Business Valuations in Divorce – An Overview of the Rueschenberg Decision By Mark Hughes, CPA, ABV, CFF On May 13, 2008, the Court of Appeals of Arizona, Division 1 decided Rueschenberg v. Rueschenberg (1 CA-CV 07-0300). This decision has had a significant impact on the valuation of sole and separate business interests in Arizona marital dissolutions. Business valuators now perform “Rueschenberg Analyses” when ownership of a sole and separate business interest business is found to pre-date the marriage. The Rueschenberg Decision concluded the following with respect to apportioning the increase in value and/or profits from a separately held business. …it is not error to apportion both profits (net earnings) and increase in value (whether that is goodwill or a measurable increase in value of some other asset) if the community labor was responsible for a portion of both and if such an apportionment “will achieve substantial justice between the parties.” The Rueschenberg Decision states the following with respect to the methodology utilized to apportion the increase in value of Desert Mountain Medical (“DMM”). The special master's report used the capitalization of earnings method of valuation to find that DMM had a fair value of $163,166 at the commencement of the marriage. This value was based on the special master's finding that normalized earnings were $38,000 at the time the parties married, that the applicable capitalization rate was 25%, and that there was an additional $11,166 in a non-operating asset/shareholder loan which added to the value. Using the same method, it found that DMM was worth $1,440,000 (having normalized earnings of $360,000) on October 31, 2003. The report then awarded Husband a sole and separate property interest of $550,000. It arrived at this figure by giving what it considered to be a fair rate of return on the original investment of $163,166. The report then subtracted that $550,000 from the value at the dissolution of marriage, $1,440,000, and found that the community was responsible for two-thirds of the resulting increase (i.e. two-thirds of $890,000), which amounts to $593,333. It then awarded Wife half of this amount, or $296,667. The trial court incorporated the special master’s findings verbatim into its decree of dissolution. The Rueschenberg Decision affirmed the trial court’s ruling. While the Rueschenberg Decision helped to bring a standard framework to valuing sole and separate business interests, the methodology utilized with respect to the passive rate of return may result in outcomes which are inconsistent with achieving substantial justice between the parties in certain instances.

The Rueschenberg Decision references the Cockrill Decision (124 Ariz. at 53, 601 P.2d at 1337). Cockrill presents the following two relevant methods of apportioning increase in value and profits of a sole and separate business. 1. [Determine]The reasonable value of the community's services and allocate that amount to the community, and treat the balance as separate property attributable to the inherent nature of the separate estate. 2. The trial court may simply allocate to the separate property a reasonable rate of return on the original capital investment. Any increase above this amount is community property. The special master in Rueschenberg utilized the latter method, with an extra step apportioning one-third of the excess appreciation to non-community factors. The special master found that the community had received virtually 100% of the net distributable earnings of DMM, which were between $2,875,000 and $3,122,521. Assuming $3,000,000 of profit distributions, and an increase in value of approximately $1,277,000 the total return of DMM equated to $4,277,000, which equates to a total annual rate return of approximately 81.5% over a five and a half year period. Due to the fact that DMM was a larger medical device sales representative organization, and its high annual total return of 81.5%, the capitalization rate of 25% was a reasonable benchmark for the increase in value of DMM over a five and a half year period. As the Rueschenberg Decision indicates, the passive rate of return is case specific. For a small business, or over a longer timeframe, applying the capitalization rate may distort the result of the analysis. The 25% capitalization rate utilized to value DMM, and applied as a passive rate of return, is a total rate of return. This rate includes both dividends (yield) and capital appreciation (increase in value). In Rueschenberg, the $3,000,000 of profit distributions were treated as community since husband did not assert a separate interest in them at trial. Wife did not assert that the community had been undercompensated for its labor. Due to the fact that these issues were not raised at trial, it remains an open question whether profit distributions above market compensation received by the community are subject to an offset against the community interest in the increase in value. Passive Rate of Return It is important to understand that the capitalization rate utilized to value a business is dependent upon expectations of yield and capital appreciation that are specific to the industry and business being valued. To illustrate, a start-up tech company and a pizza parlor may both have a capitalization rate of 25%. The yield expectation for the tech company would be zero, with all of the 25% return being expected to come in the form of compound capital appreciation. Conversely, the pizza parlor would have a yield

expectation of 25% and a capital appreciation expectation of minimal growth. This difference in expected return is illustrated as follows.

As demonstrated in the following graph, dividend payout ratios (dividends / net income) of publicly traded companies vary widely by industry1.

1 http://www.stern.nyu.edu/~adamodar/pc/datasets/divfcfe.xls

As shown above, some industries pay out virtually all of their earnings in the form of dividends while others pay no dividends and reinvest all earnings. Owner-operator type businesses often have high dividend payout ratios due to limited growth opportunities and the need to provide income for the owners to live on. Utilizing the company’s capitalization rate for a growth-constrained small business assumes a dividend payout ratio of zero and also assumes that the reinvested funds will continue to compound at the capitalization rate over the period analyzed. The following table illustrates the capital appreciation growth of $200,000 at 25% per year compounded for 20 years.

As illustrated above, the law of compounding begins to significantly increase the value around year seven. Due to the five and a half year marriage duration in Rueschenberg, the effects of compounding were somewhat minimized. Rather, for owner-operator business, the expectation and practice is typically to distribute all of the available earnings each year. These distributed earnings do not compound at the company’s capitalization rate and do not drive the dramatic compounded value increase illustrated above. Buyers do not purchase a $200,000 single-location pizza parlor with the expectation to sell it for $17,000,000. Therefore, it is illogical to apply the capitalization

rate as a passive rate of return for growth-constrained small businesses since it ignores the effects of the dividend payout. A case can also be made that the capitalization rate for an owner-operator business is not, by its very nature, a passive rate of return. Unlike larger companies that trade on multiples of EBITDA and cash flow, owner-operator businesses typically trade on multiples of seller’s discretionary earnings (“SDE”), which is EBITDA plus one owner’s salary. The reason that owner-operator businesses transact based upon SDE multiples rests in the fact that the buyer is primarily concerned with the total cash flows that will accrue to him or her and are indifferent as to whether these cash flows come in the form of profits or salary. Typical SDE multiples range from 1 to 4 and, when expressed as capitalization rates, often result in values between 20 to 40 percent. For these reasons, owner-operator capitalization rates represent active rates of return that are based upon buyers who expect to work in the business and receive the economic benefits of this labor each year. This fact provides further justification for selecting alternate passive rates of return to apply in Rueschenberg analyses for owner-operator businesses. Pizza Restaurant Illustration Evidence supporting of the lack of significant appreciation in a growth-constrained industry such as a pizza parlor is demonstrated by actual transaction data for pizza restaurants from Pratts Stats and BizComps. The following chart represents a five-year rolling average of the sale price of small pizza restaurants from 2000 through 2014.

The graph above demonstrates that there has not been any significant appreciation in the average sale price of pizza restaurants over the 15-year period. This is largely due to the following downtrend in price to revenue multiples.

Based on the data above, it appears that pizza restaurants may not have even appreciated at the rate of inflation over the last 15 years due to a general decline in industry multiples. This data is presented solely to illustrate the fact that, for certain growth-constrained small businesses, the company’s capitalization rate is not an appropriate benchmark for a passive rate of return when the dividend payout ratio is not considered. Proxies for Passive Rate of Return Proxies for determining capital appreciation rates for an owner-operator business include industry growth rates, GDP growth rates or inflation over the period analyzed. For companies that operate solely or predominately within a particular metro area, one relevant proxy may be the growth of the local economy. The following graph details the uneven growth of the Phoenix metro economy from 2002 through 20132.

2

http://www.statista.com/statistics/183876/gdp-of-the-phoenix-metro-area/

For many industries with elastic cyclical demand, the local economy represents a relevant passive rate of return indicator. The following graph details the growth of a $200,000 business over 12 years based upon the Phoenix metro GDP data above.

Conclusion There is no universal answer to the question of an appropriate passive rate of return to apply in Rueschenberg scenarios. The passive rate of return must be carefully considered based upon the yield and capital appreciation components of a particular total rate of return for a company. For the owner-operator small businesses, the typical practice is to distribute the most of the total return to the owner in each year. This distribution policy, along with the growth-constrained nature of many small companies, results in an expected capital appreciation growth rate that is closer to inflation, industry growth or the growth of the economy. It should be noted that the special master in Rueschenberg implemented a second level of apportioning the increase in value above a passive rate of return. In the case of DMM, one-third of the excess appreciation was attributed to sources other than the marital community. Given this second step of apportionment, it makes sense to utilize a conservative rate for passive appreciation as any non-community factors can be considered in the second step of the apportionment. By understanding the dynamics of the yield and capital appreciation that comprise a total return, Arizona business evaluators, attorneys and judges can apply passive rates of return that help to achieve the “substantial justice between the parties” that permeates the Cockrill and Rueschenberg decisions.

Mark Hughes will speak at the Arizona Divorce Conference Oct. 22 and 23, co-sponsored by the Arizona Society of CPAs. http://azdivorceconference.com