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BETHESDA, Md. — The need to place a value on a business arises in many contexts, affecting lawyers whose practices range from transactional law to litigation, from family law to tax law. The concept of goodwill often becomes a critical issue in connection with business valuations and can have a significant impact on the ultimate determination of value. In fact, the valuation and classification of goodwill can be the difference between what a client perceives as either a successful or an unsuccessful outcome. This is because a skillful lawyer can use the issues surrounding goodwill to attempt to slash or enhance the value of a business. From a purely accounting perspective, goodwill can be defined as the excess of the value of a business over the fair market value of the business’s individual assets. For example, if a business is determined to be valued at $1 million and the aggregate value of its individual assets, both tangible and intangible, is determined to be $600,000, then the excess, or $400,000, would be considered the value of goodwill. This relatively simple analysis, however, is seldom sufficient. In the context of valuing a business for litigation or other legal purposes, goodwill usually has a more complex meaning. Generally, it is the intangible asset that arises as a result of name, reputation, customer patronage, location, products and similar factors that have not been separately identified and/or valued but that generate economic benefits. The classic definition of goodwill in this regard is found in Joseph Story’s “Commentaries on the Law of Partnership,” Sec. 99 (William S. Hein & Co., 1980)(1841): “The advantage or benefit, which is acquired by an establishment, beyond the mere value of the capital, stock, funds or property employed therein, in consequence of the general public patronage and encouragement, which it receives from constant or habitual customers, on account of its local posture, or common celebrity, or reputation for skill or affluence, or predictability, or from other accidental circumstances, or necessities, or even from ancient partialities, or prejudices.” A similar but more up-to-date definition of goodwill can be found in Department of Treasury Revenue Ruling 59-60, which describes goodwill to include “factors such as the prestige and renown of the business, the ownership of a trade name or brand, and a record of successful operations over a prolonged period in a particular locality.” In essence, goodwill is defined in terms of the increased earnings capacity it creates, or, stated conversely, increased earnings capacity not traceable to specific assets is evidence of the existence of goodwill. TYPES OF GOODWILL Generally speaking, goodwill is a saleable business asset and is properly includable in the value of a business for most purposes. The calculation of goodwill, however, takes on an added dimension when the business being valued is a professional practice. In such situations, it is necessary to distinguish between various types of goodwill. Various jurisdictions and courts refer to the types of goodwill using different terms, but it can be generally broken down into two types. The first type is commercial or business goodwill, that is, the goodwill associated with businesses other than professional practices. The second type is professional goodwill, that is, the goodwill associated with professional practices. Professional goodwill, in turn, can be further divided into two additional types of goodwill. The first subdivision of professional goodwill is sometimes referred to as enterprise goodwill and represents the portion of professional goodwill that resembles business goodwill described above. That is, even professional practices may have goodwill associated with a trade name, location, etc. The second subdivision of professional goodwill is sometimes referred to as personal goodwill and represents the portion of professional goodwill that stems directly from a particular individual’s reputation, knowledge or skill. Though real, personal goodwill presents valuation issues that must be carefully considered in light of the purpose for which the business valuation is being performed. By definition, personal goodwill depends on the continued presence of a particular individual and, consequently, generally it is not considered a marketable business asset. As a result, any valuation of a professional practice must specifically account for the value of personal goodwill, if any, to ensure that if it exists it is not included in the value of the business. That is the difficult part. Going back to the simple example above, if it is determined that $400,000 of the $1 million value is goodwill, what part, if any, of the $400,000 is personal goodwill? If it is determined that none of the goodwill is personal goodwill, then the $1 million value of the business remains unchanged. If, however, it is determined that all of the goodwill is personal goodwill, then the value of the business may drop to $600,000 in certain contexts. Clearly, the existence and value of personal goodwill can have a significant impact on the value of a business. The difficult part of the analysis is to determine if personal goodwill exists in any given business and, if it does, to value it. Concepts such as reputation are very difficult to quantify. Once quantified, it is a daunting task to convincingly explain the process to a judge, jury, opposing counsel or even a client without sounding arbitrary and/or appearing to advance your client’s position without a specific factual basis. METHODOLOGIES There is no magic formula that can determine the existence of personal goodwill or value it. It is necessarily a case-specific endeavor that must be adapted to the unique circumstances of each case. However, certain methodologies have been developed to assist in this determination. In one such methodology, a detailed analysis of the business is performed to identify the various factors that are believed to contribute to the overall goodwill. These factors are virtually limitless and may be different for each business, but include items such as the name of the business, location of the business, existence of certain types of contracts and agreements, pricing, reputation of the business and its principals, and many other factors. For the specific business being valued, a ranking system must be established that, under the specific facts and circumstances present, determines the relative significance of each factor. Once ranked, an analysis is performed on a factor-by-factor basis to determine which, if any, factors indicate the presence of personal goodwill. This analysis is also intended to determine, both on a factor-by-factor level and in the aggregate, the relative allocation between the various types of goodwill. Once allocated, the ultimate treatment of the types of goodwill is dictated by the purpose for which the valuation is being performed. Goodwill often represents a significant portion of the total value of a business. Depending on the purpose for which a valuation is being performed, goodwill may need to be allocated among its component parts, including business goodwill and professional goodwill, and may even need further allocation. The ultimate treatment of the various types of goodwill depends on the context in which the valuation will be used. In all cases, however, a logical and supportable basis for the value and allocation of goodwill is invaluable. John J. Young is an attorney and certified public accountant with the accounting firm of Klausner Dubinsky + Associates in Bethesda, Md. He specializes in litigation support/consulting and business valuations. This article originally appeared in The New York Law Journal, a Recorder affiliate.

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