March 01, 2013

The role of a financial expert can be divided into three main focuses: 1) discovery and information gathering; 2) analysis and the formation of opinions; and 3) case resolution. It is in this third area that a settlement can be reached and perceived equitability is paramount. The “value” that each party receives in settlement will be the measure of equity they take with them as they begin to rebuild their separate lives. But, as much as lawyers and experts like to see value in terms of dollars and cents, the emotional and intangible aspects of divorce often complicate this simplistic view of what value really is. The purpose of this article is to explore the relative nature of value, and show through examples how settlement can be reached when the gap between clients’ perceptions of value is bridged.

Value: An Economic Definition

In discussing the concept of value, it may be useful to first understand what the term “economics” truly means. Many people exclusively think of stock market charts and mortgage rates when they hear the word economics, assuming the term is purely a financial concept. This, in truth, is not the case. “Economics” refers to the study of human action, specifically the decision-making process. Economist Alfred Marshall provided a widely-accepted definition in his textbook Principles of Economics, writing:

Economics is a study of man in the ordinary business of life. It enquires how he gets his income and how he uses it. Thus,
it is on the one side, the study of wealth and on the other and more important side, a part of the study of man.

Given that the study of economics is primarily concerned with understanding the methods by which people acquire things, use them, and make decisions concerning how to acquire and/or use more of them, it is crucial to understand how people make these decisions. Said differently, how does a person evaluate the potential outcomes of their impending decision? The answer to this question lies in the definition of value. Economist Ludwig von Mises discusses “value” in his work titled, Theory and History: An Interpretation of Social and Economic Evolution. Mises states:

Judgments of value are voluntaristic. They express feelings, tastes, or preferences of the individual who utters them… Guided by his valuations, man is intent upon substituting conditions that please him better for conditions which he deems less satisfactory.

Considering this definition, we can better see how one spouse may value an asset differently than another. A dentist wife may refuse to sell her business for an otherwise reasonable amount because she enjoys the autonomy of being her own boss. Similarly, a real estate mogul husband may value a piece of property more than his wife values it because he thinks he can improve and sell it at a higher price later. These differences result from personal value judgments that reflect the differing feelings, tastes, expectations and preferences of each individual spouse.

Rational Decision Making

If one devalues rationality, the world tends to fall apart.
– Lars von Trier

Economists assume that people make decisions rationally. That is to say, when a person makes a decision, they make that decision with the assumption that their life will be enriched in some way as a result. This can be applied to every choice a person makes throughout the course of a day, consciously or subconsciously, for decisions both significant and insignificant. What color shirt will you put on this morning? What will you eat for breakfast? What college will you send you children to? Will you pursue a new job opportunity? When faced with these questions, people will choose the option they feel best improves their life. These are inherently economic decisions.

Of course, that is not to say people do not make bad decisions. Bad decisions are made every day. However, it is important to understand these bad decisions are typically not born out of irrationality, but rather incomplete or inaccurate information or emotional interference that prevents full consideration of potential outcomes.

Working in the divorce arena, it is tempting to conclude that clients regularly make irrational decisions. For example, a wife might inform you that she would like to investigate her husband’s spending habits through a full forensic review of his bank and credit card accounts. The rationale is “so she can finally know what he is spending their money on.” While it may seem that spending thousands of dollars to investigate what is likely to be a financially or legally trivial issue is irrational behavior, the wife may in fact not be acting irrationally. Rather, given her present state of mind and her understanding of the situation, her perceived personal satisfaction resulting from the investigation, regardless of its outcome, is worth more to her than the thousands of dollars it will cost. However, because the attorney and expert may have a more complete and accurate understanding of the total costs and benefits associated with such an endeavor, they can provide value by helping the client make a “good” decision.

Value to Whom?

Don’t tell me what you value, show me your budget, and I’ll tell you what you value.
– Joe Biden

Generally speaking, when a valuation expert expresses an opinion of value, he or she concludes that a rational person would be equally indifferent toward owning the asset in question or an amount of cash equal to his or her conclusion of value. In this regard, the valuation expert is contemplating a hypothetical transaction involving two parties – one holding the cash and the other holding the asset.

“Value” represents a decision point, and decisions are made based on the judgment of individuals who are as unique as the decisions they make. Therefore, the process of valuing an asset must be expressed as an opinion and it must be augmented by the phrase “value to whom?” In the field of business valuation, we refer to this as the “Standard of Value.” Commonly employed Standards of Value include Fair Market Value (or Market Value), Investment Value, and Fair Value. The table below briefly summarizes these three Standards of Value.

To illustrate the concept of “value to whom?”, imagine a thirsty man standing in front of a soda machine. The stated price of a Coke in the machine is $1.50. If the man values the Coke more than he values the $1.50 in his pocket, he will buy the Coke. Conversely, if he does not value the Coke more than the $1.50 he holds in his pocket, he will pass on the transaction. After consideration, the man decides to buy the Coke. So, based on this transaction, is the value of the Coke $1.50? The answer is, “it depends.” We can draw certain factual conclusions about each party in the transaction that will help us to better understand the value of the Coke, but first we must answer one very important question: value to whom?

In our soda machine example, there are only two parties and one asset: the buyer, the seller, and the bottle of Coke. While it may not be possible to determine the Fair Market Value of the bottle without a market of participants, what we do know is that to the consumer, the Coke was worth at least $1.50, while to the vendor, the Coke was worth at most $1.50. If the man would not have paid a penny more than $1.50 and the vendor would have accepted no less than $1.50, then this common point of value at which the transaction actually happened would either have been an example of perfect market positioning, segmentation, and pricing…or perhaps just a serendipitous coincidence of Investment Value!

Now, let’s assume our soda machine is placed in a well-traveled area of a shopping center with many other vending machines owned by many other vendors. Every day hundreds of people pass our soda machine and make a decision whether to purchase a soda from our vendor, purchase a soda from another vendor, or continue on their way. Given the economic laws of supply and demand, the owner of the soda machine has attempted to price the soda at an amount that best positions his soda to be sold to the greatest number of people given his competition, but also maximize his profits. This illustrates the concept of market value. A valuation expert tasked with determining the market value of an asset will take steps to determine at which price a specific asset would hypothetically transact if the seller were in roughly the same shoes as the owner of the soda machine, and the buyer were a member of a pool of potential buyers in roughly the same shoes as the group of passersby.

Finally, and perhaps most applicable to settling a divorce case with emotions running high, let’s assume that the soda being valued is not in a machine at all. Rather, it is a vintage bottle of Coke-a-Cola that was given to a man by his father when he was a young boy. Even if similar bottles regularly sell at auction for $15, this particular man would not consider selling this particular bottle for even 10 times the auction value. This is an example of how, under the Investment Value standard, the unique features of a person and an asset can combine to give rise to unique value.

These examples illustrate just how varied the value of an asset can be depending on how one answers the question, “value to whom?”

Standard of Value

Value to Whom?

Fair Market Value

The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of relevant facts.

Investment Value

The value of an asset to a specific person, including all benefits and costs associated with the asset specific to that buyer, seller or holder. This includes “Holder’s Interest Value,” which is used in some jurisdictions to mean the value to the current owner assuming no fundamental changes to the operations of the business and no transactions with a third party.

Fair Value

The definition of this standard depends on the context and jurisdiction in which it is used.

 

Settlement Examples: When Market Value Becomes Meaningless

Case I

In a recent case, Stout was jointly engaged to value a manufacturing business that had once been a large tool and die shop, but had fallen on hard times and as of the divorce, only owned two pieces of machinery, a 3D printer and a CNC machine. Combined, the machines had a value of less than $200,000. Each machine had a separate and reliable, but small customer base. The divorcing parties had few other assets. The husband ran the business, and while the wife had worked in the office at the business in the past, she was supporting herself during the divorce as an hourly worker earning minimum wage. Since the breakdown of the marriage, the wife had been romantically involved with the CNC machine operator. Significant distrust existed between the parties and the wife was afraid the husband’s lack of business acumen and/or spite would prevent her from reliably receiving alimony or future property settlement payments.

Two full days of mediation were unproductive as the wife repeatedly dismissed settlement proposals that attempted to structure various pay-off scenarios. Finally, on the third day she articulated a concern that after a 25-year marriage of being a cobusiness owner, she would spend the rest of her life working for minimum wage and her settlement would not provide a reliable source of income. Her husband would have a business with which he could attempt to build a future, and she would only have a promise from him to pay.

The resulting settlement split the business in two, with each spouse taking one of the machines. They would each set up individual shops, with the husband running his 3D printer, and the wife and her new romantic interest running the CNC machine. Even though the CNC machine was worth less than the printer, she was willing to forego any property settlement payments or alimony to effectively buy herself a job.

Irrespective of the appraised market value of the machines, the wife valued owning a business, and a machine that would provide her the security of continued employment, more than she valued a promissory note from someone she could not trust.

Case II

In another recent case, Stout was hired by a successful medical device manufacturer who was divorcing his wife. After months of investigation and analysis, both Stout and the wife’s expert valued the company at approximately $10,000,000. Complicating matters, however, the wife was convinced the business was worth at least $15,000,000, and was simply unwilling to settle for less than what she believed the value to be. The husband, on the other hand, feared uncertainty under new health care laws and felt the valuations had failed to appropriately consider the risk, thus overvaluing the company. In short, he was unwilling to pay his wife half of the $10,000,000 business value and assume the risk of keeping the doors open to recover her buyout.

Despite the complete agreement of the valuation experts on the Fair Market Value of the company, each of the parties in this case was unwilling to accept any concluded value other than their own for the company. The impasse was finally overcome by both parties agreeing to sell the company and split the proceeds. This arrangement allayed the husband’s fears of having to fund a fixed buyout price with a failing company and afforded the wife the peace of mind that she would receive 50% of the “actual” value of the company, even if ultimately proven wrong about her $15,000,000 assessment of value.

Conclusion

As shown in the examples within this article, divorcing parties often make decisions that are not necessarily based on which outcome will provide them with the most money. As a result, the “right” settlement in any divorce may seem illogical to attorneys or experts, yet allows each party to feel as they have walked away with equitable value. Giving this creative consideration to security, liquidity, long-term financial stability, and yes, emotional comfort, can open up possibilities that go beyond a simple division of a predetermined pie of wealth and give your clients the value they need to begin the rest of their lives.