“Goodwill is the one and only asset that competition cannot undersell or destroy.”
– Marshall Field
Goodwill is also one of the more difficult assets to apportion in equitable distribution. Goodwill represents the portion of a business entity’s value that remains after accounting for the value of tangible assets and all otherwise identifiable intangible assets. Accordingly, despite Justice Ralph J. Cappy’s observation to the contrary in Butler v. Butler , 541 Pa. 364, 378, 663 A.2d 148, 155 (1995), the existence and valuation of goodwill is almost always an issue to address in privately held businesses.
In Butler , the Pennsylvania Supreme Court ruled, unequivocally, that goodwill value that is “intrinsically tied to the attributes and/or skills of certain individuals is not subject to equitable distribution because the value thereof does not survive the disassociation of those individuals from the business. In other words, where such goodwill is attributable solely to an individual’s attributes, it cannot be viewed as a value of the business as a whole. On the other hand, as the court also noted in Solomon , goodwill which is wholly attributable to the business itself is subject to distribution.”
The value of a small business, particularly professional services firms, is often a product of the skills and/or charisma of key personnel. The real question, then, is what portion of goodwill is attributable to one or more individuals and what portion is allocable to the enterprise itself. The former is excluded from equitable distribution; the latter is not.
Three General Approaches to Business Valuation
Whether performed in accordance with the requirements of the Uniform Standards of Professional Appraisal Practice, the accounting profession’s Statement on Standards for Valuation Services No. 1 or the standards of the National Association of Certified Valuators and Analysts, accepted professional standards consider three general approaches to business valuation: asset, market and income. The asset approach, tied as it is to values of discrete assets and liabilities, is difficult to apply to operating companies. Often, these companies have significant value in intangible assets such as the value of an assembled workforce, recognized intellectual property and trademarks and customer data and systems for handling that information. The asset approach works best for holding companies that, generally, do not have meaningful levels of goodwill.
The market approach and income approach, on the other hand, measure value based on the totality of economic returns that the business enterprise generates. Whether applying a market-derived multiple of revenue or gross profit or discounting anticipated future cash flow, these are more common techniques for valuing operating entities. Both of these approaches, however, value the totality of the enterprise, including returns on tangible (inventory, plant and equipment) and intangible assets (intellectual property, workforce-in-place, established systems, policies and procedures, etc.). Assessing goodwill, then, is an exercise in elimination.
While personal goodwill discussions arise most often in the context of professional practices, the specter of this valuation issue can appear in any small business that relies on the work of a “heavy hitter.” The obvious examples are individual physician practices and small law or accounting firms, but consider, for example, a small real estate agency or an insurance brokerage with just one or two salesmen. Consider musicians. Some bands exist and prosper because of the talent or personality of a particular individual or group of individuals, such as The Beatles, which collapsed when personality differences led to discord. Other bands can function and prosper for decades while members come and go; for example, Chicago, which has successfully performed for more than four decades with 16 different musicians joining and leaving the group at various times.
Factors to Consider
The first step in the analysis is to determine if the value driver for the goodwill is entity-related or individual-related. Some factors to consider in this evaluation are:
• Expectations about future revenues. The current value of any business is a reflection of future benefits that are expected to flow through to equity holders. To the extent those future revenues derive from the actions of specific individuals, goodwill value is more likely to be personal. If, on the other hand, the future revenues result from assets, such as intellectual property, belonging to the business entity, the value of the goodwill would belong to the entity as well. Typically, the appraiser needs to parse revenues by source to evaluate this issue. Situations arise where the individual’s skills and reputation are familiar to most attorneys, but careful analysis can show that what appears on the surface to be a product of individual reputation is, in fact, due to entity-level value drivers. For example, imagine a hypothetical actor famous for action films. To participate in the profits of his movies, but insulate himself from liability, he created a production company that owns his share of a variety of films, including those he has starred in and others. In valuing the production company, the appraiser must distinguish between the value that derives from his actual participation in some movies from that which derives from films in which the company merely provides production assistance.
• Level of competition. Particularly relevant to professional practices, the density of practitioners in a geographic region can affect the appearance of personal goodwill. For example, the U.S. Department of Health and Human Services has identified portions of Lancaster County as a Health Professional Shortage Area, indicating that southeast Lancaster City, Pa., is underserved for primary medical care. In valuing the practice of a physician in the area, what might at first appear to be professional goodwill may, in fact, merely reflect a relative lack of competition for patients in the region. In evaluating personal goodwill, the appraiser should consider whether or not the entity provides an essential good or service for which there is no adequate and reasonable substitute. If that is the source of revenue, the value would be transferable to a prospective purchaser and is, thus, enterprise goodwill. Similarly, a business entity and the employee may have entered into a restrictive covenant that prohibits the employee from pursuing a competitive position within the employer’s geographic market. In such cases, the employer may have effectively converted otherwise personal goodwill to an asset of the entity.
• Work-flow issues. The organizational structure of the business and the extent to which the business owners rely on technicians or team members to provide goods or services to customers will have an impact on the degree to which goodwill belongs to the entity or the individual. For example, imagine a hypothetical, self-employed endocrinologist with a thriving practice. A cursory review of financial information for the professional corporation reveals she is the only physician in the practice and, accordingly, this medical practice, at first blush, is a classic example of professional goodwill. Further inquiry reveals that endocrinology involves a variety of diseases, and most of her patients have diabetes, which, with proper medication and nutrition management, can be controlled for long periods. The doctor employs three nurse practitioners who are the primary, and in many cases the sole, contact with all but the most advanced patients. In this case, after evaluating the actual practices of the organization, an appraiser might conclude that most of the goodwill belongs to the professional corporation, which would be transferable, along with the existing workforce, to a prospective buyer.
• Age and health concerns. In multiple-owner professional practices (for example, accounting firms and law offices), there is typically a mix of institutional and professional goodwill. Some clients are drawn to the firm’s name brand or obtained through submissions in response to a request for proposals. Other clients come through individual practitioners’ personal network of referral sources. The age and health condition of the professionals are one factor in evaluating the balance between personal goodwill and enterprise goodwill. As individuals approach retirement, they can be relied upon less to be a source of future revenue, and, to the extent there is goodwill involved, it may be shifting toward the entity (or, alternatively, projected cash flow might be declining). Similarly, changes in health of a rainmaker could have an adverse impact on the individual’s ability to commit time to developing business; absent a successful transition of the rainmaker’s reputation to the entity, future cash flow could decline.
The allocation of value between enterprise goodwill, distributable as a marital asset, and personal (or professional) goodwill, a nonmarital asset, can be a major component of determining the value of a small business. Particularly in service industries and professional practices, tangible assets are a relatively small component of the overall value of the entity. In those types of businesses, an even division of goodwill between personal and enterprise can easily result in a one-third reduction, or more, in the value of the marital asset. Detailed analysis of the nature and operations of the business, as well as the circumstances surrounding the professional goodwill allocation, are critical to a proper valuation of the business interest. •
Michael J. Molder is a senior manager in the advisory group of Marcum LLP. He uses more than 25 years of experience as an accountant and litigator to analyze financial misconduct and damagesand value business interests and other intangible assets. Molder can be contacted at firstname.lastname@example.org.