Business Valuations in Divorce Settlement

By avm

BUSINESS GOODWILL IN CALIFORNIA FAMILY LAW

Three issues must be addressed in valuing business interests for the purposes of property settlements in family law. They are:

  • Personal vs. Institutional Goodwill (Personal and Professional Goodwill are similar in nature – personal applies to all types of companies and professional applies to professional practices (i.e. medical practice, law firm, etc.)
  • Intellectual Properties that may be held by a divorcing spouse, or by the business entity.
  • Minority Interests in business investments, which may dictate substantial discounts in value for lack of control and/or lack of marketability.

 

GOODWILL IN GENERAL

A principal area of contention is over the issue of goodwill value. The term itself in the valuation context, is usually used to mean that portion of the total asset value of a business after values have been assigned to all other assets. For example if a business with fixed assets of $10,000,000 is sold for $20,000,000, and there are no discrete intangible assets (i.e. patents, copyrights, etc.) the difference is considered non-discrete intangible asset (goodwill) value. (Discrete intangibles will be discussed in a separate section.)

 

The term “goodwill” is often confusing, because it may mean different things in different contexts. In some contexts it is not a quantifiable term, and is qualitative only – such as “a company has been in business for 100 years and enjoys goodwill in the community”. It may in fact have no goodwill value from a valuation context.

 

In the accounting context, it is the value that remains after the fair value of all the other assets are considered. It arises primarily in transactions. For example, if a company sells for $10,000,000 and has only $5,000,000 in tangible assets, it would have, for simplicity, $5,000,000 in goodwill value, as reflected on the new balance sheet.

 

It gets further complicated because “goodwill” shown on the books may be an arbitrary purchase price allocation rather than a fair value. This occurs because when a business is sold, the parties allocate the purchase price to various asset classes. This is for the purposes of establishing the “book value” and is not necessarily an indication of the fair value. There is no particular way in which this is done if the company does not follow GAAP accounting principles (which few do). It is based upon an agreement between the buyer and seller and may bear no resemblance to the actual fair value for the assets. The key point is that both parties must agree, and submit concurring signed schedules on their tax returns which establish the basis.

 

For instance, in states where sales tax is charged on sales of fixed assets, the parties may arbitrarily agree to allocate the majority of the purchase price to “goodwill” which can be amortized over 15 years, in lieu of fixed assets, which normally can be depreciated over 5 years. Although the buyer does not benefit from the 5 year depreciation advantage, the buyer does not have to pay sales tax on the goodwill.

 

For example, consider a sale of a professional practice. Let’s assume a transaction value of $1,000,000. If all of the asset value is allocated to fixed assets, the buyer will pay about 9% for sales tax, or $90,000, but have an annual depreciation allowance of $200,000 a year for five years to offset the ordinary income. Conversely, if the buyer allocates 100% of the asset value to goodwill, then there is no sales tax, but the buyer will only receive $66,666 of amortization expense to offset the ordinary income. However, the buyer will receive this amortization expense for 15 years. The decision as to which election to take will depend on the needs of the buyer. (This does not address personal property which has been depreciated under accelerated schedules. The personal property should be identified and allocated in the purchase and sale agreement and valued so as to eliminate recapture.)

 

The point of this is that the goodwill value shown (or not shown) on the books is irrelevant for the purposes of valuation. These assets must be valued by a valuation, and shown at fair value. (Note, though the term “valuation” was normally used for the valuation of goodwill, and “appraisal” was used for tangible assets, this is a distinction which has been eliminated by NACVA when it took over the IBA, and under the new definitions of terms, that has been signed by all of the major valuation certifying entities, can be used interchangeably.)  

 

As the profits of a company grow, so should the goodwill value. It makes sense. If the company is sold, (or considered for sale in a divorce action) when compared to other analogous companies with similar fixed assets, the buyer is usually willing to pay more for higher profits – and that difference in value is the goodwill. It is termed a non-discrete intangible asset because the value cannot be separated from the basic business enterprise and sold separately.

 

PERSONAL / PROFESSIONAL and enterprise/institutional GOODWILL

The intangible asset value (goodwill) may be comprised of two components: Enterprise/Institutional Goodwill and Personal/Professional Goodwill (terms separated by a slash are essentially interchangeable). Goodwill which is created because of the persona/reputation/contacts of a key owner is termed personal or professional goodwill. (The terms are interchangeable and differ only in context as explained previously.)

 

Enterprise or Institutional Goodwill is the value that is owned by the company per se. Personal/Professional Goodwill is the enterprise value that would be lost if the key person at issue were to leave the enterprise, and worse, compete with it. It occurs frequently in small private companies. It is rarely a significant factor in larger companies. From a valuation point of view it is actually a liability of the company when considering the value of an enterprise.

 

In the real world, mitigation is usually achieved with a non-compete agreement, and an employment agreement (or continued minority interest) for a reasonable period of time after which it is presumed the clientele will have become comfortable with the new owner(s), developed a working relationship with the new owners, and not look elsewhere once the sale is completed. This can be problematic, because a divorcing spouse may not be willing to “sign away” his rights. And without mitigation, the value of his personal/professional goodwill to an enterprise would be lost.

 

goodwill valuation in the courts

How do the courts treat goodwill in family law matters? To understand this issue it is necessary to first put it in the perspective of the various laws in the 50 states plus the District of Columbia. The first issue with seeking guidance from the court cases is their date. Until the Appraisal Foundation, under the direction of Congress, created the Uniform Standards for Professional Appraisal Practice in 1989 (under the FIRREA legislation) there was no universally accepted standard for business valuation.

 

The following is a list of the currently accredited valuation organizations which offer accredited credentials to business appraisers:

  • ASA, since 1981
  • IBA, since 1978
  • AICPA, since 1997, and finally
  • NACVA, since 1991, (now the largest organization of business appraisers and which holds the highest level of accreditation of the group.)

 

All of them either hold to USPAP standards, or their own standards that they deem equal to or greater than USPAP standards, or both. In point of fact the standards are all quite similar.

 

 

COURT CASES

The “prevailing cases” in nine states occurred before USPAP was implemented and before the formation of the now existing system of appraiser qualification and accreditation. There were no standards. California has the most ancient prevailing case –In re Marriage of Foster, 42 Cal. App. 3d, 577, 1974.

 

The trends from the court cases show that as of 2011 there is still considerable disagreement amongst the states as regards goodwill in marital estates:

 

  • 13 States hold that both institutional and professional goodwill are marital assets (This is true of California)
  • 28 States hold that institutional but not professional goodwill is a marital asset
  • 1 State has no decisions at all
  • 5 States have no clear resolution
  • 4 States hold that neither institutional nor professional goodwill is a marital asset

 

(Washington, DC is included as a state, hence a total of 51.)

 

Generally speaking, the 28 states holding that institutional goodwill is a marital asset and professional goodwill is not, have, except for one, prevailing cases dated after USPAP was implemented in 1989. This appears to be the most defensible position in light of modern valuation practice. Therefore, in the 13 states which reflect both as marital assets, there is an opportunity to argue the differences on the merits because of the new standards and better valuation methodologies and showing that the “prevailing case” is based upon antiquated information and procedures.

 

Under the Business and Professions Code §14102 the goodwill of a business is classified as property, and is transferable. Under California law, the goodwill must attach to a business, and for the past 50 years has been valued as a marital asset in dissolution actions.

 

The “prevailing” court case in California is In re Marriage of Foster, 42 Cal App 3d 577, 1974. This was a small medical practice. The case does not distinguish between professional goodwill and institutional goodwill, and implies that all goodwill is a marital asset whether professional, institutional, or both. It puts California in the minority of 13 states that value both professional and institutional goodwill as marital assets without a distinction.

 

Foster refers to Mueller v. Mueller 144 Cal App 2d 245 “the courts have not laid down rigid and unvarying rules for the determination of the value of goodwill but have indicated that each case must be determined on its own facts and circumstances and the evidence must be such as legitimately establishes value.” The court further indicated that the standard of value was not fair market value, but did not replace fair market value with another standard. In a later case, Sharp v. Sharp 143 Cal App 3d 577 (1983) another court of appeals reestablished fair market value as the preferable standard. However, the California Supreme Court denied a petition for hearing, leaving attorneys without clear guidance as to which standard a court is most likely to uphold in a dissolution case. There have been subsequent cases which have shown that despite the fact that a professional practice may have no goodwill value in the marketplace, there is nevertheless significant goodwill value for the purposes of settlement in a divorce. This flies in the face of logic. The California Supreme Court has denied review in all cases involving goodwill in a divorce, and there is no decision that settles the various differences in the court of appeals decisions.

 

The case that lays the framework for treating goodwill in a professional practice as a community asset is Golden v. Golden 270 Cal. App 2d, 401 (1969) in which the court based the opinion on the concept that by virtue of a “wife’s position as a wife” she contributed to her husband’s professional career.

 

There are many other “older” cases that show opinions which are based upon antiquated or otherwise marginally relevant premises. Improvements in appraiser qualifications and standards since those early years allow for more rational and consistent approaches to valuation. This means that current cases must be argued on their merits based upon modern methodologies, and if necessary, the issue must be appealed, and hopefully one day the California Supreme Court will agree to settle the issue.

 

However, the earlier cases and the Foster case do leave the door somewhat open to reason. Since the methods of finding 1) that there is goodwill present, and 2) the valuation approach to valuing the goodwill, are very loose and flexible, appraisers have considerable flexibility in determining reasonable value for divorce purposes. Consistent with Mueller, it requires a complete analysis of the facts and circumstances and application of current valuation methodologies.

 

Additionally, since 1974, there has been an explosion in diversity of private businesses which can claim personal/professional goodwill as well as institutional goodwill. Thus not only the facts and circumstances can be quite different from those considered in previous court cases, which were primarily legal and medical practices, there is now a profusion of data available for comparative valuation which did not exist at that time, including legal and medical practices.

 

DISCRETE INTANGIBLES (INTELLECTUAL PROPERTY)

Discrete intangibles differ from non-discrete (goodwill) in that they can be sold separately from the company per se. For instance, if a patent is owned, the patent can be sold, usually in conjunction with a license agreement to the seller for continued use on a non-exclusive basis).

 

The issue of valuation of discrete intangibles is complex. If patents are licensed to others, and have identifiable income streams, they can be valued using a conventional income approach valuation. However, if they are used internally, they must be valued either on their replacement cost basis, or on the “royalties saved” approach which estimates what expected royalty would have to be paid for the use, which is deducted from the net income, and then the value of the royalty income is capitalized and added to the balance sheet as a discrete intangible asset. By reducing the net income, it will also reduce the non-discrete intangible asset value (goodwill), but the offset is the increased discrete intangible asset value shown on the balance sheet, which is usually a higher value overall. The appraiser must make a determination as to whether the replacement cost, or saved royalty approach, is the best basis for valuation. Valuation of discrete intangibles should be done by a highly qualified and experienced appraiser in this field.

 

MINORITY INTERESTS

Where a marital asset is a minority interest in an enterprise, normally the value would be reduced by discounts for lack of control and lack of marketability. This is considered to be the Fair Market Value of the interest for IRS purposes which set this as the defined standard. In marital law, this is sometimes complicated because some courts did not allow minority interest discounts, and instead relied upon a “fair value” approach which is based upon the pro rata equity value of the enterprise, and not the specific fair market value of the minority interest. This is similar to the “dissenting shareholder” provisions in most states. In these cases, the attorney should work with the appraiser to determine which court cases, if any, will be used as precedent, and what the requirements will be in each case.

 

CONFLICTING vAluations

If a valuation report is performed in compliance with the Uniform Standards for Professional Appraisal Practice (USPAP), (Published by the Appraisal Foundation under the direction of Congress) it will usually be a defensible valuation. If both parties to a marital dispute have their own appraisers, and the reports differ, there are provisions within USPAP for the two appraisers to reconcile their opinions. Usually significant differences arise from differences in information that is presented by their respective clients.

 

Under all established standards, the appraiser is obligated to be an advocate for the valuation, and not for the client. However, there are people who purport to be appraisers, who submit valuation reports that exaggerate their client’s position, which usually is not defensible under USPAP standards. The best approach if this situation is encountered is to entertain a “Daubert challenge”. If your appraiser meets the credential qualifications, and has prepared a USPAP based valuation, they should provide you with specific elements for a Daubert Challenge. This requires a thorough knowledge of USPAP and legitimate valuation industry practices.  

 

The Federal Rules of Evidence says:

 

Rule 702. Testimony by Expert Witnesses

A witness who is qualified as an expert by knowledge, skill, experience, training, or education may testify in the form of an opinion or otherwise if:

 

(a)    The expert’s scientific, technical or other specialized knowledge will help the trier of fact to understand the evidence or to determine a fact in issue;

(b)   The testimony is based on sufficient facts or data;

(c)    The testimony is the product of reliable principles and methods; and

(d)   The expert has reliably applied the principles and methods to the facts of the case.

 

Pursuant to this rule, a party may bring a motion before or during trial to exclude the testimony of unqualified evidence to the judge and/or jury. This has become known as the Daubert standard. There are three United States Supreme Court cases that address the Daubert standard:

  • Daubert v. Merrell Dow Pharmaceuticals,(92-102), 509 U.S. 579 (1993) which held that Rule 702 of the Federal Rules of Evidence did not incorporate the Frye “general acceptance” test as a basis for assessing the admissibility of scientific expert testimony;
  • General Electric Co. v. Joiner, 522 U.S. 136, (1997), 78 F. 3ed 524, reversed and remanded, which held that an abuse-of-discretion standard of review was the proper standard for appellate courts to use in reviewing a trial court’s decision of whether expert testimony should be admitted;
  • Kumho Tire Co. v. Carmichael(97-1709) 526 U.S. 137 (1999) 131 F.3d 1433, reversed, which held that the judge’s gatekeeping function identified in Daubert applies to all expert testimony, including that which is non-scientific.

If a Daubert challenge is successful, the unfounded valuation report will be rejected by the court.

 

It is important to remember that your appraiser should be able to provide a report that will withstand a Daubert challenge, because the opposing side will use the same tactic if they can.

 

conCLUSIONs

In family law, court cases, while providing some guidance, must be analyzed in the context of the nature of the specific situation. Each case must be thoroughly analyzed based upon the facts and circumstances. There is no universal rule of thumb that can be applied. Though there are “prevailing cases” identified for most states, actual review of the family law cases shows many inconsistencies, and a wide variation of approaches that are acceptable.

 

The sophistication of the valuation profession has grown rapidly in the past 15 to 20 years. This makes valuations used as a basis for earlier court cases often questionable.

 

The appraiser must work closely with the attorney to reconcile key issues both from a legal perspective and from a valuation perspective, and these issues should be identified and addressed completely in the valuation report.

 

Finally, there is now a lot of empirical evidence available as to value, and this should be persuasive in and of itself. Databases such as Pratt’s Stats and BizComps did not exist in 1974.

 

 

about the author

Gerald W. Barney began his career as a financial professional in 1971 as a NYSE, ASE, and NASD licensed securities broker with the regional firm Mitchum, Jones & Templeton (later acquired by Paine Webber) dealing in mid-sized mergers and acquisitions and commercial real estate syndications. Since 1983 he has been active principally in providing financial services including, business appraisals, machinery and equipment appraisals, consulting, business brokerage and financing. During the years 1994 through 2003 he was the president of Barney & Associates, Inc., a firm engaged in business brokerage, machinery and equipment brokerage, and business appraisal. In 2004 the business appraisal division was spun off as American ValueMetrics Corp., where Mr. Barney continues to serve as president, and the brokerage operations were spun off as Triaz International.

He is a member of the National Association of Certified Valuators and Analysts (NACVA) and holds the designation Certified Valuation Analyst (CVA) and also the designation Master Analyst in Financial Forensics (MAFF).   He is a member of National Equipment & Business Brokers Institute (NEBB) and holds the professional designations of CMEA (Certified Machinery & Equipment Valuator). He is also a member of the International Society of Business Analysts and holds the designation as a CSBA (Certified Senior Business Analyst).

 

In 2008 the National Commission for Certifying Agencies (NCCA) granted accreditation to NACVA for its CVA designation for demonstrating compliance with the ICE Institute for Credentialing Excellence, making these designations the only ones in the industry to receive this prestigious and internationally recognized accreditation.

 

As an Valuator Mr. Barney has performed valuations of over 10,000 business entities, Intellectual Property and/or equipment assignments throughout the spectrum of industries, from start-ups to billion dollar sales companies.   General qualifications are:

 

  • M.S. Cybernetic Systems, San Jose State University (1980)
  • B. A. Management, Sonoma State University, California (1973)
  • A.A. Engineering, San Mateo College, California (1958)
  • Graduate, New York Institute of Finance (1974)
  • Formerly licensed NASD securities broker. (1972-1974)
  • Licensed California Real Estate Broker
  • Certified Machinery/Equipment Valuator (CMEA)
  • Certified Valuation Analyst (CVA)
  • Master Analyst in Financial Forensics (MAFF)
  • Certified Senior Business Analyst (CSBA)
Posted in .