CLASSIFYING AND VALUING THE GOODWILL OF A FRANCHISE BUSINESS IN A DIVORCE CASE
© 1999 National Legal Research Group, Inc.
The goodwill of a business is most simply defined as the difference between the total value of the business as an ongoing concern and the total value of the business's tangible assets. The difference arises because the earnings of a business depend not only upon its tangible assets but also upon such intangible factors as location and reputation. When these factors are transferable to a third party pur chasing the business, the free market gives these intangible factors a value, resulting in an increased purchase price. The amount of that increase is generally known as goodwill.
When goodwill can be realized through a sale of the business on the open market, there is general agreement that the goodwill constitutes divisible property in a divorce case. The goodwill is marital property, of course, only to the extent that it was acquired during the marriage. When goodwill cannot be realized by sale, there is a serious and roughly even split in authority among jurisdictions. Some jurisdictions divide such goodwill, reasoning that it is not different in nature from realizable goodwill. Other jurisdictions hold that unrealizable goodwill cannot be divided, reasoning that it is generally not distinguishable from the personal reputation of the owners of the business. The most common example of a business with unrealizable goodwill is a law or medical practice. For a full discussion and citation of authority on goodwill generally, see Brett R. Turner, Classification and Division of Business and Professional Goodwill, 8 Divorce Litigation 121 (1996), and Brett R. Turner, Equitable Distribution of Property 6.22 (2d ed. 1994 & Supp. 1999).
This article will consider the goodwill of a partic ular type of business: the business of a franchisee. Since franchise businesses are generally transferable, and since they are rarely dependent entirely upon the personal reputation of any individual owner, fran chise business goodwill should be divisible in the majority of jurisdictions. If the divorce case is being heard in a state where unrealizable goodwill is not divisible, however, the reader should carefully consider whether the goodwill of the business is actually realizable before reaching any conclusion as to divisibility. The remainder of this article assumes that the goodwill at issue is sufficiently realizable to be divisible in all jurisdictions.
While franchise business goodwill is generally divisible, the classification and valuation of such goodwill poses a new and significant problem. When an ordinary business has a fair market value in excess of its tangible assets, it can safely be assumed that the difference is due to factors within the control of the owner. That conclusion does not hold true, however, in the setting of a franchise business. The income of a franchise business results from the efforts of two different entities: the franchisor and the franchisee. The franchisor is a third party in the franchisee's divorce action, and the franchisor's goodwill is obviously not marital property. See generally Turner, supra, 5.07 (assets owned by third parties are not subject to division upon di vorce).
An example demonstrates the point. Assume that the husband owns a fast-food franchise business which was acquired during the marriage. The going- concern value of the business exceeds its tangible assets, because the business has existed for many years and has a large number of loyal repeat custom ers. Thus, goodwill is clearly present. It may or may not, however, be the goodwill of the franchisee. If the loyal customer base was developed primarily because the franchisor spent millions of dollars on a nationwide advertising campaign, the goodwill may primarily be that of the franchisor. Conversely, if the customer base arose from local advertising of the franchisee or from the franchisee's selection of a particularly desirable location, the franchisee may possess the majority of the goodwill.
In short, to classify and value the goodwill of a franchise business, the court must distinguish be tween the goodwill of the franchisor and the good will of the franchisee. The purpose of this article is to discuss case law making this distinction and to suggest how that law might be applied in settings which have not arisen.
II. REPORTED CASE LAW
All three reported decisions discussing franchise goodwill issues involve insurance agencies. In In re Ziegler, 69 Wash. App. 602, 849 P.2d 695 (1993), the husband was an agent for State Farm. His agency was successful by any standard; indeed, it had been the most profitable agency in the state for each of the eight years before the divorce. The agency could sell only State Farm products, and the names and addresses of all policyholders were the property of State Farm. If the business ceased to be a State Farm agency, the husband could not directly solicit State Farm policyholders, but this limitation applied only for one year after termination. During this period, the husband could sell competing insur ance to State Farm policyholders who applied on their own, and he could of course solicit business without limit from persons who were not State Farm policyholders. The organization and the operation of the agency were controlled by the husband alone.
Both parties submitted expert testimony on the goodwill issue. The husband's expert testified that a fair rate of return on the assets of the agency was 15%. Since the profits of the business were less than this amount, the expert opined that there was no goodwill. The wife's expert testified that a fair rate of return on the assets of the agency was 10%. The expert further testified that the husband's salary was unreasonably large, so that part of that salary should be treated as a disguised profit of the busi ness. Because the profits exceeded the 10% figure, the wife's expert believed that the business had divisible goodwill.
The trial court held that any goodwill which existed was the goodwill of State Farm, and the appellate court affirmed. The court first noted the absence of any evidence that the location or office organization of the agency enhanced its earning capacity. It then continued:
In this situation, the Agency's captive status means that any reasonable expectation of continued patronage is indistinguishably inter twined with the reputation and goodwill of State Farm. Mr. Ziegler is a State Farm agent operating out of his own office as an inde pendent contractor. If Mr. Ziegler terminates his relationship with State Farm, he may retain his office and sell other companies' insurance, but he cannot solicit business from State Farm's existing policyholders. Whether they would then seek out another State Farm agent to take care of their insurance needs, or stay with Mr. Ziegler and ask him to find them a new insurer, is speculative. State Farm retains the vital rights to the policyholders and the stream of renewals from them. Because State Farm retains the expectation of continued public patronage, any goodwill attaches pri marily to State Farm, not its captive agency.
849 P.2d at 698. A dissenting opinion noted that "if the agency were to terminate its association with State Farm, the agency still maintains its name, staff, internal procedures and location, all of which are likely to assure public patronage." Id. at 699 (Swee ney, J., dissenting). Thus, the dissent would have held that the agency had at least some goodwill.
Comparing the two opinions, one is struck by the lack of evidence presented on the crucial issue. The majority stated blindly that the location and the office organization of the agency did not affect earnings; the dissent stated equally blindly that these factors did affect earnings. Neither opinion referred to any evidence on the question. In a sense, there fore, both opinions were the result of speculation. If the wife truly did not introduce any evidence that increased earnings were caused by factors specific to the agency and not specific to State Farm, the majority's decision to affirm the trial court is not surprising.
Both opinions paid insufficient weight, however, to one factor which was clearly present in the re cord: the fact that the husband's agency had the highest earnings of any agency in the state. Simply put, the husband's agency earned more income than many other similar agencies. It is possible, of course, that the husband's agency was located in an unusually profitable area, or that a large existing customer base had been developed by prior State Farm agents in the area. In these instances, there might be no agency goodwill. But the striking success of the husband's agency cries out for further factual investigation. It is at least possible, and perhaps even likely, that the husband's agency performed well because of factors unique to this agency factors within the control of the husband. If so, the agency surely had at least some divisible goodwill.
The record suggests, however, that the wife may not have taken full advantage of the high earnings level of the husband's agency. Her expert valued the goodwill using the excess earnings method, which compares the earnings of the business to the "aver age" earnings of other similar businesses. To com pute the excess earnings, the expert chose to use the average rate of return on the capital invested. Since the husband's expert used the same approach with a higher average rate of return, the net result was to turn the case into a credibility battle between the experts, a setting in which appellate reversal is unlikely.
The wife's expert would have done better to base his average earnings figure upon the earnings of other State Farm agencies. This valuation method would have stressed the single fact in the case most favorable to the wife: the fact that the agency had much higher earnings than other agencies in the state. If State Farm's goodwill were truly the main operative factor, one would think that its agencies would have generally similar earnings. The fact that the husband's agency had higher earnings therefore suggests the existence of factors other than State Farm's goodwill. It appears from the court's opin ions that the wife may not have placed sufficient weight upon comparative earnings in stating her position to the court.
The majority opinion also suggests to some extent that the court was influenced by the restric tions placed upon the agent in terms of realizing his goodwill. The husband's goodwill could be trans ferred only if he left the agency, and his ability to compete after leaving was restricted. If Washington divided only realizable goodwill, the court's concerns would be valid. Washington has held, however, that unrealizable goodwill is divisible. See In re Hall, 103 Wash. 2d 236, 692 P.2d 175 (1994). If the courts can divide the absolutely nontransferable goodwill of an attorney or a doctor, it is hard to see why partial limitations upon the transferability of the goodwill of an insurance agent should change the result. Moreover, the one-year noncompetition provision does not seem like a strong restriction. Still, if the wife truly introduced no evidence minimizing the impact of the transferability restric tions upon the future realization of goodwill, her case was substantially incomplete.
Comparative earnings were stressed at much greater length in the next decision, In re Graff, 902 P.2d 402 (Colo. Ct. App. 1994). Graff, like Ziegler, involved a State Farm insurance agency. The earnings of the agency at issue in Graff increased substantially after the husband assumed control of it. The court did not state the transferability restrictions in detail, but indicated that the husband's ability to realize his goodwill was limited. The court referred to the business as a "captive" agency, id. at 404, the same term used in Ziegler, thus further suggesting that the transferability restrictions were probably similar.
The trial court in Graff held that the agency had divisible goodwill, and the appellate court affirmed. The court expressly held that the transferability restrictions were irrelevant, since nontransferable goodwill is still marital property under Colorado law. The court then stated:
To the extent that the Ziegler majority held as a matter of law that any goodwill attached to a local State Farm insurance agency was indistinguishably intertwined with the reputa tion and goodwill of State Farm, we disagree with that conclusion.
Here, the trial court considered evidence regarding the constraints on husband's agency imposed by State Farm, but also found that he controlled his business expenses, that he had stated his interest as business ownership with the Internal Revenue Service, that the net income of the business had increased substan tially under husband's ownership, and finally, that husband had no plans to discontinue his relationship with State Farm. Under these circumstances, the trial court could properly determine that there was goodwill attached to the ownership of the State Farm agency.
Id. at 405.
Most of the factors identified by the Graffcourt the husband's control over his own agency, and the lack of any plan to discontinue the agency relate exclusively to the role of the transferability restrictions. As noted above, the court correctly held that the transferability restrictions did not, in and of themselves, prevent the division of goodwill.
The court's holding on transferability, however, did not determine the outcome. The fact that transferable goodwill can be divided says nothing about the question of whether goodwill exists to begin with. The most important factor relied upon in the above passage was therefore the fact that "the net income of the business had increased substan tially under husband's ownership." Id. Since other agents had earned less income, running the same agency in the same place under the same conditions, the logical conclusion is that factors specific to the husband must have accounted for the difference. Graff therefore focused, in a simple but effective way, upon the most crucial fact in the case.
Graff also provides a lesson in how expert testi mony on franchise goodwill should be presented. According to the court's opinion, the husband's expert testified essentially that the agency had no goodwill, because he could not assign or otherwise realize the value which the goodwill represented. This testimony would have been of great value if Colorado divided only realizable goodwill. Unfortunately for the husband, Colorado does divide unrealizable goodwill, and the divisibility of unrealizable goodwill necessarily implies the divisibility of partly realizable goodwill. Thus, the husband's expert's testimony was essentially a direct attack upon Colorado law involving unrealizable goodwill, an attack which failed when the court followed prior authority. Unlike the husband's expert in Ziegler, the husband's expert in Graffapparently did not apply the excess earnings method to compute a favorable value in the event that the goodwill was divisible. Because such application was lacking, once the court found that transferability was not dispositive, it was left with no option but to apply the wife's expert's method. In view of the adverse Colorado authority on unrealizable goodwill, the husband should have had his expert submit a valuation similar to the one submitted by the husband's expert in Ziegler.
If the husband had presented better expert testimony, he could perhaps have convinced the court to make a more favorable award. The opinion suggests that the wife's expert valued all of the agency's goodwill on the assumption that it was all attributable to the husband. Since the husband was an unusually successful agent, the court was on solid footing in holding that some divisible goodwill existed. But was it proper to hold that all of the goodwill belonged to the agent? As even the occasional viewer of television can testify, State Farm and other insurance agencies conduct regular nationwide marketing activities. The precise parameters of the policies sold by the husband price, content, and so forth are also presumably determined at the national level. To say that the skills of the agent had some effect is not to say that the factors operating at the nationwide level were insignificant. On the contrary, it seems almost certain that the goodwill of the agency resulted from the efforts of both State Farm and the agent. The testimony of the wife's expert, as summarized by the appellate court, made no attempt at all to exclude State Farm's goodwill. If the husband had presented testimony which drew such a distinction perhaps even conceding the existence of some divisible goodwill on the part of the agent the court might have treated some of the goodwill as belonging to State Farm. By arguing only the transferability issue, however, the husband confronted the ap- pellate court with a choice between everything or nothing. Since Colorado case law clearly rejected the latter position, the court was left with no alternative but to accept the valuation of the wife's expert and to treat all of the goodwill as belonging to the agent.
The final reported decision, Seiler v. Seiler, 308 N.J. Super. 474, 706 A.2d 249 (App. Div. 1998), involved an Allstate insurance agency. The husband was one of four agents who together opened an agency during the marriage. Unlike the agents in Ziegler and Graff, who apparently had wide discretion in the operation of their agencies, the agents in Seiler could hire and fire employees only with Allstate's approval. Allstate owned all of the agency's office equipment, handled all advertising, and even paid for the agency's telephones. There was no evidence of how the agency's earnings ranked in comparison to other Allstate agencies. The trial court held that any divisible goodwill belonged to Allstate, and the appellate court affirmed:
Defendant's ability to earn a substantial income must not blind us to the fact that he is an employee of a major insurance company selling its insurance products in accordance with the terms and conditions established by his employer. The compensation scheme does not transform a person in defendant's position into an independent entrepreneur. He remains a salesman whose job is to aggressively solicit new clients and to retain old clients.
Certainly, defendant has much more discretion and control over the conditions of his employment than many employees; nevertheless, he remains an employee with significant limitations imposed on him by his employer. Unlike an independent insurance agent, he cannot hire and fire employees without the permission of Allstate. He can sell no product other than Allstate. He has no transferable book of accounts. Like any employee, he can be terminated.
Defendant's reputation in the community may have generated new business; however, that can be said for any salesman. We cannot ignore that the captive agent, like defendant, is selling a product of a major nationwide insurance company which has fashioned its own reputation for price, quality and service over many years with the assistance of a formidable national, regional and local advertising campaign.
706 A.2d at 252.
Seiler is an example of a case where the franchisee had little opportunity to establish independent goodwill. Allstate's role in the agency was substantial, as it had the power to hire and fire employees without the husband's consent. Unlike the agencies in Ziegler and Graff, which could terminate their relationship with State Farm (subject to various competition restrictions), the agency in Seiler could not exist independently, as Allstate owned all of the office equipment. Given this pervasive level of control by the franchisor, the husband arguably lacked the ability to establish his own goodwill.
If any argument in the wife's favor could be made at all in Seiler, it would have to begin with a showing that the agency earned higher profits than other agencies in similar situations. If such profits had been present, the wife could then have argued that the husband must have had considerable control. The wife might also have looked at whether Allstate actually exercised its theoretical right of control. For instance, if Allstate routinely approved the hiring and firing decisions of its agents, then the husband might have had in practice the same level of control as the husband in Graff. The complete lack of transferability would not have been an obstacle, for, like Colorado and Washington, New Jersey is willing to divide goodwill which is completely untransferable. See Dugan v. Dugan, 92 N.J. 423, 457 A.2d 1 (1983). Notwithstanding Dugan, however, it makes sense that the goodwill should be attributed to the entity which makes the relevant business decisions. The facts of Seiler suggest strongly that that entity was Allstate, and the court's ruling therefore makes sense.
All of the cases cited in this argument apply the franchise goodwill concept to insurance agencies. The theory should have broad application, however, to any franchise business. For example, fast-food restaurants, automobile dealerships, and retail sales businesses often operate using a franchise system, where the franchisees concede varying amounts of autonomy in exchange for the right to use the name of a larger entity and benefit from its marketing. The concepts discussed in this article apply whenever the profits of a business result from the combined efforts of a franchisor and a franchisee.
When the franchise goodwill theory applies, the first step is to determine whether divisible goodwill exists at all. In states where the completely unrealizable goodwill of a law or medical practice is divisible, the limited realizability of the franchise goodwill is obviously not itself a sufficient basis for refusing to divide such goodwill.
In states where only realizable goodwill can be divided, however, the first step is to consider whether the franchise's goodwill meets the realizability standard. This step requires the court to determine whether the franchisee can retain all or part of the existing customer base if it terminates the franchise relationship. This determination should be made on a fundamentally practical basis. For example, the mere fact that the franchise agreement places limits on transferability should not be dispositive, if in fact those limits can reasonably be circumvented. In Ziegler, for example, where the noncompetition period lasted for only one year after termination, where it applied only to competition directed specifically at prior customers, and where the agent could respond at any point to inquiries initiated by those customers, it seems likely that at least some portion of the customer base was loyal to the agency rather than to the franchisor. Likewise, if the franchisee in a fast-food restaurant situation retained the right to operate a restaurant in its present desirable location, while switching franchisors or even becoming independent, location- based goodwill would obviously survive the transfer. The relevant question at this stage of the inquiry should simply be whether, in the event of a change in the franchisor, customers would continue to follow the franchisee. If so, the restrictions upon transferability do not prevent division of the goodwill.
Where the goodwill is effectively realizable, or where the realizability of the goodwill is not an issue, the question then becomes one of allocating the goodwill between the franchisor and the franchisee. It should be stressed that this is a completely distinct question from the issue of realizability. In states where unrealizable goodwill is divisible, the goodwill may still belong more to the franchisor than to the franchisee. The clearest example is Seiler, which found that the goodwill belonged entirely to the franchisor, even though New Jersey divides many different forms of unrealizable goodwill.
The need to allocate the goodwill between the franchisor and the franchisee is present only where the court computes the value of the goodwill using an income-based formula which applies to businesses generally. This was the factual setting in each of the above cases. In some situations, it may be possible to use actual data from comparable sales of similar franchises, values from buy-sell agreements, or evidence which is specific to the valuation of a franchise business. For instance, in Smith v. Smith, 111 N.C. App. 460, 433 S.E.2d 196 (1993), rev'd in part on other grounds, 336 N.C. 575, 444 S.E.2d 420 (1994), the court valued an automobile dealership using a method generally accepted in the industry for valuing such dealerships, a method which obviously took into account the limited control of the dealer over its own operations and products. When franchise-related concerns are incorporated in the assumptions of the valuation method employed, there is no need to consider the concerns discussed in this article.
In allocating the goodwill between the franchisor and the franchisee, the court must determine the extent to which each party's actions created the goodwill at issue. The existing three cases all attribute the goodwill entirely to either the franchisor or the franchisee. As noted above, this approach seems oversimplistic, for, in the great majority of cases, earnings probably result from the conduct of both parties to the franchise agreement. A realistic assessment of any franchise business will probably result in allocating at least some part of the goodwill to each of the parties involved.
The allocation of goodwill, like valuation questions generally, is probably not governed by any fixed rules. The above cases looked at a variety of factors, and future decisions are likely to adopt the same approach. A review of the cases shows that several factors are relevant to the determination:
Control over Operations. Where the franchisee's operations are heavily regulated, the goodwill is more likely to come from the franchisor. Conversely, loosely regulated franchisees have considerable opportunity to acquire their own goodwill. This point emerges clearly from a comparison of Seiler, where an agent with little control over his own agency had no independent goodwill, with Graff, where an agent with complete control over his own organization had substantial goodwill.
Control over Advertising. In many businesses, advertising is essential to the development of a loyal customer base. Most franchise businesses concentrate advertising activity at the national or regional levels, and this factor therefore most often favors the franchisor. When the franchisee does its own advertising, the case for individual goodwill should ordinarily be quite strong. Automobile dealerships, for example, conduct sufficient local advertising that they often have their own goodwill. The mere presence of national advertising does not prevent individual franchisees from having goodwill, particularly when some franchises are more successful than others, see Graff, but it should be a rare case where all of the goodwill belongs to a franchisee without the power to advertise.
Location. Just as advertising often favors the franchisor, so does location often favor the franchisee. Location is obviously a factor, of course, only in those instances where a particular desirable location influences the earnings of the business. Since location is not a major factor in insurance cases, none of the above cases focus extensively upon this factor. In other settings, however, such as fast-food restaurant chains, location could be a primary factor in determining the earnings.
Where location is a factor, it should logically favor the party who has the right to use the location in the future. If the franchisee selected the location and can switch franchisors easily, location favors the franchisee. If the right to operate a location- dependent business at a particular location resides with the franchisor, that fact suggests that there is not a great deal of franchisee goodwill.
Relative Earnings. Perhaps the best evidence of control, in a functional context, is how the business ranks in comparison to other franchisees working under the same franchisor. Where the earnings are all similar, the earnings of the franchisor are a more substantial factor. Where the earnings are dissimilar, but the business at issue has a low ranking, individual goodwill is probably possible but not present in the below-average franchise at issue.
Where a franchise performs better than other similarly situated franchises, there is a good argument that divisible franchise goodwill exists. Graff is an excellent demonstration of this point. Even where the franchise agreement limits the franchisee's power over the operation of the business, the fact of disparate earnings suggests that the franchisee retains significant control in actual practice.
It is essential, of course, that comparisons with other franchises control for differences in location and market. An outstanding franchisee in a small market may have unexceptional earnings; a poor franchisee in an outstanding market may have larger earnings. The court must therefore look to the overall context of the business, and it should not look at profitability figures in isolation.
In any franchise setting, the income of the business probably results from the combined efforts of both the franchisee and the franchisor. Thus, when the franchisee is divorced and the business enjoys goodwill, courts must distinguish between the goodwill of each party to the franchise agreement.
Given the popularity of the franchise system in certain areas of business, it is almost certain that questions involving the allocation of franchise goodwill will continue to arise. The results of these future cases, like the results of the cases discussed in this article, will probably be heavily fact-dependent. By focusing the attention of the experts and the trial court upon the right questions, however, attorneys can give their clients the best possible chance for a favorable result.
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