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Valuation fo Goodwill of Law Practice - Excess Earning Method
© 2003 National Legal Research Group, Inc.
CALIFORNIA: In re Marriage of Rosen, 105 Cal. App. 4th 808, 130 Cal. Rptr. 2d 1 (2003).
In valuing the goodwill of a law practice under the excess earnings method, the trial court must use a reliable long-term average figure for the husband's income. It is error to base the valuation upon the income from a single year when that income was uncommonly high and is not representative of the practice's actual earning capacity. The trial court must also use a reasonable average earnings figure for a similar practice. When the practice's caseload is almost exclusively publicly funded criminal appeals in southern California, it is error to use a nationwide average income figure for all types of law firms.
In 1996, after a 12-year marriage, the parties separated and the wife filed for divorce. The husband was a self-employed attorney in the southern California area. His practice was limited almost exclusively to criminal appeals funded by the State of California, which paid the husband at an hourly rate depending upon the nature of the criminal charge. He did not earn a salary, and his earnings fluctuated both prior to and subsequent to the parties' separation. After a bench trial, the trial court issued an order which valued the husband's law practice at $60,500, of which the court determined $42,000 to constitute goodwill under an "excess earnings" calculation. The husband appealed, asserting that his practice had no goodwill value, and alleging that the trial court misapplied the excess earnings method for calculating goodwill. The court of appeals reversed. (Although California is a community property state, the law of valuation does not differ materially between community property and equitable distribution jurisdictions.)
The court of appeals first noted that in determining the value of a law practice or an interest therein the trial court should determine the existence and value of the goodwill of the practitioner in his law practice as a going concern. There is no unvarying rule for determining the existence or value of a law practice's goodwill, but capitalization of the excess earnings is one method that may be adopted.
While the court approved the excess earnings method on the law, it held that the method had been seriously misapplied on the facts. An expert testifying for the wife as to the goodwill value of the husband's practice utilizing the excess earnings method concluded that it had a value of $42,000. The husband, who did not present expert testimony, argued that the methodology employed by the wife's expert was erroneous because (1) he failed to use an average of the husband's net income, and (2) he failed to use the annual salary of the average salaried person under similar conditions. The court of appeals agreed.
The court pointed out that while the expert for the wife had considered the husband's income for the years 1992 through 1994, he relied solely on the husband's reported taxable income for 1995 and a cash-flow statement for a portion of 1996. He admitted that he possibly should have used an average and even conceded that if he had he would have concluded that there were either nominal or no excess earnings and, hence, no goodwill value. This failure to average the husband's income, stated the court, was an erroneous application of the excess earnings method, especially given the nature of the husband's volatile annual income. Use of the husband's income for 1995 to 1996, $162,000, which was one of his highest earning years, was neither an average nor reasonably illustrative of his earnings. The court remarked that a reasonable trier of fact could not help but conclude that the expert chose to use the husband's net income from 1995 solely to inflate the value of the goodwill. Picking one year's net income, where income rises or falls from year to year, is not an average and is not a reasonable basis for determining value.
Despite the wife's assertion, the court concluded that the failure of the husband to offer expert testimony to support his view that the law practice had no goodwill was not fatal to his challenge to the valuation conducted by the wife's expert. The failure of the wife's expert to use the husband's average net income in the expert's calculation of value was a legal flaw that did not require expert testimony to rebut. The court noted, in a departure from reliance upon strictly jurisprudential sources, that the correct rule on the necessity of expert testimony was summarized by Bob Dylan, when he wrote, "You don't need a weatherman to know which way the wind blows."
Because of the failure of the wife's expert to average the husband's net earnings, the conclusion of the court of appeals was that the goodwill valuation of the husband's law practice was erroneous and, since the wife's expert conceded that if he had averaged such earnings there would have been little or no goodwill value, a finding that the law practice had no such value would be directed on remand.
Although the court's ruling regarding the failure to average the husband's annual net earnings decided the question of the goodwill value of his practice, the court also addressed the husband's argument regarding the reasonable compensation of a replacement attorney. Under the excess earnings valuation method, one determination which must be made in valuing a business or practice is the annual salary of a typical salaried employee who has had experience commensurate with the spouse who is the sole practitioner or sole owner/employee. The wife's expert testified that he did not have any particular knowledge of lawyer compensation other than what he had learned from valuations he had performed and that he was not familiar with a practice such as that of the husband's. He conducted no survey or any type of study of attorney compensation in southern California. Rather, he relied entirely on two published surveys of compensation, one a national survey of lawyers' compensation and the other a survey purporting to show average compensation for officers and directors of various types of businesses. Looking to the highest and lowest compensations, the expert simply chose a figure in the middle $100,000.
The court found the expert's methodology and reliance upon the surveys to be error. It commented that the expert might just as well have plucked the figure of $100,000 from thin air. As to the surveys, it questioned whether a national survey of attorney compensation, even if statistically sound, was a proper basis for offering an opinion on average attorney compensation in a particular geographic region, in this case southern California, and also whether such a survey had any relevance to the husband's particular practice, which was limited almost exclusively to the handling of state-funded criminal appeals. The court further criticized as irrelevant the use of another survey by the wife's expert which traced the average compensation of officers and directors of businesses in general. A sole practitioner, such as the husband, does not have officers and directors. Overall, the court concluded, the expert's opinion that $100,000 was an accurate cost estimate of a replacement attorney was unsupported.
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