disagreed with certain foundations underlying Swartley’s analysis; specifically that he used an 11% capitalization rate which is usually attributable to a large publicly traded company. This rate resulted in a greater fair market value, and the court found it would be improper to use that rate.
The second concern was that Swartley didn’t evaluate the particular community interest of both businesses. Instead, he determined the value of the second business then divided that amount by five and the first business in half to ascertain the community property interest, which allegedly led to an inflated value. The trial court also noted that a minority interest has less value than the total interest of a company on a per-share basis, finding this distinction relevant because the parties didn’t own a controlling interest in either business.
The trial court ruled that the fair market value of the community’s interest in second business was $536,000 and their interest in the first company was $602,000, ordering Husband to pay Wife $569,000 for her half of the community interest in the two businesses.
Minority Discount in Business Valuation in a Divorce | The Ruling
Wife appealed the decision to the Arizona Court of Appeals, contending the trial court undervalued the community’s interest in the two businesses; specifically asserting the trial court applied a minority share discount in contravention of Arizona law.
The appellate court stated, according to state statute, the trial court must divide community property equitably, though not necessarily in kind, and as a general principle, all joint marital property should be divided substantially equally unless a sound reason exists to divide the property otherwise.
The justices also declared that no Arizona case bars a court from applying a minority share discount when valuing minority interests in a domestic relations case. The judges continued by asserting a trial court has discretion to consider whether a minority discount is appropriate, on a case by case basis, considering factors such as the minority shareholder’s degree of control, lack of marketability, and the likelihood of a sale of the minority interest in the foreseeable future.
Because a minority share discount is an attempt to take into account the difficulty of actually turning an asset into money, the appellate court believed its application may be inappropriate when the evidence doesn’t support underlying assumptions regarding lack of control and lack of marketability.
When the appeals court applied these principles to the first business, the trial court’s valuation was not supported by the evidence. Husband owned a 50% membership interest in the first business, equal to that of the only other member of the limited liability company. The record reflected that Husband held significant power regarding financial decisions, as evidenced by his decision to convert half of his salary to distributions as a tax saving strategy.
Although Husband testified he was not able to modify the terms of the first businesses’ rent, which were fixed by contract, the record does not otherwise reflect any substantial limitations on his joint control of that company as a 50% member.
Further, Husband presented no evidence he had any plans to sell his interest in the business. Thus, for the first business, the appellate court ruled that the record did not support the underlying assumptions justifying the application of a minority share discount and the trial court abused its discretion by valuing the first business at $602,000.00.
This figure was substantially below not only Schwartley’s valuation of $1,617,000.00, but also Koons’ $830,000.00 (not applying a minority share discount), and even below his $620,000.00 valuation which did apply the discount.
Accordingly, the appellate court vacated the ruling as to WME and remanded for a revaluation and equitable distribution of the community’s interest in the first business. In respect to the second business, Husband again did not testify regarding any intent to sell his interest in the business.
However, he only owned a 20% share in the second business and Wife had not cited, nor had the court’s review of the record revealed, any basis for concluding that Husband’s control over the second business was not substantially limited by the holder of the 80% interest. Therefore, because the record supports the trial court’s application of a minority share discount and corresponding valuation of the second at $536,000.00, the appellate court discerned no abuse of discretion.
Several important points of information can be concluded from these proceedings. Firstly, a trial court has the discretion to decide if a minority discount is appropriate on a case by case basis depending on the relevant factors. Also, when the court determines the value of a business asset, it must do so per the valuations given by experts in the case and other evidence provided.
Call our experienced Scottsdale and Phoenix Arizona divorce attorneys at Hildebrand Law, PC at (480)305-8300 if you have questions about business valuations and divorce in Arizona.