Over the years we have been asked to value community property interests in active business. One of the difficult areas is the allocation of Company and personal goodwill as personal goodwill is not a marital asset and is not divisible in divorce.
We have included the following illustration which is a sample allocation of how to allocate it based on David Wood's Multi-Attribute Utility Model (MUM). At the present time, this is the only objective model which allocates goodwill which has been accepted by the Court.
Allocation of Company and Personal Goodwill
Goodwill is defined as an intangible asset arising as the result of name, reputation, customer loyalty, location, products or services, and similar factors not separately identified.
Professional goodwill is based upon the fact that clients come to an individual. This may be based upon his skills, reputation or knowledge. The implied assumption with professional goodwill is that if the practitioner left to go into another practice, the clients would go with him. This is the case with the Company, as the owner is primarily responsible for the book of Company business.
Commercial goodwill attaches to the practice’s reputation. It does not depend on the presence or absence of the owner, as referrals are made to the practice and not to any particular professional.
The following schedule contains the differences between personal and professional goodwill:
|Indicators of Personal Goodwill versus Business Goodwill|
|Personal Goodwill Indicators||Business Goodwill Indicators|
|Small entrepreneurial business highly dependent on employee-owner's personalskills and relationships.||Larger business, which has formalized its organizational structures and institutionalized its systems and control.|
|No pre-existing covenant not to compete(CNTC) and/or employment agreementbetween selling company and employee- owner.||Owner-employee has pre-existing CNTC and/or employment agreement with selling company.|
|Personal service is an important selling feature in the company's product or services.||The business is not heavily dependent on personal services.|
|No significant capital investment in either tangible or identifiable intangible assets.||The business has significant capital investments in either tangible or intangible assets.|
|Only employee-owners own the company.||The company has more than one owner, some of whom are not employees.|
|Sales largely depend on the employee-owner's personal relationships with customers.||Company sales result from name recognition,sales force, sales contracts, and other company-owned intangibles.|
|Product and/or services know-how and supplier relationships, rest primarily with the employee-owner.||Company has supplier contracts and formalized production methods, patents, copyrights, business systems, etc.|
The most widely cited case detailing factors to consider when valuing professional goodwill in a divorce is a California case, Lopez vs. Lopez [in the Marriage of Lopez, 113 Cal.Rptr.58; 38 Cal. App. 3d 1044 (1974)]. The factors listed are the following:
- Age and health of the professional.
- Demonstrated past earnings power.
- Reputation for judgment, skill, and knowledge.
- Comparative professional success.
- Nature and duration of practice.
In the Lopez case, the court gave its justification as to why goodwill may have a value for marital dissolution even if it is not salable . . . “the silent partner is withdrawing because of an ‘enforced retirement’, yet the professional practice continues to exist, going automatically to the licensed spouse.” It is often difficult to distinguish between professional goodwill and practice goodwill, as one court said.
. . . the goodwill of [a] professional practice can be a marital asset subject to division in a dissolution proceeding, if it exists and it was developed during the marriage. However, for goodwill to be a marital asset, it must exist separate and apart from the reputation or continued presence of the marital litigant.When attempting to determine whether goodwill exists in a practice such as this, the evidence should show recent actual sales of a similarly situated practice, or expert testimony as to the existence of goodwill in a similar practice in the relevant market. Moreover, the husband’s expert, who testified the practice had no goodwill, stated that no one would buy the practice without a non-compete clause. This is telling evidence of a lack of goodwill (emphasis added).
Generally, the intangible value of personal service entities are dependent on the ability to maintain and increase the number of client relationships.
The Texas Supreme Court later clarified this issue, further differentiating between professional and enterprise goodwill:
- Whether the corporate name is different from the individual professional.
- The number of employees in the business.
- Whether the professional or the business entity contracts with customers.
- Whether the company supplies competitive prices and services.
- Whether customers deal with the professional or with other employees.
- Whether profits are created separately from the income of the professional, as shown by separate billings of assistants.
In addition, the following factors can be relevant in determining personal goodwill, and thus allocating the goodwill between personal and entity goodwill.
- Type of service offered.
- Type of client served.
- Length of time at the current location.
- How the fees are billed.
- Source of new client.
- The individual practitioner’s amount of production.
- The number of employees and their length of service.
- Economic and demographic information on the community where the practice is located.
- The number of other professionals in the community offering the same service or specialty.
The process of allocating the goodwill is a subjective process. For the purpose of allocating personal from professional goodwill, we have chosen to use the Multiattribute Utility Model (MUM) developed by David Wood.
The Multiattribute Utility Model (MUM) is an allocation model for distinguishing enterprise goodwill from personal goodwill in divorce cases, in those jurisdictions that require the distinction between the two components. MUM first divides certain attributes into those that indicate either enterprise or personal goodwill, and then uses relative weights to challenge, confirm, and communicate the valuator's conclusions. MUM was recently accepted by a court, in the only appellate decision to review its validity under a Frye challenge.
We have assumed that a non-compete agreement would be negotiated should an outright sale be chosen.
By paying for the restriction of the former owner's ability to practice, the buyer effectively purchases some of the personal goodwill that would otherwise take away clients. Since personal goodwill, by its very nature, is inextricably tied to the individual, most states consider a covenant not to compete as separate property.
Some analysts would consider the execution of a non-compete agreement to be equivalent to the individual having "transferred" his/her personal goodwill to the entity. It might result in the transfer of the portion of the personal goodwill that could otherwise be transferred through a market transaction sale of the business. In some cases, especially in a professional practice, this is likely to be less than 100% of the personal goodwill.
- Without the covenant-not-to-compete, personal goodwill is virtually eliminated and practice goodwill is eliminated or significantly reduced in most cases.
- Practice goodwill is a function of the amount of business that will be referred or will repeat after the change in ownership without the seller's presence.
- Personal goodwill is a function of the amount of business that will no longer be referred or will not repeat without the seller.