When a doctor, lawyer, accountant, or other professional service provider divorces, that spouse’s ownership interest in the practice usually must be valued for purposes of equitable division of marital assets or to determine the appreciation in value of a premarital business during the marriage. Valuing a professional service practice presents unique challenges, however, in comparison to the valuation of conventional companies. This article explores those challenges and discusses the accepted methods of valuing professional service businesses.
Unlike conventional companies, a professional practice’s most valuable asset generally consists of its goodwill.(1) Goodwill refers to “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 general public patronage and encouragement, which it receives from constant or habitual customers, on account of its local position, or common celebrity, or reputation for skill or affluence, or punctuality, or from other accidental circumstances or necessities, or even from ancient partialities or prejudices.”(2) Two types of goodwill exist: enterprise/commercial goodwill; and individual/personal goodwill. The former “attaches to a business entity and is associated separately from the reputation of the owners. Product names, business locations, and skilled labor forces are common examples of enterprise goodwill. The asset has a determinable value because the enterprise goodwill of an ongoing business will transfer upon sale of the business to a willing buyer.”(3) The latter “is associated with individuals. It is that part of increased earning capacity that results from the reputation, knowledge and skills of individual people. Accordingly, the goodwill of a service business, such as a professional practice, consists largely of personal goodwill.”(4)
Enterprise goodwill transfers whenever the enterprise to which it attaches is bought and sold as an ongoing concern, while personal goodwill does not transfer on sale and instead resides primarily in the personal reputation of the owner.(5) In Georgia, enterprise goodwill must be included when valuing a professional practice as marital property.(6) Whether individual goodwill also must be factored into the valuation of a professional practice remains an open question though. The majority of states hold that personal goodwill cannot constitute marital property, but the Supreme Court of Georgia thus far has declined to adopt a general rule for this state.(7) Instead, on an appeal of the valuation of a husband’s internal medical practice, the Court merely “[assumed] for purposes of this appeal only that individual goodwill does not constitute marital property in Georgia…”(8)
Our courts accept three principal methods for valuing professional business practices, including their goodwill. Those methods are a) the income or capitalized earnings method, under which an expert capitalizes indicated earnings at a reasonable return on investment based on relative risk and current interest rates; b) the market approach method, under which an expert performs a comparison with price earnings ratios of publicly traded companies in the same or comparable industry; and c) the cost approach/asset approach method, under which an expert appraises all underlying assets, tangible and intangible, with adjustment for existing liabilities.(9) An expert may measure goodwill “by any legitimate method of evaluation that measures its present value by taking into account some past result, so long as the evidence legitimately establishes value.”(10)
Under the income approach, a forensic accountant/business valuation analyst will capitalize total earnings of the business.(11) Capitalization of total earnings avoids improper inclusion of an owner-spouse’s post-divorce income from the valuation, by measuring only the present value of the business by reference to its potential to produce future income.(12) As long as the expert a) makes appropriate modifications for taxation (in cases of taxation as a Subchapter S corporation, e.g.) and for any individual goodwill, b) excludes annual income representing reasonable compensation for services, and c) capitalizes actual past earnings instead of estimated future earnings based upon a future growth rate, most courts should accept a valuation of a professional service practice using the income approach.(13)
The asset approach capitalizes a practice’s excess earnings and represents the most commonly relied upon method for valuing professional practices.(14) To determine the value of a professional practice’s intangible assets, an expert first deducts the owning spouse’s reasonable salary or an average salary for similar persons in the same field from the average net income of the practice, not from the actual salary paid to the practitioner.(15) By doing so, the expert properly adjusts the amount of excess earnings for those practices which increase or decrease their retained earnings by means of a lower or higher salary for the practitioner than is normal.(16) And by capitalizing only the excess earnings of an owner-spouse, the expert also avoids improper inclusion of the spouse’s future earnings in the business valuation, and instead properly measures only the present value of the business interest.(17)
While it has been argued that no market exists for the sale of a solo professional practice, it appears that the market approach nonetheless may be utilized as a valuation method in appropriate cases. Many states treat the market approach as a possible approach for valuing a professional practice and its goodwill; and an expert employing that approach conceivably could utilize national databases to ascertain sales prices of similar businesses, giving weight to differences in geographical locations and dates of sale.(18)
Because there is no single best approach to valuing a professional practice, an expert often will utilize multiple methods. A valuation of a professional business practice should pass muster as long as the trial court reasonably approximates the net value of the practice and its goodwill, if any, based on competent evidence and on a sound valuation method or methods.(19) A valuation method should be deemed sound where an expert submits proof of values by any techniques or methods which are generally acceptable in the financial community and otherwise admissible in evidence.(20)
(1) Miller v. Miller, 288 Ga. 274, 275(1), 705 S.E.2d 839 (2010). (2) May v. May, 214 W. Va. 394, 589 S.E.2d 536, 541 (W. Va. 2003), citing McDiarmid v. McDiarmid, 649 A.2d 810, 813 (D.C.App.1994). (3) May, supra, 589 S.E.2d at 541, citing Courtney E. Beebe, “The Object of My Appraisal: Idaho's Approach to Valuing Goodwill as Community Property in Chandler v. Chandler,” 39 Idaho L.Rev. 77, 83-84 (2002). (4) May, supra, 589 S.E.2d at 542, citing Diane Green Smith, “`Til Success Do Us Part: How Illinois Promotes Inequities in Property Distribution Pursuant to Divorce by Excluding Professional Goodwill,” 26 J. Marshall L.Rev. 147, 164-65 (1992). (5) Miller, supra, at 288 Ga. at 278(1). (6) Id. (7) Id. (8) Id. (9) Id., 288 Ga. at 275(1), citing Steneken v. Steneken, 183 N.J. 290, 873 A.2d 501, 505(II) (2005). (10) Miller, supra, 288 Ga. at 275(1), citing Barth H. Goldberg, Valuation of Divorce Assets, Revised Edition § 8:4. (11) Miller, supra, 288 Ga. at 275(1). (12) Id., 288 Ga. at 277(1), citing Courtney E. Beebe, Casenote, The Object of My Appraisal: Idaho’s Approach to Valuing Goodwill as Community Property in Chandler v. Chandler, 39 Idaho L.Rev. 77, 90(II)(B)(3) (2002). (13) Miller, supra, 288 Ga. at 277(1), citing 2 Brett R. Turner, Equit. Distrib. of Property, 3d § 7:27. (14) Miller, supra, 288 Ga. at 275(1), citing May, supra, 589 S.E.2d at 548(III)(D), fn. 18 (2003); Christopher A. Tiso, Present Positions on Professional Goodwill: More Focus or Simply More Hocus Pocus?, 20 J. Am. Acad. Matrim. Law 51, 61(III)(A) (2006); and In re Marriage of Nevarez, 170 P.3d 808, 812(II)(A)(2) (Colo. App. 2007). (15) Miller, supra, 288 Ga. at 276-277(1), citing May, supra, 589 S.E.2d at 548(III)(D), and Tiso, supra. (16) Miller, supra, 288 Ga. at 277(1). (17) Id., 288 Ga. at 277(1), citing Skrabak v. Skrabak, 108 Md.App. 633, 673 A.2d 732, 737(I), fn. 5 (1996); Nevarez, supra, 170 P.3d at 812(II)(A)(2); and 2 Turner, supra, at § 7:23. (18) Id., 288 Ga. at 276(1), citing Tiso, supra, at 65(III)(D); Popham v. Popham, 278 Ga. 852, 853(3), 607 S.E.2d 575 (2005); Jones v. Chatham County Bd. of Tax Assessors, 270 Ga.App. 483, 486(3), 606 S.E.2d 673 (2004); 2 Turner, supra, at § 7:26. (19) Miller, supra, 288 Ga. at 279(1). (20) Id., 288 Ga. at 275(1).