Business Valuation in Divorce Cases in a COVID-19 World, Part I: An Overview of Active Passive Appreciation Analysis

The impact of COVID-19 on the value of private company interests is being actively explored and discussed nationwide by business valuation professionals, their professional trade associations, and users of business valuations (e.g. attorneys).

Because COVID-19 can materially impact the value of a private company, consideration must necessarily be given to the impact of COVID-19 on an active passive appreciation (APA) analysis in a divorce case. This post is the first in a series exploring and addressing the impact of COVID-19 on APA.  While divorce cases include consideration of both business and non-business assets and liabilities, the focus of these posts will be on the business valuation in divorce cases involving the interests in private companies.

Given that COVID-19 continues to have an active impact on the U.S. and global economies and is dramatically affecting operations for public and private companies in some industries, consider these posts a work in progress and subject to revision as more information becomes available.

APA: A General Overview

An APA analysis is performed when state divorce law requires a determination of whether, and under what circumstances, value changes in a non-marital or separate business, occurring during a marriage or between the end of the marriage and the divorce trial, might be recharacterized in whole or part as marital property.

The business appraiser performing an APA analysis looks to their engaging legal counsel to define and interpret state law in the particular jurisdiction pertaining to APA, including any state-specific definitions of key terms (“marital property”, “non-marital property”, “separate property”, “divisible property”, etc.).  Given the variety of APA-related terminology utilized in divorce statutes and case law of various jurisdictions, references in this and subsequent blog posts are intended to refer to general concepts typically found in an APA context, rather than try to cover all of the jurisdiction-specific definitions and nuances of terms.  In these posts, general definitions are provided where necessary for clarity.

In practice, the non-marital or separate business interests (henceforth “Separate”) that are the subject of APA analyses are typically businesses already owned by one spouse prior to the marriage, or gifted or bequeathed to one of the spouses during the marriage

Whether changes in value of Separate businesses identified in an APA analysis are reclassified as marital property (henceforth “Marital”) is jurisdiction-specific and can depend upon factors including, but not limited to:

  • The cause(s) of the value change; and,
  • The timing of the value change:
    • Whether any change in Separate business value occurred between the date of marriage (“DOM”) and the date of separation (“DOS” – in some jurisdictions called the Date of Filing); and,
    • Whether any change in separate business value occurred after the DOS but before the date of distribution (“DOD” – in some jurisdictions also called the Date of Trial or “DOT”).

APA Overview – Active vs. Passive

Commonly recurring requirements in some jurisdictions are that value changes in Separate businesses can be reclassified as Marital based in part upon the cause(s) of the value change along with the timing of the value change, as follows:

  • Separate business value changes between the DOM and DOS:
    • Typically become Marital property to the extent they were caused by marital efforts or marital funds (often called “Active Efforts”).
    • Typically remain Separate property to the extent they were caused by factors OTHER than marital efforts or marital funds (often called “Passive Factors”).
  • Separate business value changes between the DOS and DOD:
    • Typically remain Separate to the extent they were caused by Active Efforts.
    • Typically become Marital to the extent they were caused by Passive Factors.
  • Note that in such jurisdictions, a “flip” occurs depending upon whether the measurement period is between the DOM and DOS or between the DOS and DOD:
    • Separate business value changes between the DOM and DOS caused by Active Efforts can be reclassified to Marital property;
    • Separate business value changes caused by similar Active Efforts between the DOS and DOD often remain Separate property.
    • State statute and/or case law sometimes explain this “flip” by referring to the concept that the period between the DOM and DOS is a period of an economic partnership in addition to being a marital partnership, but that the economic partnership ceases when the marital partnership ends (the DOS).

APA Overview – Hypothetical Illustration

The following graph illustrates hypothetical changes in Separate business value between the DOM and DOD.

 

 

  • The total business value is reflected by adding the blue, gray and orange areas on the graph. In this graph, the DOM business value is approximately $17 million, which increased to approximately $28 million at the DOS and approximately $38 million by the DOD.
  • The blue area reflects the cumulative DOM value, which is unchanged during the period from the DOM through the DOD.
  • Hypothetically assuming that active efforts by the owner spouse caused 75% of the value increase for the entire period from the DOM to the DOD, and that factors OTHER than active efforts by the owner spouse caused 25% of the value increase for the entire period from the DOM to the DOD:
    • The gray area reflects the cumulative increase in the Separate business value that remains separate property.
    • The orange area as of the DOS reflects the cumulative increase in the Separate business value between the DOM and the DOS that can be reclassified as marital property. Some jurisdictions characterize this amount as the part of the Separate business value increase in which the non-owner spouse gains an “equitable” Marital interest.
  • The DOS is designated in the graph as the point at which the “flip” occurs:
    • The gray area of the graph grows more rapidly than the orange area post DOS, since all of the Separate business value increase caused by the active efforts of the owner spouse post-DOS is allocated to Separate property. Increases in Separate business value post DOS caused by active efforts of the owner spouse remain Separate property.
    • The orange area of the graph grows more slowly than the gray area post DOS, as only the allocated part of the post DOS business value increase caused by factors OTHER than active efforts is allocated to Marital property. Increases in business value post-DOS caused by efforts OTHER than the active efforts of the owner spouse can become Marital property.

 

Now that a foundation for APA analysis has been laid, our future blog posts will address incorporating the impact of COVID-19 in APA analyses.

If you are interested in more information regarding business valuation in divorce cases, how you can strengthen your case with a business valuation and active passive appreciation expert, or want to learn more about our services and our team, please contact us.

Unlocking the Potential of Electronically Stored Information to Determine Lost Profit Damages

At many small businesses, it’s not uncommon to still find a mass of paper records, yellowing with age and haphazardly tossed in boxes, as well as old-school computers and dot-matrix printers with tractor feeds and green bar paper.

Yet even the most unorganized and technologically unsophisticated small business may contain a trove of useful electronically stored information (ESI) that can prove crucial in determining economic damages in a case or in providing evidence in a financial fraud investigation. 

The first and most basic step is to determine whether such data exists at a business. If in doubt, consider this question: Does the business have documents that look as if they’ve been printed from a computer? If those documents have telltale headers and footers that indicate they are generated from a computer system, then the business likely uses computers regularly and probably possesses valuable ESI. 

KEY CHALLENGES

Many small business owners and employees, as well as their attorneys are unaware of the types of ESI available that could be the key to their case.  Persistence, creativity, and knowledge are necessary to unlock the potential of a small business’ electronically stored information.

Three primary challenges are often encountered with small business ESI:

  1. The information may be stored on archaic hardware and/or software.
  2. The business owner and employees lack technological savvy and may be unaware of the type and extent of data that is present on their system. They are often adamant that no useful ESI is available from their system because they have had difficulty or even failed in trying to extract information.  
  3. Small businesses generally have limited resources, and their personnel usually do not have the expertise to extract relevant useful data from an outdated system.

A FIGHT OVER GAS

Consider this example concerning identifying and obtaining forensic evidence from a small business to help determine economic damages. Green Fuel was a small gasoline distributor that provided fuel to local gas stations. The owner, a gentleman in his late 70s did not own a computer, and he had a limited office staff that included an accounting clerk and a manager. 

Green was a defendant in a state court case where numerous claims were made by Morris, a gas station owner. Morris alleged that Green overcharged him for fuel delivered to Morris’ two small-town gas stations during an eight-year period. Morris claimed that Green failed to transact business pursuant to their contract, and as result, Morris suffered economic damages of $1 million dollars arising from overcharges and a failure to share profits as specified by their contract.

At first glance, both parties appeared to have inadequate documentation of fuel deliveries and payments.  The only documentation maintained by the gas station owner, Morris, was a sparse set of paper receipts and logs regarding fuel delivery.  

Moreover, Morris’ stations used unsophisticated point-of-sale cash registers and did not utilize a computer system to maintain accounting records or other records of fuel deliveries.  Morris said in his deposition that he relied on Green to keep detailed records of fuel orders and deliveries and that this allowed Green to overcharge him.

Green’s documentation of fuel deliveries was only slightly better than those of Morris.  Although Green used an antiquated DOS-based computer system to maintain limited accounting records, Green’s management vehemently maintained that no electronic record existed of fuel delivery or receipt of payment.

HIDDEN ESI

The Green case epitomizes not only the challenges faced in extracting useful forensic evidence in small businesses, but also the need for persistence in seeking ESI.  Left with such sparse information to determine losses, the attorneys for both parties were highly doubtful that any meaningful analysis of the transactions could be conducted.

A deeper review of the parties’ sparse documents revealed Green electronically produced invoices for fuel sales to Morris. This was a telltale sign that Green more than likely did have ESI available despite its claims to the contrary.  

The issue became not only convincing Green that the information existed, but also helping Green and its attorneys understand how it could be retrieved. An ESI challenge like this is rarely accomplished through force or the use of highly technical jargon; rather, success comes through understanding and observing key personnel’s daily routines and processes.

Information-seeking interviews with personnel that regularly use the computer system—such as the accounting clerk or administrator in this case—are a good place to start.  Interview questions should seek to understand of the daily routine, including the functions regularly performed, and the tools used to accomplish those functions.

Observation of the performance of key functions will also aid in gaining an understanding of the computer system and the software programs used.

In the case of Green, the interview required a few hours with its accounting clerk to observe her daily routine, including the data processing of fuel deliveries, creation of computer-generated invoices and subsequent processing of payment receipts.

AN EXTRACTION PLAN

At the completion of the interview, a plan was developed to extract the data from Green’s archaic system, which required a multi-step process including the use of more advanced technology.

A detailed discussion of the process is beyond the scope of this blog post, but let’s just say that Green’s system was able to provide electronic records of the gallons of fuel delivered to Morris, the date, and the amount charged – for all eight years.

With the ESI extracted from Green’s database, Morris’ economic loss claims were analyzed using two methods:

  1. Contract Method.  The analysis of the ESI focused on the terms as specified by the contract. This analysis revealed Morris was not economically damaged, and that, in fact, he had underpaid Green in excess of $1 million.
  2. Actual Performance Method.  The analysis of the ESI focused on the way business was actually transacted revealed that Morris underpaid Green in excess of $700,000.

A LETHAL BLOW

The analysis of relevant ESI dealt a lethal blow to Morris’ claims.  Initially, Morris’ claims seemed somewhat feasible due to the lack of data, and Morris’ made a bet that Green would never be able to organize and analyze the data to disprove his claims.

Morris also had no way to prove his claims with reasonable certainty, but by using electronic data analysis, Green was able to disprove the claims — and actually determine that he was owed money. The end result: Morris dismissed his claims against Green just two weeks after the findings were revealed to his attorneys. 

It’s an example that, even in the most technologically backward of businesses, it pays to find the electronic record and dig into it as deeply as possible to prove or disprove economic damages or to aid a financial fraud investigation.

To learn more about ways we help businesses and their counsel extract critical ESI, contact us for consultation.

CATEGORIZED UNDER: News