Depletion of Business Profits and Assets During Separation and Divorce Proceedings – Would it Have Happened Anyway?
Published: 27/03/2023 09:17
This article is written from the perspective of the business valuation expert. We often see business profits and assets deplete over the period of separation and during divorce proceedings. The question is to what extent this can/could have been controlled by the business owner (and usually shareholder/director in owner-managed businesses) and what was due to circumstances outside their control. Would the depletion of assets and profits have happened anyway if not for the divorce?
While it is not the role of the business valuation expert in divorce proceedings to investigate business finances, unless instructed to do, is it their role to gather sufficient information to form as accurate an estimate of value as possible, in their expert opinion, at the specific valuation date.
Attributing reasons for depletion of profits and assets
How easy it is to attribute reasons for depletion in profits and assets? Usually it is not easy, but often more could be done to attribute reasons and understand the changes in the business.
We may also ask the question, does it matter what the reasons were for the depletion of profits and assets, other than where there have been deliberate actions by a business owner? Well, the answer is yes, it does matter because those reasons could have significant implications for the value of the business. If the valuer does not sufficiently understand how the business operates and how it generates value, its critical success factors and specific reasons for changes in performance, any valuation may be flawed. There may also be consequences for the financial remedy.
Practical examples and questions to consider
Let’s consider the following questions with a view to refining how we may attribute reasons for the deterioration in the financial performance and position of the business:
(1) Was the director and business owner acting in the best interests of the company at all times (Companies Act 2006) and are they acting/have they acted in good faith in litigation, providing appropriate disclosure?
(2) Which other financial decisions have been or could have been controlled by the business owner during that period?
Was the director/business owner acting in the best interests of the company at all times (Companies Act 2006) and are they acting/have they acted in good faith in litigation, providing appropriate disclosure?
Where a director has not acted in the best interests of the company, the most common examples valuers may see is diversion of income and profits to another entity or additional cost charged to the business to benefit the business owner or a related party.
We saw the diversion of income/funds in OG v AG (Financial Remedies: Conduct)  EWFC 52,  1 FLR 1105. In this case, both parties worked in the business. During separation and divorce proceedings, the director/shareholder of the business being valued turned out to be unquestionably involved in the establishment of another entity which was a direct competitor, thereby diverting funds and reducing the prospects of the business being valued. It became clear that he was beneficiary of the new entity and had also channelled funds through it to enable him to purchase property abroad.
In this case, Mostyn J indicated that conduct was considered relevant in financial remedy cases in four distinct situations.
(1) Where there is ‘gross and obvious’ personal or economic misconduct against another party, which is taken into account in rare circumstances and only where there is a financial consequence.
(2) Where ‘one party has wantonly and recklessly dissipated assets which would otherwise have formed part of the divisible matrimonial property’.
(3) Litigation misconduct which may not affect assets to be divided but could be penalised in costs.
(4) Failure to give ‘full and frank’ disclosure. The lack of assets disclosed needs to be assessable by the court.
In FRB v DCA (No 2)  EWHC 754 (Fam), disclosure by the director/shareholder had been wholly inadequate to enable a business valuation of one company which had a valuation range which differed by more than £50m at between £54m and £108m. The court took the lower figure as the one it could be confident as being available to the husband in that case.
Where parties have not acted in the best interests of the company and where there has not been appropriate disclosure, it can clearly have a significant impact on decisions on division of assets and allocation of costs. Deliberate deprival of the company of income and profits and labouring it with excessive/inappropriate costs may also be a breach of directors’ duties under the Companies Act 2006, if they are or have been a director of the company being valued.
One question that any business valuer would be expected to ask is whether any offers have been received for the business or whether there have been any approaches or potential sale discussions/negotiations. If such discussions relating to a potential purchase are at an early stage and highly confidential, while these ought to be disclosed to the business valuer, however (informal as they may be relevant to the business valuation), the business owner may not disclose such information and the result of such discussions may only be revealed if there is actually a deal done and the transaction later executed, more likely than not at a different figure to that placed on it by the valuer.
Which other financial decisions have been or could have been controlled by the business owner during that period?
In the lead up to and during separation and divorce, it is inevitable that this question has an impact on most owner-managed businesses. This is particularly the case where businesses are owned 50/50 by both parties and/or where both parties have established or are working in the business. Not only might it affect the parties, but it is also likely to affect other family members who may be involved in the business and employees whose loyalties may be divided. Depending on the role the parties play in the business, sometimes the effect can be catastrophic, particularly if the period of separation and divorce proceedings is long and drawn out and when children are involved. Other businesses may have robust management teams and systems in place allowing the business to continue largely unaffected.
What should we look for in the accounts to determine where the figures may be more subjective and even open to manipulation? This is a particular risk in smaller owner-managed businesses which are not audited. It can be more difficult and more time-consuming to undertake a valuation of such businesses than larger entities which have to be audited because the audit should in theory, provide a high standard of verification and assurance on the figures reported.
Looking at trends across all income and expense lines is important. Even where revenue and expenses are comparable year on year, it cannot be assumed that there are no one-off or non-trading items buried in those lines and that they will continue along the same trajectory. The right questions must be asked.
Some of the areas below may be worth taking a closer look at and drilling down for further detail and supporting accounting policies and assumptions. The basic principles of double entry in accounting mean that both the balance sheet and profit and loss account can be affected by changing one figure, thereby suppressing or enhancing business value. This is considered further under the accounting areas highlighted below.
If one party is the main source of lead generation and sales and holds the main contractual relationships, they can exert a degree of control over the income and pipeline. It may, in some cases, be helpful to gain an understanding of the profile of sales in these types of businesses, including for example number of customers, turnover by customer and the contractual cycle, if there is one. How can we know if there is a promise of a significant contract where pen has not been put to paper to formalise the deal? We cannot know but depending on the business to be valued it may be appropriate and relevant to ask whether they are in discussions over any new contracts which have not yet been signed. On the other hand, businesses may have relied on revenue streams from contracts which have ended and will not be renewed.
Repairs and renewals
Repairs and renewals costs may vary significantly year on year. Determining a ‘normal’ level of expenditure and understanding what is one-off or not recurring on an annual basis is helpful. There are choices that the business owners can make about how this expenditure is reflected in the accounts and if such expenditure is significant, then this can consequently have a significant impact on the business value. There may be a formal accounting policy in place which provides the framework for the choice made, but often in owner-managed businesses there is not. If the choice is made to include this in expenses in the profit and loss account, this could significantly lower a business valuation. However, if the choice were made to include this figure instead in the balance sheet, which means capitalising it as an asset which depreciates over say 5–10 years (or whatever is deemed the appropriate period for the item(s) of expenditure), this latter approach would both increase the profits and the net asset value of the business.
There are of course depreciation and tax consequences but these can be dealt with appropriately by using the right valuation method(s) for the business. The same principle for decisions made on how to treat repairs and renewals in the accounts and the consequential impact on business value may also apply to software and IT expenditure for some businesses.
Are we confident that rent is being paid at market rate for the premises actually used by the business? Is there spare capacity? If rent has increased as further capacity is required, is there a corresponding increase seen in revenue and if not, when will this be seen?
Often, when properties are valued, the property valuers are not instructed to include the value of the market rental (at the dates relevant to the case) in addition to the freehold/leasehold. Instructing property values to include the market rate rental in these reports may be done at small extra cost and may help to produce a more accurate valuation and mitigate any uncertainties or disputes about the level of rent charged after the business valuation report is completed.
Legal, professional and consultancy fees and management charges
It should go without saying that legal fees which relate to the parties’ costs in divorce proceedings should not be expensed to the business. However, legal fees may be worthy of further examination.
In relation to professional and consultancy fees and management charges, depending on the level of these and the nature of the business, it may be worth seeking clarification whether any such fees are being paid to directors and shareholders or related parties and, if they are, what services are provided. It may be the case that such fees are being paid in lieu of directors’ remuneration and adjustments should be made here by the business valuer alongside any adjustments required for directors’ remuneration.
Provisions may be included under liabilities/creditors in the balance sheet, thereby appearing to reduce the business value. With reference to their size and nature, it might be appropriate to consider whether these could have a significant impact on the business value.
Such provisions might relate to bad debts, warranties, impairment of assets, obsolete stock or taxes for example. For provisions relating to any one-off non-recurring events or items, it may be appropriate to make adjustments to these in the business valuation.
Stock can be particularly subjective in owner-managed businesses and, often, the stock figure is provided to the accountant by the business owner and for unaudited businesses, no verification work is undertaken on this figure. This needs to be looked at in conjunction with expenses in cost of sales, and the impact on turnover. It may be the case that stock is understated or that cost of sales has increased disproportionately to sales. Looking at trends over several accounting periods such as levels of gross profit margin, stock levels in proportion to turnover and stock as a proportion of total assets may help to determine anomalies. Some of these issues should be flushed out in the financial statements over time, if the party who does not have any control over the business has time to play with.
Regarding impairment of assets, ideally any property values will be supported by an independent valuation of the freehold/leasehold (including, as noted above, the market rate rental). Any significant provision made for impairment of other assets should be supported by documentary evidence. The same principle should be applied to any significant losses on disposal of assets, and it should be determined whether those disposals have taken place on normal commercial terms. This will assist the business valuer in their work and the court in deciding how to deal with these, should the parties be in dispute on these items.
Understanding the decisions made and the impact on business value
It may be difficult if not impossible to determine whether the director/shareholder, if they are a party to the divorce and/or others they are closely affiliated with in the business, would have made the same decisions had the separation and divorce proceedings not taken place. However, understanding what changes have been attributable to decisions controlled by the director/shareholder, and the impact of those decisions on the financial performance and position of the business, may influence the business valuation.
Challenges for the business valuation expert
When initially appointed as a business valuation expert, we may have little more than statutory accounts available to us when we commence work. On the other hand, we may have disclosure bundles running into thousands of pages. In either case, to achieve a reasonable valuation estimate, it is necessary to understand the business, how it operates, how it generates its sales, what its critical success factors and major risks and opportunities are and who are the people that drive the business. The numbers tell a story but by no means provide the full picture, and a true understanding and reasonable valuation of the business cannot be achieved without substantive qualitative information to support the numbers, both for the business in question and for similar businesses in the industry. Therefore, the context in which the business is operating at any one time is critical to the valuation, as well as attributing specific reasons for changes in financial performance and position. This is essential for building the most accurate estimate of value possible in the absence of a real purchaser, providing full disclosure has indeed been given of any offers, approaches and negotiations relating to any potential sale.
Conclusions and matters to consider for instructing lawyers
In order to unpick some of the issues considered in this article, it is necessary to ask appropriate questions of the parties at the very earliest opportunity.
Why is building an understanding of the business and the reasons for depletion in profits and assets important? This is about undertaking a valuation which is robust, systematic and based on the real life experience of the business valuation expert. This cannot be done without building the best understanding reasonably possible of opportunities, risks, how a business operates and other relevant factors and identifying specific reasons for any depletion in profits and assets over the period. There may be many and those reasons may be complex. The right questions need to be asked and the business valuer undoubtedly needs to have the right skills and experience.
Lawyers may wish to consider in more detail those accounting areas identified above and specify in instructions to business valuers that they should give specific reasons for changes in the financial performance and position of the company when undertaking the valuation. While most good valuers will do so anyway, this helps to ensure that the valuer gives proper consideration to the reasons in their estimate of business value and that they explain these reasons in their report.
Business valuation experts should ensure that their information requests enable them to build a strong understanding of the business and the context in which it operates. Often, more could be done to attribute reasons for depletion in profits and assets by asking the right questions and undertaking appropriate analysis and, in doing so, perhaps reach a more robust valuation estimate and better assist with resolution of the case.