In family law matters, trial teams should consider the impact of divorce itself on the expected future benefits of a closely held company in a marital estate. This impact can even be more pronounced in smaller size firms when compared with large privately held enterprises.

Businesses today with less than 500 employees are generally the creators of most net new jobs, as well as the employers of about half of the nation’s private sector work force; and the providers of a significant share of innovations, according to “The Small Business Economy, 2010, A Report to the President” (U.S. Small Business Administration). Often times, the valuation of a small closely held business presents more challenges than large, yet private, enterprises. In marital dissolution matters, ownership levels, liquidity, key-person dependencies, personal goodwill, amongst other factors typically considered in the appraisal of a closely held business, fail to account for the risk to a commercial enterprise as a result of the divorce process itself. That is, these same factors exist independent of any divorce process, and can be material or not, damaged or not, and considered or not, in the valuation of a firm outside the context of divorce. For example, disease and death are non-controllable factors that can profoundly affect value. Even speculation surrounding such factors can lead to a loss of company value. Consider that the day after Steve Jobs announced that he was taking a leave of absence and leaving day-to-day operations of Apple to COO, Tim Cook, Apple's stock took almost a 7% plunge from the previous day's close. Non-controllable factors affecting value result from uncertainties, which are events that are indeterminate and characterized by unforeseeable consequences. In the case of publicly traded firms, these uncertainties manifest themselves in the form of underlying stock volatility. While Apple lost more than $30 billion in value during the hour following Jobs’ announcement, it recovered its loss one-week later. In contrast to uncertainty, risk represents the chance of loss, is determinate, and presents foreseeable consequences. Risk refers to those events where an investor can assign probabilities to the randomness encountered, and therefore can be monetized as well as quantified. Risk

VIEWPOINT Spring 2011 Expert Services

For more information, please contact: Rick S. Nathan Managing Director 847.562.4002 rnathan@thesorbigroup.com www.thesorbigrou.com

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THE CORPORATE RISK OF DIVORCE AND PRIVATE COMPANY VALUE

management is about business outcomes, focusing on factors that are controllable or managed by the firm through choice and consequence. In marital dissolution, awarding a spouse company shares in lieu of its cash equivalent presents such risks as potential fallouts from voting battles, defaulting creditor agreements premised on key shareholder ownership thresholds, and buy-sell agreement triggers, just to name a few. Regardless whether a spouse is compensated though share ownership or its cash equivalent, perhaps the greatest risk facing a business in divorce is both outside and inside perceptions regarding the stability of the company. Unlike the case of Apple, the value of a privately held firm does not benefit from market transparency that can correct itself. Arguably, in the case of marital dissolution, instability perceptions are somewhat controllable in that divorce is at best a choice, and at worse, is typically foreseen. As a result, a company can proactively manage these perceptions through open communication with company directors, officers, employees, suppliers, customers, and even competitors. Why competitors? Because oftentimes firms operate in “coopetition” with each other, as is the case today with Internet cloud computing and web service providers. The consequential issue is how to incorporate the resulting corporate risk in estimating the value of a closely held firm, contemporaneous with marital dissolution. From a top-down perspective, the company in a marital estate can be thought of as holding a joint and severable “covenant-not-to-separate” with both spousal parties, since reasonable investors have nothing to gain from perceptions of instability affecting a company’s future performance. Upon divorce, both spouses will have defaulted on their covenant thereby damaging the firm. As a result, the fair market value of a closely held firm in divorce is equal to the company’s value, but for divorce, less the value of the covenant-not-to-separate, all other factors being equal. The value of the covenant can be estimated as the difference between the value of the company with and without holding any such covenant-not-to separate, reflective of expected lost profits. The corporate risk of divorce on private company value can be further elucidated from a bottom’s-up analysis of other intangible assets held by the firm. For example, a company’s assembled workforce provides value by mitigating the costs that would be required to replace it due to forced or involuntary attrition. Costs avoided

include hiring, training, and productivity that is typically lost during a new employee’s training period. An assembled workforce and its relative impact on value can be more pronounced in smaller closely held companies. Large private firms typically embody strategies and operating models that compete with larger public company competitors. As a result, a large closely held firm’s know how is typically institutionalized, and not concentrated in specific company employees. As a result, large private company workforces can be more fungible when compared with firms that compete with them or others on a much smaller scale. Moreover, a smaller privately held company’s workforce can impact value in a non-linear fashion depending on the size, tenure, and skill of the workforce; and company access to a readily available pool of replacement candidates. Finally, it is important to recognize that the corporate risk of divorce itself and its impact on the value of a closely-held company is neither ascribed to, nor differentiated between, the actions of either individual spouse, but results from the impairment of a company’s underlying intangible assets. Furthermore, this impact on company value is separate and distinct from any consideration of legal entity form, ownership levels, liquidity, or other factors when estimating the value of a private firm held in a marital estate. Rick S. Nathan is the founder and managing director of The Sorbi Group, LLC, a boutique financial advisory and expert services firm with offices in Chicago and San Jose, providing economic opinions for adverse party matters, regulatory compliance, and strategic management initiatives. © 2011, The Sorbi Group, LLC

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VIEWPOINT Expert Services Corporate Risk of Divorce