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Personal Goodwill in Divorce
2005 National Legal Research Group, Inc.

A significant majority of American jurisdictions hold that the personal goodwill of a business cannot be classified as marital property. Personal goodwill is the individual, nontransferable reputation of a specific owner. It is generally distinguished from enterprise goodwill the corporate, transferable reputation of the business itself which is marital property to the extent it was created during the marriage. This article will discuss several recent cases applying the distinction in different fact settings.

Held v. Held

In Held v. Held, 912 So. 2d 637 (Fla. 4th Dist. Ct. App. 2005), the issue was valuation of the husband's insurance agency. The wife's expert valued the agency at $10.5 million, including $7.58 million of enterprise goodwill. This valuation assumed that the husband would sign a noncompetition agreement preventing him from doing future business with the existing customers of the agency. The parties stipulated that the value of the agency without goodwill was $2.9 million. The trial court accepted the testimony of the wife's expert, and the husband appealed.

The husband's argument was based upon Walton v. Walton, 657 So. 2d 1214 (Fla. 4th Dist Ct. App. 1995), which held:

The most telling evidence of a lack of any institutional goodwill was the wife's expert's testimony that no one would buy the practice without a noncompete clause. If the business only has value over and above its assets if the husband refrains from competing within the area that he has traditionally worked, then it is clear that the value is attributable to the personal reputation of the husband.

Id. at 1216. This passage, the husband argued, establishes that any valuation that assumes the presence of a noncompetition agreement necessarily includes the individual goodwill of the owner who signs the covenant.

The trial court distinguished Walton, finding that a covenant not to compete with the existing clients of the business is different from an agreement not to compete for new customers. The appellate court reversed, holding that individual goodwill is included in any valuation that assumes any type of noncompetition agreement:

For the purpose of distinguishing enterprise goodwill from personal goodwill in the valuation of a business, there is no distinction between a "non-solicitation/non-piracy agreement" and a covenant not to compete. Both limit a putative seller's ability to do business with existing clients of the business. In this case, the husband's personal relationship with his clients allowed him to obtain their repeat business. The trial court's valuation method inserted into enterprise goodwill an aspect of personal goodwill, the value of the husband's personal relationship with the 60 clients. This method of valuation contravened Thompson, which emphasized that to be a marital asset, goodwill "must exist separate and apart from the reputation or continued presence of the marital litigant." 576 So.2d at 270.

Held, 912 So. 2d at 640-41. The case was remanded with instructions to value the business without including any goodwill, as there was no persuasive evidence that the agency had any enterprise goodwill.

There may be ways to find enterprise goodwill in an insurance agency, but the way used by the trial court in Held is not among them. The mere fact that an assumed noncompetition agreement is limited to the existing customers of a business does not limit the valuation to enterprise goodwill for, as the court noted, some of the existing customers of the business were probably attracted by individual goodwill. Because the assumed covenant did not distinguish between clients attracted by the individual reputation of the owner and clients attracted by the reputation of the agency, the court could not properly assume that the valuation included only enterprise goodwill.

At the same time, there is every reason to be troubled by the notion that every valuation that assumes a noncompetition agreement necessarily includes only individual goodwill. The wife's expert in Held testified, and the husband did not appear to contest, that similar agencies had actually been sold for values far in excess of their hard assets. Actual sale prices are normally solid evidence of enterprise goodwill, for individual goodwill cannot be transferred.

The reason for excluding sale prices that include a covenant is that the value of the covenant is the value of the owner's individual goodwill. But this assumption is not always completely true. If the owner of a business could steal 40% of the business's clients by opening a competing business in the same area, a buyer of the business would almost certainly insist upon a noncompete. But this insistence does not mean that all of the goodwill is individually based, for 60% of the clients would remain with the enterprise. Because a reasonable buyer of the business will not want to lose any customers, the buyer is likely to insist upon a noncompetition agreement if the owner has any significant amount of individual goodwill. Thus, while the fact that a reasonable buyer would want a covenant is evidence normally suggesting that some amount of individual goodwill exists, it does not by any means indicate that all of the goodwill is individual.

When representing a spouse who owns a small business, in a state that does not divide individual goodwill, asking whether a sale would include a covenant has traditionally been a very good way to show that a valuation includes individual goodwill. But the presence of a covenant is being given more weight in the cases than it deserves.

For example, the fact that the buyer in actual practice always insists upon a covenant does not mean that there is no enterprise goodwill. A reasonable buyer will not want to lose any customers, and will therefore insist upon a covenant if there is any individual goodwill, even if some or even a majority of the clients are attracted to the enterprise. Business transactions are structured for the purpose of maximizing the value transferred to the buyer, not for the purpose of helping courts classify goodwill in future divorce actions.

The proper question to ask is whether the business could command any value above its hard assets following a sale that does not include a covenant. The fact that such sales are not commonly made is not evidence that such sales could not be made. A buyer would not have much motive to purchase only the enterprise goodwill of the business; most buyers would probably prefer to purchase all of the business's goodwill. But the fact that a sale of individual goodwill is rare does not mean that it is not possible. The distinction between enterprise and individual goodwill is crucial in the law of equitable distribution, but it is not of compelling importance in the business world.

Nevertheless, from the facts stated in the opinion, Held reached the right result. The fact that the expert assumed a covenant in reaching his valuation meant that his value probably included some significant amount of individual goodwill. For the reasons stated above, the assumption did not establish that the goodwill was entirely individual, but the court mentioned no other evidence suggesting how much of the goodwill was individual. There was therefore insufficient evidence to prove the presence of enterprise goodwill.

Had such evidence been present, the mere fact that a reasonable buyer would have insisted upon a covenant need not have destroyed the wife's case. For example, the wife's expert might have testified, based upon the records of the business, that 60% of the clients of the agency were attracted by the convenience of the agency's location or were carried over from a previous owner sources entirely independent of the owner's personal reputation. This fact would surely have been some evidence that 60% of the goodwill was enterprise-based. The expert could then have explained that a reasonable buyer would have required a covenant to protect against the loss of 40% of the clients who were attracted by the husband's individual reputation, regardless of the fact that 60% of the clients came from other sources.

By using testimony of this sort, it should be possible to reconcile the presence of a noncompetition agreement with other evidence that a portion of the business's goodwill is based upon factors other than individual reputation. It is essential, however, that other evidence be produced where a buyer of the business would require a covenant. Otherwise, there may be a critical failure to establish how much of the value produced by an actual sale would be the value of the covenant.

Another option would be to address the presence of the covenant directly, by computing its real value and excluding it from the valuation. For example, an expert could testify that the sale price with a convenant would be $10 million; that the value of the covenant was $2 million; that the hard assets of the business were $3 million; and there was accordingly $5 million of enterprise goodwill. The difficult task using this approach is to value the covenant, but it should be possible to argue that the actual amount of earnings forgone by signing the covenant, reduced to present value, is a reasonable measure.

This method of valuation could lead to an interesting situation. Assume that the seller of the business would lose $2 million in earnings by signing a covenant. Assume, however, that the covenant covers only a limited geographical area, and that the owner could earn $1.5 million by starting a new business outside the area. Alternatively, assume that the covenant covers only a limited field (e.g., automobile insurance), and that the seller could earn $1.5 million even in the same area by starting a new business in a related field outside the scope of the covenant (e.g., life insurance). In these sorts of situations, the seller is forgoing only very limited earnings by signing the covenant. But it is still possible that all of the existing clients of the business might have been attracted by the individual reputation of the seller, so that the seller's ability to establish a new business outside the covenant is really another opportunity for converting personal reputation into monetary value.

This situation points directly at one of the real policy issues involving individual goodwill. If individual goodwill is excluded from division because reputation cannot be sold on the open market, that rationale is not universally true. If the owner of an insurance agency can sell the agency for a large sum, subject to a covenant, and then earn the same amount in a different field or area, the owner really has the ability to sell his personal reputation. The strong general rule is that any asset with an actual market value can be treated as marital property.

Conversely, if individual goodwill is excluded from division because reputation is inherently personal, then it should logically remain separate property even if it has a monetary value. But this rationale may be bad policy. A piece of jewelry may be inherently personal to one spouse, but it clearly has monetary value and it is clearly marital property if acquired during the marriage. Is there any valid reason for treating individual goodwill with a monetary value differently from jewelry? The existing decisions all avoid this question by holding that individual goodwill cannot be sold, but a covenant not to compete is essentially a way to sell individual reputation, and it does not always necessarily result in lost future earnings equal to the amount of consideration received.

The issue is important because broad arguments based upon individual goodwill can be used to value a business at an amount that is less than its fair market value on the open market. Held is a perfect example of a case in which this actually happened. The wife proved with comparable sales that the husband could sell his practice for $10.2 million; the appellate court nevertheless held that its value at divorce was only $2.9 million because to obtain more than that amount the husband would have had to sign a noncompetition agreement. If the husband would really have lost future earnings worth $7.3 million by signing the agreement, the valuation is reasonable; the added value would really be just an advance upon future earnings. If the husband would lose less than $7.3 million in future earnings by signing the covenant, however, then the fair market value of the practice exceeded $2.9 million, and the divorce valuation was unfairly low. The doctrine of individual goodwill should not be used as an excuse to value businesses at an amount materially less than their net transferable fair market value.

Balicki v. Balicki

Another facet of the distinction between individual and enterprise goodwill was explored in Balicki v. Balicki, 837 N.E.2d 532 (Ind. Ct. App. 2005). The husband's expert in that case valued the business at $145,000. He stated correctly that Indiana law requires the court to exclude personal goodwill from the value, and he testified that his value did not include personal goodwill, but he did not state a specific value for the personal goodwill of the business. Two other appraisers valued the business at $300,000 and $430,000. These experts did not discuss goodwill of any sort in explaining their valuation, but they did testify that their value was the amount that an outside investor would actually pay to acquire the business.

The trial court valued the business at $400,000. The husband appealed, arguing that the two higher valuations were not credible because they failed to include an express subtraction for personal goodwill. The Indiana Court of Appeals affirmed. "Neither of [the two higher appraisals] indicated that their valuations included an amount representing goodwill, either enterprise or personal." Id. at 537. Thus, there was no immediate basis for subtracting anything from either valuation. To the extent that a subtraction may have been permitted, the record did not contain sufficient evidence to determine the proper amount:

Here, neither Darcy nor Mark presented any evidence regarding the value of any personal goodwill in T & M. Mark's appraiser did acknowledge the distinction between personal and enterprise goodwill and believed that if there was any personal goodwill attached to T & M it would have belonged solely to Mark. Nowhere, however, did the appraiser place a value on that purported personal goodwill; in fact, he never said that there necessarily was such goodwill. Moreover, Mark did not question the other two appraisers regarding whether any part of their valuation included or relied upon goodwill; neither their written reports nor their testimony mentioned goodwill at all, either enterprise or personal.

The trial court could not assign a value to Mark's purported personal goodwill associated with T & M with no evidence in the record to guide such a valuation.

Id. at 538-39.

Balicki shows that the trial court is not required to make a specific subtraction of personal goodwill from the value of a business. Some businesses have no personal goodwill; for example, most publicly held companies get no value from the personal reputations of their shareholders. Where personal goodwill exists, a valuation based upon transferable value normally excludes it automatically, for personal goodwill by definition cannot be transferred to a buyer. The two higher valuations in Balicki, by computing transferable value, automatically excluded personal goodwill. A separate subtraction for personal goodwill is usually needed only when the expert uses an income formula or other method that reduces current income to present value, without considering whether the income results from the owner's nontransferable personal reputation.

Rao v. Rao

A final decision of note involves an issue not addressed in many of the reported cases. A majority of jurisdictions hold that the value attributable to the personal goodwill of one of the spouses is not marital property. But what about value attributable to the personal goodwill of another owner? The question was presented to the Louisiana Court of Appeals in Rao v. Rao, 2005 WL 2898066 (La. Ct. App. 2005). While Louisiana is a community property state, the rules for valuing community property are not materially different from the rules for valuing marital property.

Rao involved a medical practice owned by a group of physicians, one of whom was the husband. The value of the practice was established by a buy-sell agreement that expressly controlled divorce value, and which had been signed by the wife. The wife nevertheless argued that the agreement did not control, because it was established to defraud her. To prove that she was damaged, she introduced expert testimony giving the practice a higher value than the value given in the buy-sell agreement. The appellate court, in affirming a trial court decision accepting the agreement, was not impressed by the wife's valuation:

The evidence clearly supports the conclusion that the hypothetical value postulated by Mrs. Rao's expert accountant was largely based upon goodwill attributable to the personal qualities and patient relationships of Dr. Rao and his fellow stockholder physicians using the corporate facilities as part of their professional practice. Although Louisiana Endoscopy Center, Inc. is not a professional medical corporation per se, we conclude it was intended by the parties to be an extension of a professional medical practice group in accordance with the federal "safe harbor" regulations. It is inappropriate to use such goodwill attributable to Dr. Rao in the valuation of community corporate stock. See La. R.S. 9:2801.2. See also Preis v. Preis, 94-442, pp. 6-7 (La.App. 3rd Cir.11/2/94), 649 So.2d 593, 595-96 and Depner v. Depner, 478 So.2d 532, 534 (La.App. 1st Cir.1985), writ denied, 480 So.2d 744 (La.1986). Although the issue has not been specifically addressed by the legislature and seems to be res nova, we conclude it is likewise inappropriate to incorporate goodwill attributable to the personal, professional qualities of the other physician stockholders in such valuation.

Id. at *8.

The court's holding is consistent with the nature of personal goodwill. As noted above, personal goodwill is excluded from the marital estate primarily because it is the value of an individual person's nontransferable reputation. Reputation is not "property," and so cannot be "marital property." This is true not only of the reputation of the spouses themselves, but also of the reputation of others. In states that exclude personal goodwill from the marital estate, the rule applies to all personal goodwill, regardless of whether the person to whom the goodwill attaches is a spouse or a third party.

Conclusion

Personal goodwill is excluded from the marital estate because it is essentially the owning spouse's personal reputation, and personal reputation cannot be transferred for consideration. As long as the valuator focuses upon transferable value, personal goodwill is necessarily excluded from the valuation. Any valuation based upon comparable sales or other market data will not normally include personal goodwill.

Enterprise goodwill is included in the marital estate because it is a real asset with tremendous potential value, and business owners would receive a tremendous windfall if it were excluded. Many actual sales of real businesses, not related in any way to the pendency of divorce, occur at an amount greater than the total value of the tangible assets transferred. In the business world, the whole often has much greater value than the sum of its parts. If enterprise goodwill is not marital property, then the valuation of a business in a divorce case will be much lower than the actual price that the same business could command in a sale on the open market.

The best way to value enterprise goodwill without valuing personal goodwill is to pay significant attention to comparable sales. It is not possible to use comparable sales as the exclusive valuation method, however, as the universe of comparable sales is simply not large enough. Most small businesses and many professional practices are unique; it is difficult to find a sale that is truly comparable.

The universe of comparable sales would be greater if sales subject to noncompetition agreements could be included. They cannot be included without modification, of course, as the noncompetition agreement is essentially a sale of personal goodwill. But there is no reason why the total sale price, minus the fair value of the covenant, should not equal the transferable value of the business, including enterprise goodwill. To rule otherwise would be to value a business at less than the actual proceeds that could be obtained by selling it, a result that gives the owning spouse an unfair windfall.

The hardest cases are those in which no comparable sale exists, and valuation must be based upon an income formula. The result reached by an income formula must often be modified to account for goodwill attributable to the individual personal reputation of the owner. Because this modification can be difficult to make, it is good policy to permit the widest possible use of actual sale data, which is often the easiest way to obtain a value that excludes personal goodwill. Future decisions should therefore hold that actual sale data can be used to value a business, even if the sale includes a noncompetition agreement, as long as the fair value of the noncompetition agreement is subtracted from the sale price. This practice will increase the amount of comparable sale data available, and will therefore lead directly to easier and more accurate valuations.

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