Professional v enterprise goodwill a deeper dive 10-24-2012

A Global Reach with a Local Perspective

www.decosimo.com

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.

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 valuations

Debates, 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, Cause
No. 49S02-9906-CV-353. Decided June 21, 1999.
711 N.E. 2d 1265; 1999 Ind. LEXIS 402

Entertain the thought…

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

Other horizons

 Tax implications - potential 20% rate differential may
apply in certain purchase price allocations
 Debate over goodwill within ―hea lthcare 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 the
United States Tax Court

Who Authorized This?

• State statutes • Payment for • Intangibles
Marital 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’s
Guide to Personal v. Enterprise Goodwill, 2008 ed.; Ch.1.

Personal Goodwill, defined
 ―Pesonal goodwill is a personal asset that depends
r
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
Goodwill Relationships

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. knowledge
adequate
skills

Enterprise Goodwill, defined
 ―En terprise 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
Location, location,
location!
Business Branding: name, logo,
website, phone
number
Goodwill

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 tothe 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 ―w illing‖ 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:
―W are not persuaded, however, that this state should adopt the
e
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:
―W agree that ‗p
e rofessional 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 be
Eberting v. Eberting, No. E2010- considered
02471-COA-R3-CV, Tenn. Court of
App. 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 52746
Tennessee 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 ―i nsisted‖ 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 ―n asset
et
value principles‖ did not apply to incorporated
professional practices that do not depend solely on the
professional reputation of the practitioner (citing Witt).

Concepts Are (Inextricably?) Intertwined

Restrictive
buy-sells

Non-
compete
agreements

Willing seller /
hypothetical
exchange

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 value

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

Personal Goodwill Is Not Just for
Professionals…

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
practitioner's goodwill analogous to…a
corporation had no
from 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 ―Doubledipping‖
-
 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 ―Unwillin
g‖
Seller?
 Many courts have considered the ―unw illing‖ 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 ―w illing 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 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)

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


Step 1: Define the objective

―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 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.


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 Important

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

Step 4b: Determine the Attributes‘ Existence
Utility Weights

0 1 2 3 4
Weak Below Moderate Above Strong
Presence Average Presence Average Presence

How present is each selected attribute?


Step 5: Aggregate the Results
Importance Existence Multiplicative Percent
Utility Utility Utility
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%

This analysis is specific to the engagement

Step 6: Fit the Results to the Alternative and
Analyze 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 reciprocal
is the percentage of enterprise goodwill.

“Review and analyze the outcome using sensitivity analysis to challenge and
confirm the assessments.”


Step 7: Express an Opinion

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

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


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
 ―Go odwill 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, ―Goo dwill 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.

Professional v enterprise goodwill a deeper dive 10-24-2012

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