In divorce cases, where one or both spouses own a business, the value of the business for equitable distribution purposes is often one of the more difficult issues to resolve in the case. When these issues arise, the Court may appoint an expert. the parties can agree on a joint expert, or each party may retainer their own expert to value the business. While there are many objective parts of a business valuation report, reasonable (a/k/a replacement) compensation is subjective. Why is it important? Because the higher the reasonable compensation, the lower the value of the business and vice versa. As such, when there are partisan experts, it is not unusual for these subjective factors to favor the party that the expert is working for.
For divorce purposes,as well as many other situations where businesses are valued, they are valued based in whole or part on their income. Reasonable compensation is a consideration in two valuation methods often seen in divorce cases – the excess earnings method and the capitalization of earnings method. These methods involve examining earnings available to a potential hypothetical buyer after he or she receives a "reasonably compensation" for running the business. Earnings available, beyond
"reasonable compensation" are a large factor in valuation. The higher this figure is, the more the business may be worth. In the excess earnings method, the difference between actual compensation and reasonable compensation is capitalized and for all intents are purposes represents the "intangible asset" known as good will of the business.
Some factors to determine reasonable compensation are as follows:
1. Employee’s role/job description in the company
2. Industry in which the business operates
3. Location of the business
4. Company character and condition
5. External compensation comparison
6. Company compensation program
7. Qualifications necessary to perform the services of the specific job
Depending on the industry, there are numerous publications and databases that the experts use to determine reasonable compensation.
Sometimes, reasonable compensation can be manipulated to get a desired result. In one case I had, the husband was the sole partner of a law firm that had a few associates. While the firm was extremely profitable for its size, much of the profits were based upon leveraging associates, as the owner’s actual billable hours were pretty small compared to the "average" lawyer. Because there was no office manager, his expert used reasonable compensation for a lawyer (without adjusting for the fact that this lawyer billed less hours than the peer group that he was being compared to) plus reasonable compensation for an office manager. The net result of this was substantially lowering the value of his practice. After a trial, the judge did not buy this and accepted the valuation of our experts who were much more conservative.
In another matter, the opposing expert used a similar figure that our expert used. However, though he used a five year model, he kept the compensation fixed for each of the 5 years, which is not only unrealistic, it is contrary to economic reality. As such, it skewed his value in favor of his client’s position.
It is important to understand the concept of reasonable compensation, question the experts about their assumptions and data sources used, to make sure that the "reasonable compensation" used in your valuation is really reasonable.
Eric Solotoff is the editor of the New Jersey Family Legal Blog and the Co-Chair of the Family Law Practice Group of Fox Rothschild LLP. Certified by the Supreme Court of New Jersey as a Matrimonial Lawyer and a Fellow of the American Academy of Matrimonial Attorneys, Eric practices in Fox Rothschild’s Roseland, New Jersey office though he practices throughout New Jersey. You can reach Eric at (973)994-7501, or email@example.com.