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Professional v. Enterprise Goodwill

A Deeper Dive Shannon Farr, CPA·ABV·CFF Decosimo Advisory Services | 423.756.7100 | ShannonFarr@Decosimo.com October 24, 2012

Shannon Farr, CPA, ABV, CFF Business Valuation Manager

(800) 782-8382 | shannonfarr@decosimo.com

Shannon Farr is a valuation manager in Decosimo’s Chattanooga office with more than 15 years of accounting experience. Her practice has focused on business valuation and litigation since 2004. She is accredited in business valuation (ABV) and also certified in financial forensics (CFF). Shannon provides valuation services to clients in a wide variety of industries, with a focus on healthcare entities. Her specialized expertise in this area assists hospital and health system clients in ensuring their acquisitions meet industry regulations surrounding the concepts of fair market value and commercial reasonableness. Her litigation support experience has been used in numerous marital dissolution cases as well as contract and shareholder disputes involving physicians. Shannon provides expert witness testimony, as well as serving the court as Special Master.

Debates, questions, comments, etc. at the end of the presentation as time allows

Identify practical solutions to apply in professional practice valuations

Discuss precedent-setting cases in Tennessee

Discuss related concepts of standard of value, purpose of value

Discuss concepts of goodwill, professional/personal goodwill and practice/enterprise goodwill

What are we going to do today?

Goodwill—that intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified. (SSVS #1 Glossary of Terms)

As defined by the Indiana Supreme Court (Yoon v. Yoon):

…the expectation of continued public patronage.

Goodwill, defined

Jay Myoung Yoon v. Sunsook Yoon. Indiana Supreme Court, Cause No. 49S02-9906-CV-353. Decided June 21, 1999. 711 N.E. 2d 1265; 1999 Ind. LEXIS 402

Personal and enterprise goodwill are concepts that exist beyond the context of marital dissolution

Entertain the thought…

Tax implications - potential 20% rate differential may apply in certain purchase price allocations

Debate over goodwill within ―healthcare fair market value‖ transactions

Valuation for financial reporting – isolating the value of identifiable intangible assets, including workforce-in-place (although workforce-in-place is recorded as part of goodwill)

Other horizons

I Scream for Ice Cream…

Martin Ice Cream Company v. Commissioner, United States Tax Court (Docket No. 1477-93., 110 TC --, No. 18, 110 TC 189, Filed March 17, 1998.

See also Norwalk v. Commissioner, decided July 30, 1998 by the United States Tax Court

“This Court has long recognized that personal relationships of a shareholder-employee are not corporate assets when the employee has no employment contract with the corporation. Those personal assets are entirely distinct from the intangible corporate asset of corporate goodwill.”

Mar

ital D

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lutio

n • State statutes • Case law

Hea

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re F

air M

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t Val

ue

• Payment for goodwill may be deemed payment for referrals

• Evidence of intangible value must be documented Fi

nanc

ial R

epor

ting • Intangibles

such as customer relationships may be separately identified

• Workforce-in-place is part of goodwill

Who Authorized This?

From the FASB Codification Master Glossary – Goodwill: an asset representing the future economic benefits arising from other assets acquired in a business combination…that are not individually identified and separately recognized.

• Owner-professionals • Employed professionals • Specialized equipment or

processes

Who or what is generating

earnings?

• New customers • Returning customers • Referrals

Importance of the

customer

Concepts Spanning the Purposes

Pure Personal Goodwill

Transferable Personal Goodwill

Pure Enterprise Goodwill

Goodwill as a spectrum?

As a business increases in size and complexity, its goodwill transitions from primarily personal to enterprise

Consider Size and Complexity

Personal goodwill

Enterprise goodwill

Understanding the Difference Between Personal and Enterprise Goodwill is Vital to the Identification of Marital Assets

Dr. Shannon Pratt

Pratt, Shannon P. Business Valuation Resources, LLC. BVR’s Guide to Personal v. Enterprise Goodwill, 2008 ed.; Ch.1.

…the separation of personal versus enterprise goodwill depends on whether (or the extent to which) the customer returns because of the

individual, or because of an element or elements that belong to the enterprise.

―Personal goodwill is a personal asset that depends on the continued presence of a particular individual and may be attributed to the individual owner‘s personal skill, training or reputation.‖ (Supreme Court of Appeals of West Virginia, May v. May, (No. 31123))

Personal Goodwill, defined

The professional‘s

goodwill expertise

specialized skills

knowledge relationships

reputation

personality (charisma)

Elements of Personal Goodwill

Personal Goodwill

Attorney / Legal Advisor

Personal Relationships

Expert Witness

Personal Physician

Pure Personal Goodwill = Nontransferable

The concept of transferability is closely linked to distinguishing between professional and enterprise goodwill

The Concept of Transferability

Can relationships be transferred? A process that may occur over time

Transferable Personal Goodwill

Ensure adequate

skills

Introduce to patients /

clients / etc.

Client / patient files

aid the transfer of knowledge

Demonstrate trust

Oversee transferred relationship

―Enterprise goodwill is an asset of the business and may be attributed to a business by virtue of its existing arrangements with suppliers, customers or others, and its anticipated future customer base due to factors attributable to the business.‖ (Supreme Court of Appeals of West Virginia, May v. May, (No. 31123))

Enterprise Goodwill, defined

The Business Goodwill

Location, location, location!

Staff/employees

Operating procedures/protocols

Reputation

Branding: name, logo, website, phone

number

Elements of Enterprise Goodwill

The majority of states, but not all, have precedent-setting cases establishing enterprise goodwill attributable to the business itself as a marital asset, and personal goodwill intrinsically tied to the attributes and skills of an individual, as not marital.

Majority Rules

a free download from BVR

download ―Goodwill Hunting in Divorce‖-

For a state-by-state

summary,

In the event of a marital dissolution it may be necessary for the court to: First distinguish between personal and enterprise

goodwill and, then, Decide which type of goodwill is a marital or

distributable asset.

Goodwill as a Marital Asset

Gordon, Noah J. Business Valuation Resources, LLC. BVR’s Guide to Personal v. Enterprise Goodwill: Goodwill Valuation in the Courts, 2008 ed.; Ch.2.

A number of courts, but not a majority, make no distinction between personal and enterprise goodwill. These jurisdictions have taken the position that both personal and enterprise goodwill in a professional practice constitute marital property. A minority of courts have taken the position that neither personal nor enterprise goodwill in a professional practice constitutes marital property. The majority of states differentiate between enterprise goodwill and personal goodwill. Courts in these states take the position that personal goodwill is not marital property, but that enterprise goodwill is marital property.

Fair Market Value

Fair Value (for

shareholder dissent and oppression

cases)

Fair Value for Financial Reporting

Investment Value

Standards of Value

The fair market value standard contemplates a hypothetical exchange. Therefore, applying this standard theoretically limits

the value of goodwill to transferable personal goodwill and enterprise goodwill

Fair Market Value

For state legal matters only, some states have laws that use the term fair value in shareholder and partner matters. For state legal matters only, therefore, the term may be defined by statute or case law in the particular jurisdiction. In this context, fair value typically excludes

consideration of minority interest discounts For financial reporting: the price that would be

received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Fair Value

Investment value - the value to a particular investor based on individual investment requirements and expectations. (SSVS #1, Glossary of International Business Terms)

Often referred to as ―the value to the holder,‖

goodwill may not need to pass the transferability test to carry value under this standard

Investment Value

Although the valuation analyst may or may not be asked to assist in the determination of child support or alimony, the basis of these determinations is the parties‘ (presumably ongoing) current income.

If the income used in the support determinations is generated by a spouse‘s professional practice, it is conceptually unreasonable to assume that the professional is ―willing‖ to sell his/her practice.

―For Purposes of Marital Dissolution‖

Let‘s Talk Tennessee

Tennessee Goodwill Decisions Continuum

Neither Personal nor Enterprise Goodwill is

Considered a Marital Asset

Enterprise Goodwill is a Marital Asset, Personal

Goodwill is Not

Smith v. Smith, 709 S.W.2d 588

(Tennessee Court of Appeals, 1985)

Witt v. Witt, No. 01-A-019110CH00360, 1992 WL 52746

(Tennessee Court of Appeals, 1992)

McKee v. McKee, No. M2009-01502-COA-R3-CV

(Tennessee Court of Appeals, 2010)

York v. York, No. 01-A-01-9104-CV-00131, 1992 WL 181710

(Tennessee Court of Appeals, 1992) Hazard v. Hazard,

833 S.W.2d 911 Tennessee Court of Appeals, 1991

The wife appealed the Trial Judge‘s treatment of the husband‘s law practice as a nonmarital asset. The Tennessee Court of Appeals stated as follows:

―We are not persuaded, however, that this state should adopt the rule that professional goodwill is a part of the marital estate. We find the position taken by the Wisconsin Court of Appeals in Holbrook v. Holbrook, 103 Wis. 2d 327, 309 N.W.2d 343 (1981) to be persuasive.‖

Smith v. Smith (TN Court of Appeals 1985)

Smith v. Smith, 709 S.W.2d 588 Tennessee Court of Appeals, 1985.

The valuation should include only physical assets and accounts receivable

The Tennessee Court of Appeals upheld the trial court‘s value of $500,000 and held to Smith, stating as follows:

―We agree that ‗professional goodwill is not a marital asset which would be accounted for in making an equity distribution of the marital estate.‘‖ (quoting Smith).

The Court emphasized that other evidence of value (in addition to the two expert opinions, which were $224,000 (H) and $700,000 (W)) was presented at trial: the price that Husband paid to purchase the practice, Husband‘s testimony that he would be upset to sell the practice for $224,000, and values presented on recent financial statements (among other factors).

Eberting v Eberting (TN Court of App. 2011)

Eberting v. Eberting, No. E2010-02471-COA-R3-CV, Tenn. Court of App. 2011.

Specific facts and circumstances should always be considered

The wife (a pediatric dentist) owned a one-third interest in the dental practice of which she was a partner.

The two experts testifying at trial agreed that it was inappropriate to consider personal goodwill in valuing a business for divorce purposes, but they differed in their categorization of patient files. The wife‘s expert testified that no value should be attributed to the patient records in the context of the divorce proceeding because it equates to personal goodwill.

Key points of his testimony included: Patient records are not capable of earning money “without

a professional providing the service,” and The presence of the restrictive covenant in the wife’s

partnership agreement was “proof” of the existence of personal goodwill

McKee v. McKee (TN Court of Appeals)

McKee v. McKee, No. M2009-01502-COA-R3-CV (Tennessee Court of Appeals, 2010)

The Husband was the chief of radiological services at a hospital and also operated a diagnostic clinic with eight technicians that provided services to referring physicians.

The Court approved the trial court‘s finding that the value of the husband‘s medical practice substantially exceeded the net asset value even if the husband’s professional goodwill were excluded.

Witt v. Witt (TN Court of Appeals)

Witt v. Witt, No. 01-A-019110CH00360, 1992 WL 52746 Tennessee Court of Appeals, 1992.

Although husband originally had a solo surgical practice, at the time of divorce he owned 85% of an incorporated multi-specialty medical group employing 11 physicians, 10 nurses, a psychologist and an optometrist. The company also owned an office building housing physician offices, an ambulatory clinic, an optical store, and space for an endoscopy clinic.

Husband ―insisted‖ that any valuation of the company should, as a matter of law, not include business goodwill (citing Smith).

However, the appeals court ruled that Smith‘s ―net asset value principles‖ did not apply to incorporated professional practices that do not depend solely on the professional reputation of the practitioner (citing Witt).

York v. York (TN 1992)

Willing seller / hypothetical exchange

Non-compete

agreements

Restrictive buy-sells

Concepts Are (Inextricably?) Intertwined

One issue on appeal was whether the value established by the buy-sell governed the value

The Court found that factors specifically excluded from the buy-sell (like A/R) were pertinent to the value and should be considered

The trial court may also consider whether the limitations created by the buy-sell affect the value

Harmon v Harmon (TN Court of Appeals)

See also Bertuca v Bertuca, No. M2006-00852-COA-R3-CV, Tenn. Court App., May 10, 2007

Owner – or employee – of any business

Specialized Skills

Contacts and Relationships

Reputation

Personal Goodwill Is Not Just for Professionals…

The Court found that the goodwill of Ms. Judy’s

Daycare would be “valueless” without Judy

Alsup

Extended concepts of professional

practitioner's goodwill from Smith and Hazard

Cites Koch v. Koch: “…a sole proprietorship is

analogous to…a professional practice”

Also found that the fact Ms. Judy’s was organized as a

corporation had no effect

Alsup v Alsup (TN Court of Appeals)

How is revenue generated? From the owner-professional‘s efforts only? Or from employee-professionals efforts as well?

How many employees does the practice have? What are their functions? Do they have credentials/ certifications? Are they ―highly trained‖?

How are the facilities contributing to patronage? Is location a factor?

What equipment is in place? Is equipment integral to the services provided?

How does the entity compare to other entities within the same professional (smaller, larger, etc.)?

Company/Practice Analysis

Asset approach – typically excludes all intangible assets, including goodwill (whether personal or enterprise)

Likely the best approach for valuing professional practices similar to that in Smith

Can be used in conjunction with determinations of the value of enterprise goodwill components such as a trained and assembled workforce

The Asset Approach

Often an option to value a professional practice with enterprise characteristics The discount rate/capitalization rate can be adjusted to

consider key man factors The excess earnings method could be used to determine the

value apart from personal goodwill If cash flows from ancillary services (services provided

without the direct effort of the professional) can be isolated, these income streams can be capitalized

The Income Approach

Practice Value

Ongoing Owner

Compensation

Relationship between Ongoing Owner-compensation and Value

In Holbrook v. Holbrook, the (Wisconsin) Court said: The concept of professional goodwill evanesces when one

attempts to distinguish it from future earnings capacity. Although a professional business’s reputation, which is essentially what its goodwill consists of, is certainly a thing of value, we do not believe that it bestows on those who have an ownership interest in the business, an actual, separate property interest. The reputation of a law firm or some other professional business is valuable to its individual owners to the extent that it assures continued substantial earnings in the future. It cannot be separately sold or pledged by the individual owners. The goodwill or reputation of such a business accrues to the benefit of the owners only through increased salary.

The Concept of ―Double-dipping‖

Many courts have considered the ―unwilling‖ seller issue. This concept is sometimes referred to as ―value to the holder.‖ Quite simply, these courts have considered the fact that the owner-professional spouse is not a ―willing seller‖ as contemplated by the definition of fair market value.

A covenant not-to-compete is an essential element in this consideration

In these jurisdictions, the M&A method results likely will not apply/be considered

The Market Approach: An ―Unwilling‖

Seller?

Do judges follow King Solomon's ―split the baby‖

advice? “If the evidence of value is conflicting, the trial judge may assign a value that is within the range of values supported by the evidence. See Ray v Ray, 916 S. W. 2d 469, 470 (Tenn. Ct. App. 1995)”

From Cunningham v Cunningham, No. W1999-02054-COA-R3-CV (Tenn. Ct. App. 2000)

Another thought…

The Multi-attribute Utility Model (MUM) was developed by David N. Wood, CPA/ABV, CVA ―to allocate enterprise and personal goodwill by assessing the utility of each attribute identified.‖

MUM was first described in 2004 in the American Journal of Family Law.

A methodology that ―bring[s] more objectivity and consistency to these [subjective] judgments and decisions, and provide[s] results that are better understood and more meaningful to those who depend on the valuations.‖

David Wood‘s MUM

Source: “Goodwill Attributes: Assessing Utility” by David N. Wood, CPA/ABV, CVA, The Value Examiner, January/February 2007.

Express an opinion

Fit the results to the alternative and analyze the outcomes

Aggregate the results

Determine each attribute’s importance and existence utilities

Define the attributes

Establish the alternatives

Define an objective

MUM‘s Seven-step Guide

Source: “Goodwill Attributes: Assessing Utility” by David N. Wood, CPA/ABV, CVA, The Value Examiner, January/February 2007.

―Step Zero‖: Determine the value of the business (or practice) including all tangible and intangible assets.

• For purposes of this example: • Value of equity = $1 million • Net tangible assets value = $200,000 • Goodwill/intangible value indicated = $800,000

Step 1: Our objective is to ―determine the value of the two elements of goodwill, personal and enterprise, from the total goodwill, such that a reasonable, well founded basis can be communicated as the support for the opinion of value.‖

Step 1: Define the objective

Source: “Goodwill Attributes: Assessing Utility” by David N. Wood, CPA/ABV, CVA, The Value Examiner, January/February 2007.

FIVE ALTERNATIVE RANGES

ALTERNATIVE FROM (1) TO (1) OUTCOME (2)

1 0% 20% 10%

2 20% 40% 30%

3 40% 60% 50%

4 60% 80% 70%

5 80% 100% 90%

Step 2: Establish the Alternatives

(1) A range of percentages of personal goodwill assigned to each alternative. (2) A specific personal goodwill percentage within the range. Enterprise goodwill

is the reciprocal percentage.

Source: “Goodwill Attributes: Assessing Utility” by David N. Wood, CPA/ABV, CVA, The Value Examiner, January/February 2007.

Personal Attributes

Skills and knowledge

Age and health

Personal relationships

Enterprise Attributes

Business name and reputation

Branding

Staff/workforce-in-place

Step 3: Define the Attributes

These attributes are specific to the engagement

1 Least

Important

3 Moderately Important

5 Most

Important

Step 4a: Determine the Attributes‘ Importance Utility Weight

How important is each selected attribute to making an allocation between enterprise and personal goodwill?

0 Weak

Presence

1 Below

Average

2 Moderate Presence

3 Above

Average

4 Strong

Presence

Step 4b: Determine the Attributes‘ Existence Utility Weights

How present is each selected attribute?

Source: “Goodwill Attributes: Assessing Utility” by David N. Wood, CPA/ABV, CVA, The Value Examiner, January/February 2007.

Importance Utility

Existence Utility

Multiplicative Utility

Percent

Personal Attributes

Skills and knowledge 5 4 20 35%

Age and health 3 1 3 5%

Personal relationships 3 3 9 16%

Total Personal Utility 11 8 32 56% Enterprise Attributes

Business name/reputation 3 2 6 11%

Branding 3 1 3 5%

Workforce-in-place 4 4 16 28% Total Enterprise Utility 10 7 25 44% Total Multiplicative Utility 57 100%

Step 5: Aggregate the Results

This analysis is specific to the engagement

FIVE ALTERNATIVE RANGES ALTERNATIVE FROM TO OUTCOME

1 0% 20% 10% 2 20% 40% 30% 3 40% 60% 50% 4 60% 80% 70% 5 80% 100% 90%

Step 6: Fit the Results to the Alternative and Analyze the Outcome

The outcome is expressed as the percentage of personal goodwill; the reciprocal is the percentage of enterprise goodwill. “Review and analyze the outcome using sensitivity analysis to challenge and confirm the assessments.”

Source: “Goodwill Attributes: Assessing Utility” by David N. Wood, CPA/ABV, CVA, The Value Examiner, January/February 2007.

Based on this analysis, we estimate that the value of equity includes $400,000 of personal goodwill value and $400,000 of enterprise goodwill value. • Remember, for purposes of this example:

• Value of equity = $1 million • Net tangible assets value = $200,000 • Goodwill/intangible value indicated = $800,000

―This opinion may be expressed as an opinion of value or as an estimate of value.‖

Step 7: Express an Opinion

Source: “Goodwill Attributes: Assessing Utility” by David N. Wood, CPA/ABV, CVA, The Value Examiner, January/February 2007.

Cost to replicate (workforce-in-

place)

With-and-without discounted cash

flow (non-compete agreements)

Multi-period excess earnings

method (customer-related intangibles)

Relief-from-royalty (branding-related

intangibles)

Relief-from-royalty (proprietary

process intangibles)

Other Valuation Techniques and Methods

―Goodwill Hunting in Divorce‖ free download available at www.bvresources.com

Valuing Small Businesses and Professional Practices, Pratt, Reilly and Schweihs

BVR‘s Guide to Personal and Professional Goodwill Wood, David N., CPA/ABV, CVA, ―Goodwill Attributes: Assessing Utility,‖

The Value Examiner, January/February 2007 Smith v Smith, 709 S.W.2d 558 (Tenn. App. 1985) McKee v McKee, No. M2009-01502-COA-R3-CV (Tenn. Ct. App., Aug. 17,

2010) Witt v. Witt, No. 01-A-019110CH00360, 1992 WL 52746 (Tenn. Ct. App., Mar.

20, 1992) York v York, No. 01-A-01-9104-CV-00131, 1992 WL 181710 (Tenn. Ct. App.,

Jul. 31, 1992) Harmon v Harmon, 2000 Tenn. App. LEXIS 137 (Tenn. Ct. App., March 2,

2000 Alsup v Alsup, 1996 Tenn. App. LEXIS 425 (Tenn. Ct. App., July 24, 1996) Eberting v Eberting, No. E2010-02471-COA-R3-CV (Tenn. Ct. App., Nov. 8,

2011)

Resources

Shannon Farr ShannonFarr@decosimo.com 423-756-7100

CONTACT SHANNON FARR

DISCLAIMER: The contents and opinions contained in this presentation are for informational purposes only. The information is not intended to be a substitute for professional accounting counsel. Always seek the advice of your accountant or other financial planner with any questions you may have regarding your financial goals.