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Valuation in Divorce (Personal Goodwill vs. Enterprise Goodwill))

by

Charles F. Vuotto, Jr., Esq. and Barry S. Sziklay, CPA, ABV, PFS
(With special thanks to Cheryl Connors, Esq.)

 

            This article shall explore whether New Jersey follows the majority of states which do not distribute “personal goodwill” in a divorce.  Based on an analysis provided by the New Jersey Supreme Court in Dugan v. Dugan, 92 N.J. 423 (1983)  and other relevant New Jersey cases, the authors suggest our courts intended to provide for the distribution of only “enterprise goodwill” (defined as “that which attaches to a business entity and is associated separately from the reputation of the owners and will transfer upon the sale of the business to a willing buyer”) and not “personal goodwill” (defined as “that part of increased earning capacity that results from the reputation, knowledge and skills of individual people”). See May v. May, 589 S.E. 2d 536 (W. Va. 2003).  With those definitions in mind, it is suggested that the goodwill of many service businesses, such as professional practices, consists largely of personal goodwill.

Overview of the Law of “Goodwill”

            A.  Decisions of Other States:

            The recent West Virginia case of May v. May, 589 S.E. 2d 536 (W. Va. 2003) provides an excellent overview  of this issue, stating that divorce courts in most states agree that “personal goodwill” should be excluded from the property distribution and if any goodwill is to be distributed, it should be limited to “enterprise goodwill.”  This avoids, or at least reduces, the “double-dip” when a portion of the business value based on the business owner’s income is distributed to the non-owning spouse and that same income is used to fix spousal and child support obligations

            In May,  the husband operated a dental practice.  The trial court adopted the fair market value of the practice submitted by the wife’s expert, including a value for goodwill.  The husband appealed.  Id. at 540.  The appellate court held that the lower court erred in adopting a valuation which included a value for goodwill.  Id. at 551.  The May court further discussed three approaches taken by various states:  1) thirteen states make no distinction between personal and enterprise goodwill in a professional practice and hold that both constitute marital property;  2) five states hold that neither personal nor enterprise goodwill in a professional practice constitutes marital property; and 3) twenty-four states hold that personal goodwill is not marital property while enterprise goodwill is marital property.  Id. at 543-46.  The May court adopted the third approach and stated:

Personal goodwill, which is intrinsically tied to the attributes and/or skills of an individual, is not subject to equitable distribution.  It is not a divisible asset.  It is more properly considered as the individual’s earning capacity that may affect property division and alimony. On the other hand, enterprise goodwill, which is wholly attributable to the business itself, is subject to equitable distribution.  

 

Id. at 547.  The court reasoned that this holding was consistent with its declaration that a professional degree is not marital property subject to equitable distribution.  Id.  Thus, the court held that personal goodwill is an asset that cannot be separated from its holder.  Id

            Finally, in 2008, Maine has resolved the issue of whether it would include the value of personal goodwill in its calculation of equitable distribution.  Ahern v. Ahern, 2008 Me. Lexis 1 (January 3, 2008) outlines that State’s concerns regarding personal goodwill compared to enterprise good will and whether those concerns should come into consideration in divorce matters. 

            The Aherns were married 21 years when the complaint for divorce was filed.  Mr. Ahern was a dentist and the sole principal in a practice which was acquired during the marriage and therefore subject to equitable distribution.  It was the first time Maine addressed whether personal goodwill in a practice (such as the dental practice) was subject to equitable distribution.  The court went further to note that the majority view in the United States is that such a practice is not subject to equitable distribution.  In this matter, however, both parties’ experts agreed that Mr. Ahern’s business had goodwill, but neither could agree on the number or attribute a number to that value it purportedly held.  The one thing both experts did agree upon was that the value of the goodwill of Mr. Ahern’s business was attributable to his skill and reputation.

            The Court defined enterprise goodwill as “intangible, but generally marketable, existence in a business of established relations with employees, customers and suppliers that may include a business location,” name recognition and reputation.  Frazier v. Frazier, 737 N.E. 2d 1220 (1225 (Ind. Ct. App. 2000).  Personal goodwill, following May, was identified as being “. . . associated with individuals.  It is that part of increased earning capacity that results from the reputation, knowledge and skills of individual people.”  May v. May, 589 S.E. 2d 536, 542 (W. Va. 2003).  The court in Ahern found that an insurance agency has goodwill and its value is divisible upon divorce.  A professional practice, degree or license, however, such as Mr. Ahern’s dental practice, is not divisible.  The ultimate reasoning was that personal goodwill of a professional practice was not a “species” of property and therefore not subject to equitable distribution.

            B.  New Jersey Decisions:

                        In one of the earliest New Jersey cases addressing whether goodwill is available for equitable distribution in a divorce, the court discussed whether there was an intangible asset of goodwill to be evaluated in distributing the value of the husband’s law practice. Levy v. Levy, 164 N.J. Super. 542 (Ch. Div. 1978).  The husband was a solo practitioner for many years and in the year before the divorce, he hired an associate and incorporated as a professional association.  Id.  The court explained that goodwill is measured by excess net earnings and stated that it requires a comparison of the net earnings with the reasonable value of the personal services which produced them to determine the excess net earnings for a service organization.  Id. at 547.  The court concluded as follows:

. . . determination of goodwill is a question of fact and not of law; expert opinion on the subject is helpful, but like any other evidence, not conclusively binding upon the tryer of the fact; what is being measured in the final analysis are those “excess earnings” of an enterprise which are properly attributable to its goodwill, and they are to be derived by deducting from the properly determined average earnings whatever reasonable amounts are appropriate to compensate for a proper return on the capital or the reasonable value of the personal services or both, to the extent that either enters into the production of the income of  the enterprise.  What is being measured is in reality the capacity of repeat patronage and a certain immunity to competition to produce earnings beyond the average for that kind of business.  Hence, the multiple to be applied by way of “number of years purchase” will vary inversely with the amount and intensity of competitiveness in the line of business being appraised. 

 

Id. at 553-54. (Emphasis added.) 

             By deducting a “proper return on the capital and the reasonable value of the personal services,” the authors assert that the Levycourt was intending to exclude “personal goodwill” from the computation.  In light of these conclusions, the court determined that there was no goodwill in the husband’s law practice.  Based on the expert opinion, the court concluded that the value of the husband’s personal services would not be less than the average earnings of his practice and thus no excess net earnings would exist.  Id. at 555. 

            In Dugan v. Dugan, 92 N.J. 423 (1983) the New Jersey Supreme Court defined goodwill as “essentially reputation that will probably generate future business” and held that the attorney’s goodwill in his solo practice was a marital asset subject to equitable distribution.    Id. at 429.  Goodwill, the court held, includes “a whole host of intangibles including the quality of management, the ability of the organization to produce and market efficiently, and the existence and nature of competition.”  Id. at 430.  The court explained that the price paid for goodwill “is equivalent to the excess of actual earnings over expected earnings based on a normal rate of return on investment.”  Id. at 431. 

            The Dugan court declared that goodwill does not exist at the time a license to practice law is obtained.  Id. at 433.  Rather, reputation is at the core of goodwill in a law practice and is earned after accomplishment and performance.  Id.  The court stated:  “Future earning capacity per se is not goodwill.  However, when that future earning capacity has been enhanced because reputation leads to probable future patronage from existing and potential clients, goodwill may exist and have value.  When that occurs the resulting goodwill is property subject to equitable distribution.”  Id.  The court reasoned that following a divorce the law practice will continue to benefit from the goodwill it developed and had during the marriage and the non-attorney spouse’s contribution to that goodwill should not be ignored.  Id. at 434.       

            In valuing goodwill in a law practice, the court should first ascertain what an attorney of comparable experience, expertise, education and age would be earning as an employee in the same general locale.   Next, the attorney’s five year net income before federal and state income taxes should be averaged and then be compared with the employee norm.  If the attorney’s actual average exceeds the total of the employee norm and a return on the investment in the physical assets, the excess would be the basis for evaluating goodwill. Where information about a comparable attorney is unavailable, it is possible to evaluate the partnership agreement that sets forth value in excess of capital accounts.  Id. at 440. Given these conclusions, the Dugan court remanded to the trial court to determine the value of the husband’s law practice with respect to goodwill and accounts payable and to modify equitable distribution.  Id. at 444. 

            The next significant case is Piscopo v. Piscopo, 232 N.J. Super. 559 (App. Div. 1989),  which addressed the issue of celebrity goodwill.  Id. at 560.  The husband (Joe Piscopo of Saturday Night Live fame) conceded that celebrity goodwill was a distributable marital asset but argued that goodwill could not be distributed in his case because his reputation as a celebrity could only be related to possiblefuture earnings.  Id.          

            The appellate court agreed with the trial court’s analogy to the professional goodwill in Dugan, finding that “the goodwill value of plaintiff’s business was a distributable marital asset.”  Id. at 562, 565.  Under Dugan,“the valuation of goodwill is not measured by future earnings, but by past earning capacity and the probability that such past earnings will continue.”  Id.  The court determined that the plaintiff had achieved celebrity during the marriage and that his record of past earnings was undisputed.  Id. at 563.  The court further stated that “[w]hile the trial judge recognized that it would be difficult to value plaintiff’s celebrity goodwill, that difficulty would not affect its includability in the marital estate.”  Id.  Thus, the court held that the celebrity goodwill of the husband’s corporation was a distributable marital asset.

            In Berrie v. Berrie, 252 N.J. Super. 635 (App. Div. 1991), the appellate court rejected the husband’s argument that one person’s effort cannot be determinative of the value of a public corporation.  Id. at 643. As a business grows, the court stated that it becomes a question of fact of how much one individual influences the value of the business.  Id.  “The issue becomes intertwined with the valuation of the entity’s goodwill, which is itself equitably distributable in an appropriate case.” (Emphasis added.)  Id

            With respect to a public corporation, the court explained that “[t]he efforts expended by the principal or even his or her mere presence may cause a willing buyer to pay more for the stock.”  Id.  Moreover, the court stated that “the fact that market forces might combine with such effect to control the price of the stock does not eliminate the factors relating to the individual.  Each can be analyzed separately, one as a passive factor, the other as an active factor.”  Id.  Thus, the court held that expert analysis was admissible to determine whether the husband’s efforts had an effect on the value of the corporation, and if so, whether any part of the premarital cohabitation period could be considered in determining the base from which any active increase in the value would be measured for purposes of equitable distribution.  Id. at 644. 

In Seiler v. Seiler, 308 N.J. Super. 474 (App. Div. 1998), the husband operated an insurance agency exclusively representing Allstate. Id. at 476.  The husband was an employee of Allstate, could hire and fire employees only with the consent of Allstate, collected all insurance premiums in trust for Allstate without any deduction for commission or expenses, and received an allowance for expenses from Allstate.  Id.  Allstate owned all of the office equipment, assigned the phone number for the agency, maintained the signs for the agency, and designed and paid for all advertisements.  Id. at 477. Although goodwill existed in the insurance agency, the court determined that the goodwill belonged to Allstate and not to the husband who was deemed an employee.

Financial and Economic Considerations

            Although goodwill has been defined in a variety of ways;  the key financial and economic point is this: however defined, goodwill represents expected future economic benefit from an asset, albeit the most intangible of intangible assets.  The capitalized excess earnings valuation method is commonly used (and oftentimes, misused) by business appraisers to quantify the value of enterprise goodwill, which appears to be the only distributable asset.  To do so, one must:

1.                  Estimate the net tangible asset value for the subject business…

2.                  Estimate a normalized level of economic earnings…

3.                  Quantify the amount of excess earnings…

4.                  Estimate an appropriate direct capitalization rate to apply to the amount of excess economic earnings…

5.                  Capitalize the excess economic earnings at that estimated direct capitalization rate…

6.                  Add the values from step 1 (i.e., the net tangible asset value) and step 5 (i.e., the intangible value).  The sum of these two values indicates the value of the subject business.

7.                  Perform a sanity check by calculating the implied overall capitalization rate.

 

Shannon P. Pratt, CFA, FASA, MCBA, MCBC, CM and AA & Alina V. Niculita, CFA, MBA, Valuing a Business:  The Analysis and Appraisal of Closely Held Companies pp 334-335 (New York:  The McGraw-Hill Companies, Inc., 2008.

The definition of “normal level of compensation,” as stated above, is one of the most litigated aspects in the valuation of closely held businesses.  The failure to normalize owner compensation may lead to the distribution of personal – rather than enterprise – goodwill.  To the extent that the business appraiser understates reasonable compensation, the business value will ultimately be overstated.  Barring the court compensating for this error through a reduction of the non-owner spouse’s equitable share of the business, this failure to normalize owner compensation may result in a possible distribution of personal goodwill.   Likewise, overstating reasonable compensation could lead to an insufficient distribution of value unless the court compensates by increasing the allocation percentage.  In any event, it is incumbent upon the business appraiser to present a credible analysis to the court in this respect.             

Inherent difficulties in this undertaking include, but are not necessarily limited to: properly identifying and measuring the value of different tasks performed by the owner; estimating adequate compensation to the business owner based upon his or her experience, expertise, education and age as compared to an employee in the same general locale (Dugan factors. Id.); estimating the required rate of return on the owner’s investment; estimating the cost of obtaining a replacement for the business owner; and ensuring that earnings are properly being attributed to the superior ability and competency of the business owner (“personal goodwill”) as opposed to the enterprise (”enterprise goodwill”).  In short, goodwill should only be considered enterprise goodwill if it would continue to exist in the enterprise if the practitioner were not present.  (See Deluxe BVUpdate – October 2000 (Judges and Lawyers), Editor’s Column, “Practice” goodwill must be independent of the practitioner.)  

Thus, it is oftentimes insufficient to simply compare a particular professional or entrepreneur’s compensation to some survey “average” or “median” comparable individual compensation level.  Rather, the business appraiser has to analyze the business owner’s unique experience, education, expertise and age, as the Dugan court noted.  In making that analysis, the business appraiser should review a person’s curriculum vitae, employment history, number of hours worked, specific job responsibilities, time spent per day, per week and per month by task, and the quality and success of the individual’s endeavors. 

Furthermore, in real transactions, a standard ‘deal” term is the expectation that the seller shall enter into a commercially reasonable covenant-not-to-compete (“covenant”).  A business appraiser in estimating value using a fair value (Brown v. Brown, 348 N.J. Super. 466,cert. denied, 174 N.J. 193 [2002]) standard of value for New Jersey matrimonial dissolution purposes is implicitly assuming that the business owner shall be (not would be) entering into a commercially reasonable covenant.  (Caveat:  Such a covenant is not even possible in the context of a law firm valuation.)  In the absence of such an assumption, the appraiser’s valuation of enterprise goodwill (and therefore, the business as a whole) should be reduced by the estimated value of a lack of a covenant. 

The manifestation of goodwill is in enhanced cash flow.  The business appraiser’s task is to separate out, to the extent possible, the enhanced cash flow attributable to the business owner and who he/she is (personal goodwill) versus the enhanced cash flow attributable to the business itself (enterprise or practice goodwill).  Until the aforementioned analysis is satisfactorily completed, the business appraiser is not in a position to reach a valuation conclusion to a reasonable degree of professional certainty.

Conclusion

            From a legal standpoint, we see from Levy that the goodwill being valued is determined by “those ‘excess earnings’ of an enterprisewhich are properly attributable to its goodwill.”  Levy, 164 N.J. Super. at 553-54. (Emphasis added.)  In Dugan, the New Jersey Supreme Court explained that the price paid for goodwill “is equivalent to the excess of actual earnings over expected earnings based on a normal rate of return on investment.”  92 N.J. at 431 [emphasis added].  That investment includes the long years of education, educational cost, work experience and a host of other factors that must be quantified and deducted from the “expected earnings” to determine “excess” earnings. 

It thus becomes imperative that the business appraiser properly evaluate the reasonable compensation of the business owner by taking into consideration all of the Dugan guidelines, not blindly relying upon averages or median levels of compensation contained in compensation surveys.  In valuing goodwill in a law practice, the Dugan court described one method that would consider “the amount by which the attorney’s earnings exceed that which would have been earned as an employee by a person with similar qualifications of education, experience and capability.”  Id. at 439. (Emphasis added.)  It is very possible that an employee with similar qualifications of education, experience and capability will earn substantially the same as the subject professional; therefore, there will be little or no goodwill.  This does not mean that the Dugan Court’s approach is wrong or that it must be tweaked to back into a value, but rather recognized as an intentional element needed to exclude “personal goodwill” from being distributed.    

Likewise, in considering the asset of celebrity goodwill, the court in Piscopo concluded that the “goodwill value of plaintiff’s businesswas a distributable marital asset.”  In Berrie, the court stated that “[t]he issue in the case (i.e., the extent of Mr. Berrie’s impact on the increase in value of the company) becomes intertwined with the valuation of the entity’s goodwill, which is itself equitably distributable in an appropriate case.”  252 N.J. Super. at 463. (Emphasis added.)  Again, we see the importance of “entity” or “enterprise” goodwill.  In Seiler, the husband operated an insurance agency exclusively representing Allstate.  308 N.J. Super. at 476.  Although goodwill existed in the insurance agency, the court determined that the goodwill belonged to Allstate and not to the husband who was deemed an employee.  Id. at 477.  The Seiler court noted that no case in New Jersey has recognized goodwill “as an asset unassociated with the business entity,” and thus, it was Allstate’s goodwill and not the personal goodwill of the husband that mattered.  Id. at 480.  

            Lastly, business appraisers must consider that in the real world, a business seller is expected to execute a covenant-not-to-compete in the ordinary course of selling a business, particularly in connection with the sale of a professional practice.  If the appraiser does not acknowledge this obligation, the preliminary valuation must be reduced by the value of the missing covenant. 

            Failure to take the preceding issues into consideration in a business appraisal may result in the gross overvaluation of the business or professional practice; thus leading the court to effectively distribute personal, as opposed to enterprise, goodwill in the absence of a downward adjustment to the percentage share awarded to the non-titled spouse. 

Charles F. Vuotto, Jr., Esq. is a shareholder with Wilentz, Goldman & Spitzer, P.A.

Barry S. Sziklay, CPA, ABV, PFS is the Co-Managing Member of The Sziklay Borresen Group, L.L.C. 

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