Another Big Decision: Personal Goodwill in Kentucky

Apparently the new frontier in divorce litigation is personal goodwill. Following closely on the heels of May (W.Va.2003) and other divorce decisions, the Supreme Court of Kentucky held recently that the non-transferrable goodwill of a professional practice was properly excluded from the marital estate.

The subject business in Gaskill v. Robbins (2/17/09) was an oral surgery practice, operated by the wife, without associate professionals. The wife’s expert presented an asset-based valuation, giving no value to goodwill because “Gaskill’s role in the business amounted to a ‘non-marketable controlling interest.'” The wife’s expert reasoned that no buyer would pay more than the fair market value of hard assets when the wife could set up shop down the hall and attract her patients away from the old practice.

The husband’s expert considered several approaches: capitalization of earnings, excess earnings, net asset value, and market comparables. He averaged these approaches to arrive at a valuation that included goodwill and a non-compete agreement. He also criticized the opinion of the wife’s expert who had doubled the compensation of the wife’s non-professional staff, thereby depressing earnings.

The trial court adopted the valuation of the husband’s expert, reasoning that the salary adjustment made by the wife’s expert was unreasonable, and noting that Kentucky law did not recognize a distinction between enterprise goodwill and personal goodwill.

The Kentucky Court of Appeals reversed, holding that not all businesses have goodwill; and the Supreme Court of Kentucky affirmed that reversal on other grounds.

In its Opinion, the highest court of Kentucky examined the fair market value standard and the meaning of “goodwill” in the context of business valuation. The Kentucky court noted that none of its prior decisions had specifically considered the difference between enterprise goodwill and personal goodwill but none had prohibited such an analysis. The Court recognized that the reputation and skill of this professional practice were closely associated with the wife and might not be transferrable to a buyer. The Court also noted that professional degrees are not regarded as marital property to be divided upon divorce under Kentucky law.

The Kentucky Supreme Court also considered the decision of the West Virginia Supreme Court in May v. May (2003), which contained a survey of cases dealing with goodwill nation-wide. May, in turn, relied heavily upon the Indiana Supreme Court’s decision in Yoon v. Yoon (1999), which distinguished between transferrable enterprise goodwill and non-transferrable personal goodwill. Ultimately, the Kentucky court aligned itself with these courts in reaching that distinction.

See also Helfer (W.Va.2007); Stewart (Idaho 2007); Hess (Maine 2007).

Gaskill joins a long list of cases that distinguish personal goodwill from enterprise goodwill in the context of professional practices. It will be interesting to see, in the future, whether these courts will extend this rationale to other types of businesses, where the reputation, skills and efforts of the business owner spouse are not so easily associated with the goodwill of the business.

Executive Compensation

An intriguing article, published recently by BVR on its BVWire blast email, reminds us that executive compensation is one of the most important components of a business valuation. The article summarizes a lecture given by Brian Brinig at the California CPA 2008 BV Conference, in which he challenged the term “reasonable compensation adjustment” as well as the methods that are commonly used to arrive at this normalization adjustment to the income statement.

Mr. Brinig would prefer the term “fair-value-of-the-owners’-services adjustment,” which is a mouthful but comes closer to describing the real objective: determining what it would cost to replace the owner with an equally qualified and competent manager. Brinig also indicates that by phrasing the question in this way, valuation professionals can avoid the mistake of valuing non-transferrable goodwill. The question is not whether a neurosurgeon is unreasonably compensated but whether another professional could be hired to replace the neurosurgeon, and at what price.

BVWire also considered whether valuation professionals, who are not generally trained or experienced in executive compensation matters, can qualify to give expert opinions in litigation on this subject. The verdict? If judges are unwilling to disqualify business appraisers from giving testimony on the subject, it must be okay to do so.

WV Looks at Goodwill in Professional Practices

The Supreme Court of West Virginia recently considered the enterprise goodwill of a professional practice in divorce proceedings in Helfer v. Helfer, 221 W.Va. 625, 656 S.E.2d 70 (November 2007).

In Helfer, the business owner’s expert found that his chiropractic practice was worth $41,000, based on a capitalization of earnings. His wife’s expert found the practice to be worth $388,000 based on the excess earnings method. Neither of the experts made a distinction between enterprise goodwill and personal goodwill or placed values on those elements. The trial court adopted the opinion of the business owner’s expert, and the wife appealed, arguing that the trial court failed to consider the value of enterprise goodwill.

I have mentioned before in this blog that the real issue, in matrimonial actions, is whether goodwill is transferrable. Presumably, goodwill emanating from the skills and reputation of a professional is non-transferrable, while goodwill emanating from customer base, trade name recognition, unique goods or services, or other factors indistinguishable from the business itself can be transferred to new owners in a hypothetical or actual sale.

West Virginia, unlike Pennsylvania, has expressly described at least five acceptable methods of valuing a business, two of which are the capitalization of earnings method and the excess earnings method. (The other recognized methods are the Treasury method, the market value approach, and the buy/sell agreement method.) West Virginia precedent requires the court to determine the value of a professional practice and its goodwill if it is determined that distributable goodwill exists.

Since the business owner’s expert, whose opinion was adopted by the court, did not in this case identify the enterprise goodwill, the West Virginia court remanded the case for a determination of the value of enterprise goodwill. The Supreme Court directed the trial court on remand to assign a value of zero to the enterprise goodwill if it found that no enterprise goodwill existed.

Valuation of Private Investigation Firm

The Pennsylvania Superior Court’s 2007 decision in Dalrymple v. Kilishek is relatively unremarkable from a valuation perspective. The subject business was a private investigation firm owned by the husband, which was the chief marital asset. Apparently its assets, which were valued at $45,000 as of the date of separation, were mostly or entirely dissipated by the time of trial. Since there were few or no assets left to distribute, the trial court applied the concept of “equitable reimbursement,” requiring Husband to pay Wife 60% of the DOS value of the business in installment payments over time. Additionally, Wife received an award of alimony based upon the gap between her income and her reasonable needs.

The husband argued that the trial court had erred in its valuation of his business, but his argument was deemed waived for failure to cite relevant authority in his brief. The Superior Court also noted that he had not produced business records in discovery, citing confidentiality of his clients’ matters. The Superior Court noted that the records could have been produced in a redacted or summary form. For these reasons, the trial court’s decision was sustained.

One issue that did not arise in this decision is personal vs. enterprise goodwill. A private investigation firm would seem to be a good example of a business whose goodwill is not transferrable. Therefore, a capitalized earnings approach may not have been fruitful in determining the value of the business. This issue was not reached by the Superior Court, however.

Ackerman Not the Mandelbaum of Reasonable Comp Cases

A recent California divorce decision, Marriage of Ackerman (2006), has been hailed by BVWire as the “Mandelbaum of reasonable compensation cases.” Yet, it is still unclear whether Ackerman will be as influential as Mandelbaum was on the issue of marketability discounts. Certainly, Ackerman is not as thorough and comprehensive in discussing the factors that a court should consider when determining the reasonable compensation of a manager/owner in the context of business valuation. Still, the California court’s decision is worth noting.

In Ackerman, the divorce court was presented with two competing valuations of a plastic surgeon’s medical practice. While the professional practice was non-marital property, its increase in value was community property subject to division upon divorce. Both experts used an “excess earnings” approach to valuation, but their comparative data for reasonable owner’s compensation was different.

In his valuation, the surgeon’s expert reviewed data culled from American Medical Associations’ national survey of self-employed surgeons. The expert determined the margin that surveyed surgeons were earning by dividing their net income by their gross revenues. The husband’s expert then applied that margin to the husband’s gross revenue to determine his reasonable compensation. The expert also made an informal survey of local surgeons as a “sanity check” after the expert reports were filed and exchanged.

The wife’s expert used data from the Medical Group Management Association’s survey of physicians’ compensation by geographic region, specialty and years in practice. The result of this survey was approximately one-third of what Husband was actually earning (which would have led to a much higher valuation of the husband’s practice). Frankly, this fact seemed to be the most persuasive reason why the court reached its decision in this case.

The court complained that neither party had introduced a vocational rehabilitiation expert or headhunter to testify about reasonable compensation. The court also complained that the data used by the wife’s expert was not applicable because it was a survey of employee physicians instead of self-employed physicians. But the husband’s expert used national survey data rather than regional or local data, not specific to the medical specialty of plastic surgery, averaged over a period stretching back to 1996. The wife has filed a request for rehearing in the Superior Court of California. It will be interesting to see if this decision is reversed.

More Personal Goodwill – Baker

In Baker v. Baker (2004), a predecessor to the Smith case reported previously in this blog, the Superior Court considered the intangible goodwill value of a veterinary practice located in rural Lycoming County. The husband, who was a sole practitioner, had purchased the practice of a deceased veterinarian for $250,000 (including real estate worth $90,000) approximately six months prior to the separation of husband and wife. Aside from $10,000 withdrawn by the husband from his marital retirement accounts, his purchase was entirely financed by loans.

In the Lycoming County divorce proceeding, the veterinarian’s wife offered the report and testimony of her valuation professional, David G. Bohlander of Analytics, Inc., regarding the value of the husband’s veterinary practice. Mr. Bohlander determined the value of the practice as of year-end 2002, two years after the date of separation. Husband offered no expert of his own.

The trial court accepted the opinion of wife’s expert that the equity in Husband’s veterinary practice, including enterprise goodwill, was $99,000. The briefs reveal that the wife’s expert used a discretionary cash flow method as well as a price-revenue multiple to determine the value of the practice. The discretionary cash flow multiple calculated by the wife’s expert was 2.84, which was multiplied by the discretionary cash flow of the previous owner, the deceased veterinarian. The indicated value under this method was $190,000.

Applying the price-revenue method, the wife’s expert multiplied a 0.63 ratio times the projected revenue of the practice in the hands of the new owner, the husband, to arrive at an indicated value of $115,000. Averaging the two methods, the expert expressed an opinion of value of $152,937 for the intangible value of the veterinary practice, which included its name recognition, customer lists and location.

On appeal, Husband argued that the trial court had erred in finding any value which might be attributable to enterprise goodwill. After all, unlike the Fexa case on which the wife’s expert had relied, husband’s professional practice did not employ multiple professionals or experience personnel changes over several decades. Dr. Baker’s veterinary practice was a sole practice more akin to the sole proprietorship in the Solomon case. Husband asked the Superior Court to interpret Solomon as holding that sole professional practices per se lacked any enterprise goodwill value.

Husband also argued that a substantial portion of the equity found by wife’s expert could be traced to the post-separation paydown of the loans by which the practice and real estate were acquired. Husband had paid down the loans by more than $20,000 from the date of separation to the date of the valuation.

The trial court’s decision was affirmed on appeal to the Superior Court.

Clearly, in ruling in favor of the wife, the Superior Court held that a business does not lack enterprise goodwill merely because it is a sole proprietorship. In this case, the fact that the husband had paid substantial consideration to purchase the practice was perhaps critical to the trial court’s decision.

Perhaps just as important, however, is the fact that the husband did not hire his own expert to quantify the personal and enterprise elements of goodwill. The Superior Court cited Litmans, in which the court had resigned itself to accepting uncontradicted evidence of value where no better evidence had been offered. The trial court in this case was faced with a troubling choice: to reject the opinion of wife’s expert and assign no value to the husband’s business, or to accept the report which merely proved the value of husband’s business fully two years after the date of separation. The latter, apparently, was the lesser of two evils.

The lesson: when representing a professional in a sole practice, do not neglect to hire a valuation expert while assuming that the trial court will not assign intangible value to the practice.

Quantifying Personal Goodwill – Smith v. Smith

In Smith v. Smith, the Pennsylvania Superior Court ventured into the murky waters of goodwill, an intangible element of business value. Goodwill may be derived from the positive reputation of a business, its location, and its unique products and services. This type of goodwill is generally known as “enterprise goodwill” in divorce parlance. On the other hand, goodwill also may be derived from the personal skills of a business owner or employee – such as a surgeon or accountant. This type of goodwill is generally called “personal goodwill.”

For many years, the divorce courts of Pennsylvania have held that business goodwill constitutes marital property only if it is transferable to a hypothetical buyer. Goodwill which is not transferable – in other words, personal goodwill – is not marital property. Yet, in more than twenty-five years since the Pennsylvania Domestic Relations Code was enacted in 1980, the courts of Pennsylvania have not attempted to isolate and quantify the mixed elements of personal and enterprise goodwill in a single business – until now.

In Smith, the business owner (who was the husband) operated a trucking business based in Blairsville, Pennsylvania. The husband’s business valuation expert chose the net asset value (NAV) method of valuing the trucking business. Wife’s expert, on the other hand, considered the excess earnings method, the discretionary cash flow method, and the capitalized earnings method. In contrast to the nominal value calculated by husband’s expert, wife’s expert found substantial value (which included intangible value in excess of net asset value). The trial court rejected husband’s valuation and accepted wife’s valuation in its equitable distribution decree.

On appeal, husband’s counsel argued that wife’s valuation included personal goodwill, which was not marital property subject to equitable distribution. Judge Orie Melvin for the Superior Court, while opining that “we suspect that much, if not all, of the goodwill was that of the enterprise,” nevertheless remanded to the trial court to quantify the personal and enterprise elements of business goodwill. Seemingly, this decision establishes a precedent that would require valuation experts in divorce cases to isolate and quantify personal and enterprise goodwill in a business where both might be present.