April 2014 - Pereira/Van Camp: Applying “Old School Law” to Today’s Economic Paradigm
by David V. Hanzich
In family law, when identifying the community assets of the marriage for a division of property, a separate property business that has appreciated in value during the marriage could be subject to an allocation of interest to the community. In California, two appellate decisions provide case law applicable to business valuations in a marital dissolution: Pereira v. Pereira, 156 Cal. 1 (1909) and Van Camp v. Van Camp, 53 Cal. App. 17 (1921). The misapplication of case law is common and often initially applied based upon the method that results in the best outcome for the client. However, only by conducting a detailed financial analysis of the separate property business structure can the applicable case law be determined. Additionally, today’s economic paradigm could widen the scope and applicability of the Van Camp method over the Pereira method, which favors the separate claimant with respect to allocable community interest.
When the business is a significant asset, both parties should be prepared to gauge the sufficiency of the separate interest claim and the estimate of the community’s interest in the separate property business. Although, it is the claimant’s burden to prove a separate interest in an asset (See v. See, 64 Cal. 2d 778 (1966) (superseded by statute on other grounds)), as in any litigation matter involving financial issues, reasonable minds can—and often do—differ. Given the same relevant facts, two competent business appraisers could likely reach different outcomes.
Proving the Separate Property Claim
The characterization of separate property is established by the date when the asset was obtained or purchased. Cal. Fam. Code § 770 (West 2014). The following records can provide evidence for a separate property claim regarding a business:
- Corporate or Individual (Schedule C) Federal Tax Returns, K-1’s
- Business name, fictitious business filings
- Bank records to include applications, statements, canceled checks
- Shareholder/partnership agreement
- Shareholder certificates and stock issue ledgers or transfer log
- Articles of incorporation
- Minutes of stockholder meetings
Initial Assessment of Appreciation
Once a separate property ownership interest in the business is established, the appreciation of the business value can be determined. The measurable period of appreciation begins from the date of marriage to the current date or date of separation. Although this may be an over-simplification, a relatively easy way to determine if the business has appreciated is to compare the gross sales as of the date of marriage to the current gross sales. Also, a comparison of the balance sheet’s net book value or equity can be used as an indicator of business growth. If any of these financial indicators show a significant increase, the value of the business has likely appreciated.
Pereira or Van Camp?
Generally, the Pereira valuation method benefits the community, and the Van Camp method benefits the separate claimant. Whether or not a bias exists, the decision to use one method over the other depends upon the degree of influence from the income-producing enhancements inherent in the business structure, or from the efforts the owner has had on the income earnings process and eventual growth of the business.
The Pereira method is used primarily when the appreciation of value is directly related to the efforts, skill, and ability of the owner/operator. This method assumes that appreciation of value during the marriage is allocable to the community subject to a reasonable rate of return on the claimant’s separate interest.
The Van Camp method is used when the appreciation of value is due primarily to the attributes and income enhancements established within the business structure, rather than solely relying on the influence of the owner’s efforts. The “natural enhancements” inherent in the business are also described in Estate of Neilson, 57 Cal. 2d 733 (1962). When this method is used, the owner/operator’s “reasonable compensation” is assessed to determine if the community was sufficiently compensated during the marriage.
The following are general business attributes that apply to each method:
- Applicable to small businesses and professional service industries where the owner has a direct influence on the business operations and generation of income;
- The owner provides direct services, and charges the customer for those services;
- The owner’s services represent a significant portion of the income earned by the business and can be materially affected by the owner’s absence; and
- General business categories include small retail, legal, medical, dental, plumbing, general contracting, and other service oriented businesses
- Applicable to larger business operations with an apparent corporate structure, and often includes departmentalization;
- Business operations utilize specialized equipment or technology and employ marketing strategies. They also invest in research and development and other income-generating enhancements independent of the owner/operator; and
- General business categories include manufacturing, technology, software, Internet, service industries, construction, and others
Van Camp Analysis: Diminishment of Spousal Efforts
Initially, it is difficult to imagine any justification for the diminishment of the owner’s community efforts in the operations of the business and the resulting value earned during the marriage. However, when a critical analysis of a company’s business operation is conducted, it is evident that there are other business attributes and income-generating enhancements in place that contribute to the appreciation of value further justifying a Van Camp evaluation. These business attributes include the following:
- Significant capital investment
- Research and product development costs
- Key employees and managers
- Customer relationships established by key sales personnel
- Product innovation and diversity
- New and significant customer relationships
- Intangible assets such as trademarks or patents
- New technology and innovation
- Investment in income-producing equipment and other capital purchases
- Company expansion, leading to increased market share
- High barriers to entry in the industry, limiting competition
- Exclusive contracts with customers, limiting competition
- Possibility that owner has a non-controlling interest in the company
- Favorable or upward trends in economic conditions
- Purchase or merger of other businesses
- Synergistic valuations
- Industry valuation premiums
Today’s Economic Paradigm
Considering the above issues, it is apparent that new technology-based ventures, which include information, software, and Internet-based companies, can widen the Van Camp net. Technology companies generally evolve from initial research and development to create a marketable product or service. Today’s economic paradigm includes the emergence of new technologies and services such as application developers, social media and support, click advertisers, software developers, and other Internet-based ventures.
In the technology industry, growth and appreciation in value can be largely dependent upon capital investment, usually from outside venture capitalists. Consideration should also be given to other components of the business that contribute to the income earnings process, such as the cost and development of proprietary assets, and the participation of intellectual capital to include software developers and other key employees.
Therefore, the owner’s efforts and influence on the earnings process and appreciation of value related to a technology-based business may be diminished due to the direct influence of income-producing enhancements inherent in the business structure. Furthermore, valuation models that apply to technology and Internet-based companies may include premiums that are not traditionally applicable to brick-and-mortar businesses. These valuation premiums are often independent of the owner’s efforts and involvement with the business operations.
When analyzing the business operations under both methods, consideration should be given to the extent of any causal relationship between the owner’s efforts, production of income, and the growth of the business. Pereira, 156 Cal. at 3. The evidence of the owner’s involvement in the business operations during the marriage should be documented by assessing the extent of the owner’s involvement and influence with all aspects of the business operations to include the following:
- Hourly time requirements involved in the business
- Corporate governance
- Financial management
- Development and implementation of strategic plans and policies
- Development of key products, services, or technology
- Marketing and sales efforts
- Management of human resources
- Production management
- Development of trademark and other valuable intangible assets, or serving as the face of the company, i.e. the “Martha Stewart” premium
Although the separate claimant may successfully justify the application of the Van Camp valuation method, the courts can exercise wide discretion in the apportionment of value related to the separate business. The California Supreme Court has in fact confirmed that the community must receive a “fair share” of income derived from community efforts. See Beam v. Bank of Am., 6 Cal. 3d 12, 17 (1971).
The Pereira and Van Camp valuation methods are commonly referred to in a synonymous fashion. However, these methods contain stark differences that can result in materially different outcomes. The determination of the applicable valuation method is not a clear-cut election and should not be based upon the benefits derived. Each situation is different, requiring a thorough analysis of the business operations and the identification of income-producing enhancements inherent within the business, as well as the owner’s participation and influence on the income earnings process. The completion of a detailed financial analysis, often involving complex business structures, and including technology-based companies, will provide adequate support for the application of the appropriate case law.
David V. Hanzich MBA, CPA, ABV/CFF/CGMA, CVA, CFE is the owner of Hanzich & Company, Certified Public Accountants in Tustin. The firm specializes in forensic accounting and expert witness services for civil litigation and family law matters. David may be contacted at firstname.lastname@example.org.