Personal vs. Enterprise Goodwill In Domestic Relations

Originally published by the Ohio Domestic Relations Journal

Business owners often say, “There is no business to sell – if I leave it is worth nothing”. Many clients who have been referred for business valuations will make that statement within the first five minutes of contact. I generally tell them that the surest way to lose a valuation issue in court is to go in with the claim that the business is worth nothing. There are some exceptions. In one case the business was licensed by the state and though it operated as a corporation the license was in the name of the owner. The business could not be sold. Ex President Bill Clinton makes quite a bit of money speaking. The business is quite literally President Clinton. Even George W. Bush could not buy Clinton’s book of business. But most businesses, no matter how intrinsically tied to the individual owner can be, and are often, sold.

Another common claim by the prospective client to a business valuator is that due to his or her “special relationship” with the customers or clients they would not transfer to a new buyer. The issue the client is really addressing is the issue of goodwill. The easiest way to think of goodwill is to consider the purchase of a business where there are literally no tangible assets to sell, or very little in the way of tangible assets. Lawyers, accountants, doctors, dentists and other professionals who sell their practices are, for the most part, selling goodwill. That raises the first issue, just what is goodwill?

From an accounting viewpoint goodwill exists when the cost of the assets which are being purchased is less than the total purchase price. Accountants, being very particular that things need to balance, call this excess “intangible value”, often categorizing it as goodwill on a balance sheet.

By way of illustration, think of the purchase of an accounting practice. The Purchaser will take over the equipment, software, office, the lease, the telephone number and the clients that have made up the practice. The decision of whether or not the clients will remain with the purchaser or go elsewhere needs to be dealt with, and will be examined. Parties may agree that the “hard assets” are worth $10,000.00 and agree tentatively to a purchase price of $100,000.00. The purchase price that is in excess of the hard assets can be referred to as “intangible assets”. Before one rushes to call the entire $90,000.00 goodwill, the purchase agreement, which may include many of the following terms, must be examined.

1. The seller will use his or her best efforts to effectuate a transfer of the client base to the purchaser. There are several ways to accomplish this and they are not mutually exclusive.
2. The purchase price will be paid with a given percentage at closing with the remainder being paid over a period of years. While this will vary with the specific contract three to five years is a period often seen in the agreement.
3. The seller will be prohibited from practicing accounting, other than for the Purchaser, for a given number of years. Other clauses which are somewhat similar is that the Seller will not cause the client base to go to another accountant, employees of the Seller’s practice will not be solicited for other employment.

If one looks at the individual clauses in the contract, they might be called “covenants not to compete”. Does one really care what the contractual clauses are called? Isn’t it enough that there is an intangible value of the agreement? Often the tax structure of a purchase has a major impact on what the seller really receives and what the purchaser really pays. However, tax issues are not the subject of this article. It is difficult enough to come to grips with goodwill without worrying about taxes.

Many states, Ohio not being one of them, have differentiated goodwill in a domestic relations case into two components, personal goodwill and enterprise goodwill. In many of these states personal goodwill is considered to be a non marital asset, therefore not subject to division, while enterprise goodwill is considered to be a marital asset subject to division. An article Goodwill Hunting, published by BV Resources and recently updated, presents a state by state analysis of how goodwill is treated for marital purposes.

A good way to think of personal versus enterprise goodwill is to ask “What would happen to the business if the owner suddenly died or became ill and could no longer work or even speak to the clients?” The telephone could still ring, the office would be there, and the staff would remain. Suppose a new owner came in immediately so there would be no loss of continuity in terms of an owner to deal with clients. Suppose the name stayed the same. There are many professional practices that retain the name or names of the original owners long after they have retired or died. To the extent that the client base remained there would be, by definition, enterprise goodwill. The client base and income from them is more of a function of the business, as perceived by the clients, than the importance of the owner. Some of the client base may leave immediately or in a short time after finding another professional they prefer to do business with. This element could be classified as personal goodwill. With the Seller gone the clients go elsewhere. The line may get blurry on occasion, but overall this is the concept between differentiating between personal and enterprise goodwill. How does one separate personal from enterprise goodwill? There is currently at least one software program being marketed that separates personal goodwill from enterprise goodwill. The software allows the user to weight certain variables that make up either personal or enterprise goodwill and results in apportioning the goodwill between the two. The model utilizes the concept of objective information integrated with the subjective analysis of the valuator to differentiate personal and enterprise goodwill. While not embraced by all valuation analysts the model has been subjected to peer review and has been accepted by some courts, so on its face it should stand up to a Daubert challenge.

The issue of how much of the practice or business is goodwill is not addressed by the model. There are several methods that can be used to attempt to calculate goodwill. One data base that deals primarily with small businesses reports the purchase price for a combination of goodwill and fixed assets for many small businesses. Particularly in service industries or professional practices the amount of fixed assets are relatively small which would result in the goodwill portion being relatively large (or 100% of the price in some instances). In health care a publication and, now a computer data base, reports the portion of the sales price called goodwill by the parties involved, as well as other key financial data. One cautionary word is that calling something goodwill does not make it goodwill. Because of tax laws the purchaser and seller may agree to call something goodwill that is in reality a fixed asset, or alternatively lower the actual amount of goodwill being reported. There may be arguments regarding the precision of the measurement, but the methodology for calculating goodwill does exist. A common way of calculating goodwill is to utilize a method known as the “Excess Earnings” approach. Here the business is allowed a “reasonable” return on investment and allows a “normal” salary for the owner. After these allocations the residual earnings are capitalized and the result is referred to as goodwill. While the Excess Earnings approach is generally not held in high esteem among business valuation professionals for most cases, it is still a useful approach for small businesses.

So how does one can calculate goodwill? Theoretically it can be broken down into enterprise and personal goodwill. In domestic relations cases, should this really matter? Let’s look at an extreme case; a one person professional practice. These businesses are bought and sold all the time. The issue is not then does personal goodwill get sold, but how is it transferred?

One scenario might look something like the following. Seller knows he would like to retire and would like to sell his practice. Purchaser is a young professional who views the purchase of a practice very favorably to starting from scratch or working as an employee for another professional. Purchaser and seller reach an agreement on price. The price, however, is dependent on the revenue from the practice that remains with the purchaser. Such a clause, often referred to as an “earn out” clause motivates the seller to have the clients stay with the Purchaser. The first steps would be the creation of a “partnership” and an announcement to current and prospective clients that purchaser has joined seller in the practice. Seller agrees to stay on for a period of time. Whether or not seller will have duties other than shifting client loyalties will depend on the situation. In some instances purchaser might need someone to assist with the work requirements of the practice. In that case seller would be receiving a bona fide salary or consultant’s fee. This fee, assuming it is reasonable for the functions performed by seller, for work actually performed, other than assisting with the transfer of the client base, would be a salary component and not goodwill. A covenant not to compete to protect Purchaser from further competition by seller would not be unusual. Ideally the goal is to infuse Purchaser with all the persona of seller, so to the client base there appears a seamless transition. Seller is anointing purchaser as an heir apparent. At some point seller is not there every day. At some point he is no longer there at all. The transition or attempt at transition would then be complete. How much seller receives and purchaser pays is often dependent on how successful the transition is.

How hard is transition to accomplish? My own experience has been that the longer the transition period the more likely it will be possible to transfer personal goodwill. The second situation, which may appear counter intuitive originally, is where the seller has such a good relationship with the client that the client is willing to take seller’s advice to go with the purchaser. Over the years as the scope of my practice has narrowed and I began making referrals to other attorneys or accountants I found long time clients, who have entrusted me with many of their problems, seem perfectly willing to take my advice as to the proper person on a referral, whether it is an injury case, litigation case, complex business transaction, or just a tax return.

In domestic relations cases, a business owner may claim that it is “all me” or “without me there is no business”. Presidents are changed every four to eight years and manage to get by. Clients can learn to get by without the principal. The transfer mechanism takes more than changing the locks on the doors or handing the new owner the keys. But to head down a path wherein the non business owner receives nothing of substance for the personal goodwill, developed over the period of the marriage, makes no more sense than saying there should be no spousal support. Spousal support recognizes that income differentials may exist at the end of the marriage. Spousal support is really a sort of transition mechanism as the parties separate. Personal goodwill, which is developed over a lifetime work, seems not that dissimilar to the income that is received from the business.

A review of the state by state analysis leads one to the conclusion that separation of goodwill into a personal component, which is not divisible for domestic relations cases, and enterprise goodwill which is divisible for domestic relations cases, indicates that this distinction, with its results, is an idea whose time has come. Once again Ohio may be viewed as behind the curve. But, before Ohio gets on this particular train, one need look at the equitable result that domestic relations courts attempt to attain. Denying that personal goodwill is a marital asset that should be divided in some fashion seems more like a step backward in time to when businesses assets were not thought of as marital assets subject to division. Perhaps when the train stops, Ohio should just not get on. The reality is that situations are created during marriage that leads to financial differences. One of those financial differences may be the creation of personal goodwill which may be the most valuable asset in the marital estate. A second reality is that personal goodwill may not be subject to division. Perhaps the real problem is over-dependence on the concept that treats all assets as if they were fungible goods and insist on equal division.

Until the Supreme Court of Ohio deals with the issue, trial courts will not have any clear direction.