Soshnick: Income approach in divorce valuations: Look back or leap forward?

Valuing businesses and professional practices in divorce cases is more an art than a science. Yet developments over the past three decades bring more conformity to the process. How has Indiana responded to the development of definitions, premises and standards, particularly when reviewing cash flows? The answer is: with some obscure clarity.

In order to understand the income approach to valuation, some basic definitions from the International Glossary of Business Valuation Terms are useful. “Premise of value” is an assumption regarding the most likely set of transactional circumstances that may be applicable to the subject valuation — most often “going concern.” “Standard of value” is the identification of the type of value being utilized in a specific engagement. That is “fair market value” in Indiana for divorce cases when several appellate decisions are read collectively. (See, e.g., Eyler v. Eyler, 492 N.E.2d 1071 (Ind. 1986); Houchens v. Boschert, 758 N.E.2d 585 (Ind. Ct. App. 2001); Nowels v. Nowels, 836 N.E.2d 481 (Ind. Ct. App. 2005); Alexander v. Alexander, 927 N.E.2d 926 (Ind. Ct. App. 2010); Crider v. Crider, 15 N.E.3d 1042 (Ind. Ct. App. 2014); Hartman v. BigInch Fabricators & Constr. Holding Co., 161 N.E.3d 1218 (Ind. 2021) (defining “fair market value” as “the price that a seller is willing to accept and a buyer is willing to pay on the open market in an arm’s length transaction.”)). These opinions follow Internal Revenue Service Revenue Ruling 59-60, which provides in part that “fair market value” is “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

With this background, valuation professionals in Indiana divorce cases must consider three valuation approaches: asset, income and market. (See, e.g., American Institute of Certified Public Accountants Statement on Standards for Valuation Services No. 1 paragraph .31; Uniform Standards of Professional Appraisal Practice) While all three approaches must be considered, the valuation professional applies the approach or approaches appropriate for the valuation engagement. (SSVS paragraph .32) The “income approach” is defined in the International Glossary of Business Valuation Terms as a general way of determining an indication of value of a business using one or more methods that convert anticipated economic benefits into a present single amount. One commonly used method is the “capitalization of earnings method,” or CE method, whereby economic benefits of a single period are converted to value through division by a capitalization rate. This is a retrospective analysis. (See, e.g., SSVS paragraph .33) Another commonly used method is the “discounted cash flow method,” or DCF method, whereby the present value of future expected net cash flows is calculated using a discount rate. This is a prospective analysis. Id. How have Indiana courts typically treated application of these two methods in divorce cases?

Sometimes Indiana courts do not focus on the CE method or the DCF method. For example, Bertholet v. Bertholet, 725 N.E.2d 487 (Ind. Ct. App. 2000), resulted in a remand on the issue of the valuation of a bail bond business when the trial court made insufficient findings to support its valuation conclusion. Houchens v. Boschert, 758 N.E.2d 585 (Ind. Ct. App. 2001), affirmed the valuation of a steel treating company. In each instance, the implication is that the income approach CE method was applied, but there is no tangible evidence in the appellate decision to go beyond the implication.

Other times, the methodology applied is more apparent. In Axsom v. Axsom, 565 N.E.2d 1097 (Ind. Ct. App. 1991), the wife’s valuation expert applied an income approach CE method to value a barber shop. The trial court adopted a valuation so far from that expert’s valuation that a remand for further findings based upon the record evidence was in order. Frazier v. Frazier, 737 N.E.2d 1220 (Ind. Ct. App. 2000), involved two experts effectively using the income approach CE method but remanded for a goodwill analysis. Nowels v. Nowels, 836 N.E.2d 481 (Ind. Ct. App. 2005), affirmed the valuation of a lumber company that had one expert applying the income approach capital asset pricing model and the other expert, in part, applying the income approach capitalized cash flow method (effectively the CE method). The trial court made adjustments to each valuation to reach a $2,500,000 valuation conclusion. These opinions, and several not for publication opinions, support the use of a retrospective valuation analysis — meaning the income approach CE method as opposed to the income approach DCF method in divorce cases.

Several non-divorce opinions shed light on why the income approach CE method may be favored over the income approach DCF method in divorce cases. In Office of Util. Consumer Counselor v. Citizens Wastewater of Westfield, LLC, 177 N.E.3d 449 (Ind. Ct. App. 2021), the state office offered expert testimony that the income approach DCF method takes a stream of future cash flows and converts those numbers into a value today based on a discount rate and is not appropriate for purposes of establishing a rate increase. Because the case involved the acquisition of a utility over objection of the state office, the expert testimony was rejected and the decision of the Indiana Utility Regulatory Commission was affirmed. An earlier utilities case, Office of Util. Consumer Counselor v. Citizens Telephone Corp., 681 N.E.2d 252 (Ind. Ct. App. 1997), questioned the use of the income approach DCF method and income approach capital asset pricing model in calculating the cost of equity for non-publicly-traded companies. (Cf. Lees Inn of America, Inc. v. William R. Lee Irrevocable Trust, 924 N.E.2d 143 (Ind. Ct. App. 2010), (affirming the application of the income approach DCF method in a shareholder dispute.)) The reliability of projected future income streams in determining the fair market value of private businesses and professional practices is inherently questionable.

Indiana caselaw establishes that, when the income approach is applied in divorce valuations, the CE method generally is favored over the DCF method. Similarly, the theses behind the two methods give further rationale for this preference. The income approach CE method employs a static long-term growth rate that is less discretionary than the income approach DCF method, which employs a higher short-term growth rate that levels off to a terminal long-term growth rate. The latter approach requires more speculation and professional judgment than the former. Most businesses and professional practices whose value is in issue in divorce cases have reached a certain level of maturity, as opposed to startups often seen in venture capital and private equity scenarios. While the type and maturity of the business or professional practice can defy this generality, Indiana courts tend to follow the more traditional approach that the income approach CE method provides. All in all, looking back gives a glimpse of the future and paves the way forward.•

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Andrew Z. Soshnick is a partner in the Indianapolis office of Faegre Drinker Biddle & Reath LLP. He is a past chair of the Indiana State Bar Association Family & Juvenile Law and Indianapolis Bar Association Family Law sections and a fellow of the American Academy of Matrimonial Lawyers and International Academy of Family Lawyers. Opinions expressed are those of the author.