Professional v. Enterprise Goodwill - A Deeper Dive
A Global Reach with a Local Perspective www.decosimo.comProfessional v. Enterprise GoodwillA Deeper DiveShannon Farr, CPA·ABV·CFFDecosimo Advisory Services | 423.756.7100 | ShannonFarr@Decosimo.comOctober 24, 2012
Shannon Farr, CPA, ABV, CFFBusiness Valuation Manager(800) 782-8382 | firstname.lastname@example.orgShannon Farr is a valuation manager in Decosimo’sChattanooga office with more than 15 years of accountingexperience. Her practice has focused on business valuationand litigation since 2004. She is accredited in businessvaluation (ABV) and also certified in financial forensics (CFF).Shannon provides valuation services to clients in a widevariety of industries, with a focus on healthcare entities. Herspecialized expertise in this area assists hospital and healthsystem clients in ensuring their acquisitions meet industryregulations surrounding the concepts of fair market value andcommercial reasonableness. Her litigation support experiencehas been used in numerous marital dissolution cases as wellas contract and shareholder disputes involving physicians.Shannon provides expert witness testimony, as well as servingthe court as Special Master.
What are we going to do today? Discuss concepts of goodwill, professional/personal goodwill and practice/enterprise goodwill Discuss related concepts of standard of value, purpose of value Discuss precedent-setting cases in Tennessee Identify practical solutions to apply in professional practice valuationsDebates, questions, comments, etc. at the end of the presentation as time allows
Goodwill, defined 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.Jay Myoung Yoon v. Sunsook Yoon. Indiana Supreme Court, CauseNo. 49S02-9906-CV-353. Decided June 21, 1999.711 N.E. 2d 1265; 1999 Ind. LEXIS 402
Entertain the thought…Personal and enterprise goodwillare concepts that exist beyondthe context of marital dissolution
Other horizons 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)
I Scream for Ice Cream… “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.” 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 theUnited States Tax Court
Who Authorized This? • State statutes • Payment for • IntangiblesMarital Dissolution Financial Reporting Healthcare Fair Market Value • Case law goodwill may such as be deemed customer payment for relationships referrals may be • Evidence of separately intangible identified value must be • Workforce-in- documented place is part of goodwill 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.
Concepts Spanning the Purposes Who or what • Owner-professionals • Employed professionals is generating • Specialized equipment or earnings? processes Importance • New customers • Returning customers of the • Referrals customer
Goodwill as a spectrum? Pure Transferable Pure Personal Personal Enterprise Goodwill Goodwill Goodwill
Consider Size and Complexity As a business increases in size and complexity, its goodwill transitions from primarily personal to enterprise Personal Enterprise goodwill goodwill
Dr. Shannon Pratt Understanding the Difference Between Personal and Enterprise Goodwill is Vital to the Identification of Marital Assets …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.Pratt, Shannon P. Business Valuation Resources, LLC. BVR’sGuide to Personal v. Enterprise Goodwill, 2008 ed.; Ch.1.
Personal Goodwill, defined ―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))
Elements of Personal Goodwill knowledge relationships specialized reputation skills The professional‘s personality expertise (charisma) goodwill
Pure Personal Goodwill = Nontransferable Attorney / Legal Advisor Personal Personal Personal Physician Relationships Goodwill Expert Witness
The Concept of Transferability The concept of transferability is closely linked to distinguishing between professional and enterprise goodwill
Transferable Personal Goodwill Can relationships be transferred? A process that may occur over time Oversee transferred Demonstrate relationship trust Client / patient files Introduce to aid the patients / transfer of Ensure clients / etc. knowledgeadequate skills
Enterprise Goodwill, defined ―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))
Elements of Enterprise Goodwill Operating procedures/protocols Staff/employees Reputation The Branding: name, logo, Location, location, location! Business website, phone number Goodwill
Is Branding More Important than Ever? Logos Quiz: free ap available from iTunes
Majority Rules 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. download For a state-by- a free ―Goodwill state download Hunting in summary, from BVR Divorce‖-
Goodwill as a Marital Asset 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. 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. Gordon, Noah J. Business Valuation Resources, LLC. BVR’s Guide to Personal v. Enterprise Goodwill: Goodwill Valuation in the Courts, 2008 ed.; Ch.2.
Standards of Value Fair Value (for Fair Market shareholder Value dissent and oppression cases) Fair Value for Investment Financial Value Reporting
Fair Market 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 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.
Investment 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
―For Purposes of Marital Dissolution‖ 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.
Tennessee Goodwill Decisions Continuum Neither Personal nor Enterprise Goodwill is a Enterprise Goodwill is Marital Asset, Personal Considered a Marital Asset Goodwill is Not Smith v. Smith, Witt v. Witt, 709 S.W.2d 588 No. 01-A-019110CH00360, 1992 WL 52746(Tennessee Court of Appeals, 1985) (Tennessee Court of Appeals, 1992) York v. York, Hazard v. Hazard, No. 01-A-01-9104-CV-00131, 1992 WL 181710 833 S.W.2d 911 (Tennessee Court of Appeals, 1992)Tennessee Court of Appeals, 1991 McKee v. McKee, No. M2009-01502-COA-R3-CV (Tennessee Court of Appeals, 2010)
Smith v. Smith (TN Court of Appeals 1985) 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.‖ The valuation should include only physical assets and accounts receivable Smith v. Smith, 709 S.W.2d 588 Tennessee Court of Appeals, 1985.
Eberting v Eberting (TN Court of App. 2011) 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). Specific facts and circumstances should always beEberting v. Eberting, No. E2010- considered02471-COA-R3-CV, Tenn. Court ofApp. 2011.
McKee v. McKee (TN Court of Appeals) 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, No. M2009-01502-COA-R3-CV (Tennessee Court of Appeals, 2010)
Witt v. Witt (TN Court of Appeals) 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, No. 01-A-019110CH00360, 1992 WL 52746Tennessee Court of Appeals, 1992.
York v. York (TN 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).
Harmon v Harmon (TN Court of Appeals) 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 valueSee also Bertuca v Bertuca, No. M2006-00852-COA-R3-CV,Tenn. Court App., May 10, 2007
Personal Goodwill Is Not Just forProfessionals… Contacts and Relationships Specialized Reputation Skills Owner – or employee – of any business
Alsup v Alsup (TN Court of Appeals) The Court found that the goodwill of Ms. Judy’s Daycare would be “valueless” without Judy Alsup Also found that the fact Extended concepts of Cites Koch v. Koch: “…a Ms. Judy’s was professional sole proprietorship is organized as a practitioners goodwill analogous to…a corporation had nofrom Smith and Hazard professional practice” effect
Company/Practice Analysis 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.)?
The Asset Approach 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 Income 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
Relationship between Ongoing Owner-compensation and Value Practice Value Ongoing Owner Compensation
The Concept of ―Double-dipping‖ 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 Market Approach: An ―Unwilling‖Seller? 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
Another thought… Do judges follow King Solomons ―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)
David Wood‘s MUM 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.‖ Source: “Goodwill Attributes: Assessing Utility” by David N. Wood, CPA/ABV, CVA, The Value Examiner, January/February 2007.
MUM‘s Seven-step Guide Define an objective Establish the alternatives Define the attributes Determine each attribute’s importance and existence utilities Aggregate the results Fit the results to the alternative and analyze the outcomes Express an opinion Source: “Goodwill Attributes: Assessing Utility” by David N. Wood, CPA/ABV, CVA, The Value Examiner, January/February 2007.
Step 1: Define the objective―Step Zero‖: Determine the value of the business (orpractice) 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 = $800,000Step 1: Our objective is to ―determine the value of the twoelements of goodwill, personal and enterprise, from thetotal goodwill, such that a reasonable, well founded basiscan be communicated as the support for the opinion ofvalue.‖ Source: “Goodwill Attributes: Assessing Utility” by David N. Wood, CPA/ABV, CVA, The Value Examiner, January/February 2007.
Step 2: Establish the Alternatives 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%(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.
Step 3: Define the Attributes Personal Enterprise Attributes Attributes Skills and Business name knowledge and reputation Age and health Branding Personal Staff/workforce- relationships in-place These attributes are specific to the engagement
Step 4a: Determine the Attributes‘Importance Utility Weight 1 3 5 Least Moderately Most Important Important ImportantHow important is each selected attribute tomaking an allocation between enterprise andpersonal goodwill?
Step 4b: Determine the Attributes‘ ExistenceUtility Weights 0 1 2 3 4 Weak Below Moderate Above Strong Presence Average Presence Average PresenceHow present is each selected attribute? Source: “Goodwill Attributes: Assessing Utility” by David N. Wood, CPA/ABV, CVA, The Value Examiner, January/February 2007.
Step 5: Aggregate the Results Importance Existence Multiplicative Percent Utility Utility UtilityPersonal AttributesSkills 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 AttributesBusiness 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% This analysis is specific to the engagement
Step 6: Fit the Results to the Alternative andAnalyze the Outcome 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%The outcome is expressed as the percentage of personal goodwill; the reciprocalis the percentage of enterprise goodwill.“Review and analyze the outcome using sensitivity analysis to challenge andconfirm the assessments.” Source: “Goodwill Attributes: Assessing Utility” by David N. Wood, CPA/ABV, CVA, The Value Examiner, January/February 2007.
Step 7: Express an OpinionBased on this analysis, we estimate that the valueof equity includes $400,000 of personal goodwillvalue 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 ofvalue or as an estimate of value.‖ Source: “Goodwill Attributes: Assessing Utility” by David N. Wood, CPA/ABV, CVA, The Value Examiner, January/February 2007.
Other Valuation Techniques and Methods With-and-without Multi-period Cost to replicate discounted cash excess earnings (workforce-in- flow (non-compete method (customer- place) agreements) related intangibles) Relief-from-royalty Relief-from-royalty (proprietary (branding-related process intangibles) intangibles)
Resources ―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)
CONTACT SHANNON FARR Shannon Farr ShannonFarr@decosimo.com 423-756-7100 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.