Is a market valuation ‘fair’?

As we come to the 5-year anniversary of FRB v DCA (No. 2) [2020], the question of how we value a business on divorce lingers on. And its impact can be dramatic.

This is not a question of methodology – we would all love to be able to conduct income-based valuations (using performance projections to value the business on a discounted cash flow basis), but there are just too many hurdles in matrimonial cases for this to be feasible very often. From the lack of preparation of forecasts, to the unreliability of those prepared as a result of the ‘divorce blues’, we just don’t see many of them prepared.

The core issue here is the basis of value. As a concept, this is so important to accountants when they approach a valuation exercise, as it can make a significant difference to the outcome.

The standard basis of valuation is called ‘market value’, defined by the IVSC as “The estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion.”

On the face of it, this all looks straightforward. However, compare it to the definition for ‘fair value’ (now called ‘equitable value’): “Equitable value is the estimated price for the transfer of an asset or liability between identified knowledgeable and willing parties that reflects the respective interests of those parties.”

Many people, especially lawyers, assume they are getting a fair value under a market value definition, but they are very different animals. The key differentiator here is the identification of the parties. In a market value, the parties are hypothetical, whereas under a fair/equitable value, the parties are identified.

Why does this matter? Well, if Google were for sale, it would be worth a lot more to Meta than it would to Joe Bloggs on the street because Meta could leverage Google’s platform to support their existing offerings, use economies of scale to lower their costs, share customers without the need for increased marketing, eliminate workforce overlaps to save costs, and the list goes on. Thus, Meta may pay more upfront for Google, anticipating future savings or increased revenue as a combined force.

This principle applies similarly in divorce cases.

For several of the businesses in FRB v DCA, the Husband, represented by Vardags, owned only a small legal share of them, with his family owning the remainder. The businesses were valued on a ‘market value’ basis as is standard and therefore, minority discounts (a discount to value applied because an owner does not have control over that business) were applied. However, Justice Cohen held that the family operated ‘as one unit’ and so the likely outcome would be that, were the Husband to sell, it would be his family that would buy him out. Therefore, he found no need to apply a minority discount.

This is a sort of quasi-partnership argument: the family (or business owners) would act as one unit, either buying from one another or selling the business as a whole. And the court in G v G [2002] explicitly held the view that no minority discount would apply if the business was found to operate as a quasi-partnership. This treatment of quasi-partnership has held true in RM v TM [2020] where the court again refused to apply a minority discount to a family-owned business. This approach has also been approved by the Court of Appeal in Clarke v Clarke [2020] where, on appeal, Lord Justice Mostyn found that the previous Judge should not have settled on a midway point for value between the discounted and undiscounted position as set out by the accountant, since it is binary whether it is a quasi-partnership or not. Mostyn opined that it was ‘more likely than not’ that the future of the business in that case would be for the whole company to sell as one, then no discount should apply to any one shareholding.

Now, it understandable that there’s some debate about whether courts should be opining on what the future of a business is, particularly in cases such as Clarke v Clarke, where the shareholders were 11 years apart in age, and may well have different future working trajectories. But setting that aside, what does this mean for basis of value?

When instructing a Single Joint Expert (SJE) to value a business, it is critical to specify to the valuer what basis of value you want them to use and what assumptions they should make. For instance, if a business is 50% owned by each spouse, to quote Mostyn ‘it is more likely than not’ that one spouse would sell to the other, so we need an equitable basis of value.

If we want judges to be making decisions on what outcome they think is most realistic (as they seem to be doing), then we need to provide them with the right data on which to make those decisions.