Financially Complex and High Asset Divorce in California Requires Specific Expertise
Compared to their middle-class counterparts, high asset couples often face an additional set of issues when getting a divorce. To be sure, if the only assets are a multi-million dollar account at JP Morgan, a mansion, and two luxury cars, the divorce – while high asset – is certainly not financially complex. However, most couples going through high asset divorce in California have a more complex financial profile that requires legal and financial expertise to both identify and value.
For instance, the husband might own an interest in a closely held business that he also manages. The wife might be a doctor or lawyer in private practice and, therefore, have an asset courts refer to as “professional goodwill.” Or perhaps the husband is a highly compensated executive officer who receives compensation in the form of a complex stock plan or other deferred compensation.
Addressing the complicated and sometimes convoluted issues in a complex high asset divorce requires a mastery of the law in order to properly identify a client’s interest in these potentially opaque assets. It requires knowledge of the financial principles used to value these assets in order to ensure a client pursues fair value in the divorce. It also requires litigation experience in order to orchestrate and execute on a plan that secures for the client the best possible outcome. And finally, a financially complex and/or high asset divorce requires a team of superior lawyers and support staff with decades of experience successfully serving this segment of the divorcing population. In Los Angeles, California, S.L. Pitts is the family law firm of choice for high asset and financially complex divorces.
Complex High Asset Divorce: Closely Held Business Interests
In complex high asset divorces, one or both of the parties frequently has an interest in a small or closely held business. These businesses are commonly structured as LLCs or, especially if they are older businesses, as S-Corps. The first layer of complexity when dealing with closely held business interests is to accurately identify the relevant assets. This can be easier said than done.
For instance, a closely held business might be funded by a shareholder note. While this note would be a liability to the business, it would be an asset to the shareholder/owner. And if that owner were getting a divorce, then that shareholder/owner note would need to be listed as an asset to be potentially divided with their spouse.
Or suppose the couple owns an apartment building. Often, litigants will simply value the apartment building itself. Invariably, however, the apartment building is held in an LLC, and commercial real estate LLCs almost always contain other assets and liabilities. Sometimes, even experienced attorneys fail to have the LLC holding company property valued. When that happens, real assets and/or liabilities – such as operating accounts, non-operating LLC assets, intercompany loans, or interest rate swap agreements on promissory notes – often fail to be identified. And if an asset isn’t even identified, then it doesn’t get equitably divided.
Determining the Value of the Assets During California Divorce
Once an asset has been properly identified, the next challenge is to determine its value. Valuing 100 shares of Ford is pretty straightforward – you simply look up the current share price and multiply by 100. But valuing a 75% interest in a closely held company is not so simple. In order to value a closely held business, you must hire a financial expert – a professional who has experience valuing this type of business. The valuation expert will analyze the company using three valuation methods: income approach; asset approach; sales approach. The majority of valuations ultimately end up relying on the income approach.
The theory of value behind the income approach is that a business is only worth money today because it will generate recurring cash flow for its owner in the future. The artistry of the valuation expert lies in converting this promise/hope of future cash flow into a present-day dollar amount. At the risk of oversimplifying a bit, this is usually accomplished by taking the tax adjusted, normalized income of the business (meaning the average projected net income) and dividing it by a capitalization rate (a number expressed as a percentage meant to reflect the various risks associated with the business). While capitalization rates can and do vary, the majority of them fall between 17% and 23% for small businesses.
So, for instance, if the parties owned a small business that generated passive, reliable, net income of $700,000 (after taxes) each year, then we could divide $700,000 by 0.17 and 0.23 to come up with a probable range for the value of the business. Doing so would produce a valuation range of between $3 and $4.1 million.
Please note that the above example is for illustrative purposes only and is not meant to inspire you to do this on your own. So don’t just get a bottle of wine and attempt to do this math with your spouse on the back of a napkin in an effort to save the cost of hiring a valuation expert. Not only will you still end up having to hire the valuation expert, but you will also have squandered a perfectly innocent bottle of wine.
Financially Complex & High Asset Divorce: Professional Practices and Goodwill
Highly compensated professionals in Los Angeles are often unpleasantly surprised to find that their professional practice – if they have an ownership interest in it and are not simply W-2 employees – includes an asset called “professional goodwill” to be valued in their divorce. Professional goodwill is limited to licensed professionals such as physicians, lawyers, accountants, or any other service-based professional who is licensed and regulated by the state or a recognized professional association.
In order to value an individual’s professional goodwill, you must hire a valuation expert – again, one with experience valuing professional goodwill for this type of practice. The expert will typically capitalize the tax-adjusted, normalized earnings in excess of the professional’s replacement compensation in order to arrive at a value of the professional’s goodwill. In plain terms, that means the expert will start with what the professional can be expected to actually earn each year going forward. The expert will then consult a very large and expensive book and look up the average salary for similar professionals. They will then subtract this average salary from the professional’s actual projected annual income. The professional’s remaining income is the “excess earnings” that is then capitalized. In this case, “capitalized” usually means to multiply by a number roughly between 4.3 and 5.5 (cap rate of 18% to 23% for those interested).
The idea behind this method is to try and isolate the income the professional makes solely on account of their good reputation in the community. Hence the determination of the “excess income” over and above what a similarly skilled professional would make. The law sees this “excess income” or reputation as an asset that can and should be valued as property in a complex high asset divorce.
For example, if an attorney who is a partner in their firm is getting a divorce, we would start the valuation of their professional goodwill by determining their expected after-tax income on an annual basis; in this example, let’s assume it’s $200,000. Next, we look up what an attorney in their city, with their experience, and in their practice area would likely earn; let’s say the average net salary for a similar attorney is $175,000 per year. The excess earnings in this example equals $25,000. If we multiply the excess earnings by 4.3 and 5.5, we’ll arrive at an approximate valuation range for this fictional attorney; in our example, that range is roughly $107,000 to $138,000.
Again, this example is purely for illustrative purposes. Do not – we repeat, do not – try to do this on your own in an effort to avoid hiring a financial expert.
Complex High Asset Divorce: Highly Compensated Employees and Professionals
Senior executives and other highly compensated employees often get paid in extremely complicated ways these days. The last 40 years has seen a steady evolution from the deferred compensation plans of the post-war period to include stock options, stock grants, restricted stock grants, restricted stock units, stock appreciation rights, stock warrants, employee stock purchase plans, phantom stock, “top hat” deferred compensation plans, and so on. The language of executive compensation has become as colorful as it is complicated.
These compensation plans are often unvested, unfunded, and/or illiquid, meaning that they only become valuable at a certain future event (i.e., if the employee stays at the company for a certain number of years or if there is a key event at the company). Valuing these assets can be difficult or even impossible.
For instance, a managing director at a venture capital firm may well have some direct carry in a fund. The fund’s assets typically would consist of multiple, closely held companies all in the early stages of development – many of which could have little or even no revenue. To make matters even more confusing, the fund’s interest in its start-ups could be held through a combination of outright stock as well as another security, such as a sizeable stock warrant (the right to demand that the company issue new shares to the warrant holder). Add to that the almost certain probability of future fundraising rounds that will necessarily dilute existing shareholders. Good luck valuing that managing director’s interest in the fund.
Or take the example of an executive at a medical device company who receives relatively straightforward restricted stock grants and/or incentive stock options. But the company is private and the executive knows full well that the company will never go public. In fact, as the executive knows, the company will instead be acquired by another company once it reaches its development goal, probably sometime in the next three to five years. How does all of this affect the value of the executive’s restricted stock in the present company? And how is this value fairly divided in a divorce?
Simply dividing the interest usually ensures that the parties going through high asset divorce in California will share equally in the future uncertainty of these assets. However, if the parties have different appetites for risk, then this may not be appropriate. Similarly, if the executive has undue control over the timing and nature of the liquidity event, then it may not be wise to leave the divorcing parties tethered by an in-kind division.
The Lawyer’s Role in Complex High Asset Divorce
If you have worked hard to build a company or practice – or if you have supported your spouse in doing so – then you have a lot more at risk than most divorcing people. Those experiencing high asset divorce in California need a lawyer with extensive experience handling these types of cases for many reasons – but the main ones are to reduce their risk and to ensure that the division of property is fair.
The role of the lawyer in a financially complex, high asset divorce is to identify the assets, present options for how to divide them, make the client aware of the risks that each option poses, and coordinate with other investment professionals to ensure the client makes an informed decision regarding which option to pursue. The seasoned Los Angeles family law attorneys at S.L. Pitts have been providing this type of exceptional service to clients across a broad array of industries for decades. If your divorce involves financially complex assets or income structures, contact us to schedule an appointment with one of our family lawyers today. You can also contact us to deal with other complex Los Angeles family law matters, including child custody, property division, spousal support, and more.