This weekend I attended the second annual Divorce Summit sponsored by Business Valuation Resources, one of the leading publishers in the bizval field. On Thursday, September 24, 2009, we heard The View from the Bench, giving voice to a group of family law judges from New York, Illinois, Rhode Island, and elsewhere. One of the standouts was the Hon. Edward Jordan, a family law calendar control judge from Cook County, Illinois. His commentary was insightful and pithy, and I was enchanted by the notion of a calendar control judge who could dispatch cases ready for trial to the judges within a few short weeks. 

When the judges had had their say, it was the lawyers’ turn. A panel of AAML divorce lawyers informed the assembly of bizval professionals “What Lawyers Expect from their Financial Experts.”  The breakout sessions on Thursday and Friday were stellar, starting with “Reasonable Compensation in Divorce” by Ron Signeur and Sharyn Maggio. One of the most useful discussions, in my mind, was the itemized lists of criteria that experts and courts may consider when determining reasonable compensation (hint: article forthcoming).

Another of my favorite breakout sessions was Chris Mercer’s and Ashok Abbott’s  seminar on “Active vs. Passive Appreciation.” In most states other than Pennsylvania, the divorce courts distinguish two types of increase in the value of separate assets. Appreciation in value that results from the efforts of a spouse during the marriage are regarded as separate property, while appreciation due to passive factors such as inflation is part of the marital estate. In Pennsylvania, a corollary concept is the Adelstein argument (where a nonmarital asset has experienced a post-separation increase in value). Mercer presented one of the most compelling analyses I have seen on this issue, quantifying the specific dollar amount of passive and active increase based upon the Gordon Growth present value formula. It was brilliant, and in my opinion, just the starting point of an important development in BV technique (hint: another article forthcoming!).

A Friday breakout on “Transmutation and Tracing” was informative and timely, given the proliferation of this concept in divorce litigation. Fact: some litigants in California are commissioning a forensic accounting of their entire marriage to determine whether property was acquired with community funds or separate funds. 

The Thornhill case (in which Colorado refused to adopt a fair value standard in matrimonial litigation) was highlighted in several presentations. I must say this conference was one of the best I have attended in some time.

The Tennessee Court of Appeals recently held that a business owner’s spouse who signed a buy-sell agreement was bound by the value in a divorce action. In Inzer (2009), the husband and wife both signed a buy-sell agreement when they formed an LLC to purchase a Sonic Drive-In franchise. The buy-sell agreement granted other partners a right of first refusal to buy the interests of a withdrawing partner for the lesser of book value or the offer procured by the withdrawing partner. The owner’s expert presented evidence that the owner’s 24% interest in the franchise was worth $120,000 to $135,000 using capitalized cash flow or market methods, but only $16,000 net book value after discounts. Wife’s expert testified to a value of more than $500,000 after making adjustments to the owners’ compensation and ignoring discounts for lack of marketability, lack of control or the restrictive operating agreement.

The trial court valued the owner’s interest at $200,000 without much explanation. The Tennessee Court reversed, holding that the franchise was worth $33,000 book value without consideration of intangible value or discounts (as specified in the buy-sell agreement). The appellate court distinguished cases in which buy-sell agreements were not controlling, since the non-owner spouse in those cases did not sign the buy-sell.

Consider whether it was appropriate for Wife’s expert to perform  Type I adjustments in his normalization of the income statement, i.e., adjusting the owners’ compensation. Could a purchaser of a 24% interest compel the other owners to reduce their compensation? Even if the Court had not held the buy-sell to be controlling, it seems unlikely that Wife’s expert would have prevailed.

In divorce litigation where one of the spouses owns a professional practice, such as a medical practice, dental practice, law firm or accounting firm, the lawyers and their experts have to determine whether the business has value. Their determination depends upon whether the professional practice is believed to have enterprise goodwill.

Briefly, enterprise goodwill is the price that a buyer would pay for a professional practice over and above the value of its hard assets like equipment and supplies. In theoretical terms, enterprise goodwill is the reputation of the business that is not closely associated with a particular owner or professional. The opposite of enterprise goodwill is personal goodwill, which is the reputation and skill of the professional. Enterprise goodwill has value because it is transferrable but personal goodwill is not. Someone might be willing to pay for a name like Aspen Dental Systems, but what about Jane Doe, PC?

Increasingly, there is a market for professional practices that are not part of a regional or national chain. Dental practices, even those with a single location and single dentist, are bought and sold frequently. The same is true for specialty medical practics. Yet, primary care medical practices and legal practices are rarely bought or sold. So, how does a lawyer decide whether a professional practice should be evaluated by a business valuation specialist? Here are three signs that a professional practice might have value:

1. Actual transactions. If a professional or his/her partners have bought or sold their practices, it is more likely that there is transferrable enterprise goodwill. However, you must distinguish market transactions from succession planning. If the only transactions are between retiring partners and advancing associates, then there may not be much enterprise goodwill.

2.  Subordinates and equipment.  One reason why dental practices are increasingly transferrable is that dental procedures are performed by hygenists and associate dentists. If the owner of the practice is earning profit from other professionals and paraprofessionals, then a buyer might be willing to pay something to step into those shoes.

3.  Excess compensation. If a professional is earning substantially more than industry standards, then the professional’s practice might have enterprise goodwill. No buyer would pay to assume an existing practice if he or she could start a new practice for free – except if the existing practice were more profitable than a new practice would be. This criteria is based on the principle of substitution.

The U.S. Court of Appeals for the Seventh Circuit recently took up the case of Menard v. Commissioner, 560 F.3d 620 (2009), considering whether the CEO of a privately-held company was receiving a dividend disguised as salary from the business he controlled. The CEO whose salary was questioned was John Menard, founder and controlling shareholder of Menards, a chain of retail hardware and building supply stores. The Tax Court took the position that John Menard’s $20 million salary was really a disguised dividend because it was much greater than the salaries of the Home Depot and Lowe’s CEOs, who earned $2.8 million and $6.1 million respectively.

The appellate court’s opinion in this case is so well-researched that I cannot help but include large blocks of text, starting with its introduction to the subject:

The Internal Revenue Code allows a business to deduct from its taxable income a “reasonable allowance for salaries or other compensation for personal services actually rendered,”[or] “payments purely for services.” Occasionally the Internal Revenue Service challenges the deduction of a corporate salary on the ground that it’s really a dividend. A dividend, like salary, is taxable to the recipient, but unlike salary is not deductible from the corporation’s taxable income. So by treating a dividend as salary, a corporation can reduce its income tax liability without increasing the income tax of the recipient. . . As a result of a change in law in 2003, dividends are now taxed at a lower maximum rate than salaries—15 percent, versus 35 percent for salary. 26 U.S.C. § 1(h)(11). This makes the tradeoff more complex; although the corporation avoids tax by treating the dividend as a salary, which is deductible, the employee pays a higher tax. But depending on its tax bracket, the corporation may still save more in tax than the employee pays, and in that event, if the employee owns stock in the corporation, he may, depending on how much of the stock he owns, prefer dividends to be treated as salary. . . . Even before the change in the Internal Revenue Code, treating a dividend as salary was less likely to be attempted in a publicly held corporation, because if the CEO or other officers or employees receive dividends called salary beyond what they are entitled to by virtue of owning stock in the corporation, the other shareholders suffer. But in a closely held corporation, the owners might decide to take their dividends in the form of salary in order to beat the corporate income tax, and there would be no one to complain—except the Internal Revenue Service.

The usual case for forbidding the reclassification (for tax purposes) of dividends as salary is thus that “of a corporation having few shareholders, practically all of whom draw salaries,” Treas. Reg. § 1.162-7(b)(1), especially if the corporation does not pay dividends (as such) and some of the shareholders do no work for the corporation but merely cash a “salary” check. A difficult case—which is this case—is thus that of a corporation that pays a high salary to its CEO who works full time but is also the controlling shareholder. The Treasury regulation defines a “reasonable” salary as the amount that “would ordinarily be paid for like services by like enterprises under like circumstances,” § 1.162-7(b)(3), but that is not an operational standard. No two enterprises are alike and no two chief executive officers are alike, and anyway the comparison should be between the total compensation package of the CEOs being compared, and that requires consideration of deferred compensation, including severance packages, the amount of risk in the executives’ compensation, and perks.

Courts have attempted to operationalize the Treasury’s standard by considering multiple factors that relate to optimal compensation. [Citations omitted.] We reviewed a number of these attempts in Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir.1999), and concluded that they were too vague, and too difficult to operationalize, to be of much utility. Multifactor tests with no weight assigned to any factor are bad enough from the standpoint of providing an objective basis for a judicial decision [citations omitted]; multifactor tests when none of the factors is concrete are worse, and that is the character of most of the multifactor tests of excessive compensation. . . . All businesses are different, all CEOs are different, and all compensation packages for CEOs are different.

In Exacto, in an effort to bring a modicum of objectivity to the determination of whether a corporate owner/employee’s compensation is “reasonable,” we created the presumption that “when . . . the investors in his company are obtaining a far higher return than they had any reason to expect, [the owner/employee’s] salary is presumptively reasonable.” But we added that the presumption could be rebutted by evidence that the company’s success was the result of extraneous factors, such as an unexpected discovery of oil under the company’s land, or that the company intended to pay the owner/employee a disguised dividend rather than salary. 196 F.3d at 839.

The strongest ground for rebuttal, which brings us back to the basic purpose of disallowing “unreasonable” compensation, is that the employee does no work for the corporation; he is merely a shareholder. [Citations omitted.] Comparison with the compensation of executives of other companies can be helpful if—but it is a big if—the comparison takes into account the details of the compensation package of each of the compared executives, and not just the bottom-line salary. This qualification will turn out to be critical in this case.

Having explained the context of this case, the Circuit Court next explained why the Tax Court’s analysis was wrong, especially its comparison of John Menard’s salary to the salaries earned by the Home Depot and Lowe’s CEOs in that year. The appellate court first rejected the notion that the taxpayer’s $17 million bonus, which was equal to 5% of the company’s net income before taxes, was more likely to be a dividend than salary because it was paid at year’s end; was approved by a board that the CEO controlled without outside directors; must be returned if the IRS should disallow the company’s tax deduction as salary; and exceeded the salaries earned by the CEOs of publicly-traded competitors (Home Depot and Lowe’s). The appellate court noted that the managers of privately-held companies often face greater risk than public companies, warranting greater reward for success:

Of particular importance to this case is the amount of risk in the compensation structure. Risk in corporate compensation is significant in two respects. First, most people are risk averse, and the scholarly literature on corporate compensation suggests that risk aversion is actually an obstacle to efficient corporate management because managers tend to be more risk averse than shareholders. Shareholders can diversify the risk of a particular company by owning a diversified portfolio, but a manager tends to have most of his financial, reputational, and “specific human” capital tied up in his job. [Citations omitted.] So the riskier the compensation structure, other things being equal, the higher the executive’s salary must be to compensate him for bearing the additional risk.

That is not a critical consideration in this case because, as we said, management and ownership in Menards are not divorced. But a second significance of risk in a compensation structure is fully applicable to this case. A risky compensation structure implies that the executive’s salary is likely to vary substantially from year to year—high when the company has a good year, low when it has a bad one. Mr. Menard’s average annual income may thus have been considerably less than $20 million—a possibility the Tax Court ignored. Had the corporation lost money in 1998, Menard’s total compensation would have been only $157,500—less than the salary of a federal judge—even if the loss had not been his fault. The 5 percent bonus plan was in effect for a quarter of a century before the IRS pounced; was it just waiting for Menard to have such a great year that the IRS would
have a great-looking case?

The appellate court also noted that the Tax Court had not considered the total compensation packages of the CEOs from the public companies, such as equity compensation, severance packages, retirement plans, and perks. The appellate court noted that the CEO of Home Depot, whose salary was used as a benchmark, actually earned $124 million over six years, and a $210 million severance package when he was forced out. The Court of Appeals also noted that the Tax Court had not considered the salaries of other senior managers, both of Menards and of the benchmark public companies, which may have indicated that this CEO was more productive and delegated less than average. The Court observed that John Menard worked 14 to 16 hours per day, six to seven days per week.

The Seventh Circuit adopted a skeptical, even sarcastic, tone toward the Tax Court’s remark that the owner of a business has no need for incentive compensation because ownership is incentive enough. The Court of Appeals held that owners should not be treated differently from other managers.

Having concluded that John Menard’s $20 million salary was not excessive, the Court of Appeals reversed.

Gallows humor is intended to comfort us in troubling times, I suppose. An article in the New York Times offered a new definition of “goodwill” appropriate to the ongoing economic recession. In “Losses in Goodwill Values Dog Bank Deals,” the NYT defined goodwill as “the amount they overpaid for a business compared with the sum of its parts.”

Goodwill appears on the balance sheet of a business when it purchases other businesses. In that context, goodwill is equal to the price paid for the acquisition target in excess of its book value. Every good joke contains a kernel of truth.

I will be appearing as the host of an upcoming Pennsylvania Bar Institute seminar, Business Valuation and Divorce. My guests will be Bob Grossman CPA and Melissa Bizyak CPA of Grossman Yanak & Ford. Bob, Melissa and I will be talking about the hot topics that confront business owners and their lawyers in divorce litigation, including double dipping, tax issues, executive compensation, and the market-based and income-capitalization models for business valuation. It’s a lot to cover; time will fly!

The seminar will run from noon until 4:15 p.m on August 12, 2009 at the PBI Conference Center in the Heinz 57 Building on Sixth Avenue, Pittsburgh (next to the Duquesne Club). It will be broadcast by satellite simultaneously in Philadelphia, Erie, Mechanicsburg/Harrisburg, Washington, Greensburg, Reading, West Chester and Wilkes-Barre. PBI is offering an early bird discount for those who register more than 2 days in advance. Register here!

This is the last in a series of posts containing summaries of Pennsylvania case law on the issue of double dipping in divorce. “Double dipping” occurs when an income-producing asset (such as a pension or business) is counted as marital property subject to equitable distribution, as well as income subject to an alimony or child support obligation.

Steneken v. Steneken, 873 A.2d 501 (N.J. 2005).

Although it is not a Pennsylvania decision, no discussion of double dipping would be complete without Steneken, a 2005 decision of the New Jersey Supreme Court. In this case, the husband was the sole owner of a business which was marital property subject to equitable distribution. The valuation expert performed a normalization of the owner’s compensation in his report, reducing the company’s salary expense and thereby increasing the value of the company. In determining an alimony award, the husband argued that the court should consider his lower, normalized compensation instead of his actual salary (since the excess compensation had been capitalized as part of the business valuation and divided as marital property). The trial court accepted the husband’s argument and used his normalized salary instead of his actual salary.

An appeal ensued, and the case was remanded to the trial court because the intermediate appellate court held that the record was not fully developed. On remand, the trial court reversed its earlier position and used the husband’s actual salary to determine the proper amount of alimony.

The intermediate appellate court, reviewing New Jersey’s divorce statute, held that the prohibition on “double dipping” extended only to pensions and affirmed the trial court’s decision. The husband appealed to the New Jersey Supreme Court to extend the principle to double dipping arising from the capitalization of earnings in the context of a business valuation. Since an income capitalization approach had been used by the valuation expert endorsed by the trial court, and was not challenged, the husband argued that he should not have to pay alimony from the excess compensation that had been capitalized and distributed as part of the value of the business.

The New Jersey Supreme Court disagreed, affirming the trial court’s decision to permit double dipping. Rather than adopting the intermediate court’s rationale, the New Jersey high court attacked the husband’s reasoning.

The logical flaw in defendant’s argument lies at its core. Defendant mistakenly equates the statutory and decisional methodology applied ni the calculation of alimony with a valuation methodology applied for equitable distribution purposes that requires that revenues and expenses, including salaries, be normalized so as to present a fair valuation of a going concern. Simply said, defendant’s charged mischaracterization of the issue here as one of “double counting” both misstakes the issue and ignores the fundamental principles that undergird related yet nonetheless severable alimony and equitable distribution awards.  As our statutory framework and decisional precedent make clear, the proper issue is whether, under the circumstances, the alimony awarded and the equitable distribution made are, both singly and together, fair and consistent with the statutory design. . . . Because we embrace the premise that alimony and equitable distribution calculations, albeit interrelated, are separate, distinct, and not entirely compatible financial exercises, and because asset valuation methodologies applied in the equitable distribution context are not congruent with the factors relevant to alimony considerations, we conclude that the circumstances here present a fair and proper method of both awarding alimony and determining equitable distribution.

The New Jersey court’s opinion is not convincing; other reasons might have been more forceful. For instance, the court might have started with the observation that a business valuation expert ordinarily has no expertise in executive compensation. To identify part of the owner’s salary as excessive is tantamount to saying that the business could hire someone to do the job for less, or conversely, the owner would earn less if he or she sought employment elsewhere. Such determinations are beyond the expertise of most valuation experts, and should not be relied upon to determine the owner’s earning capacity for alimony and support purposes. Yet, if those normalization adjustments are not suitable to determine the owner’s earning capacity, why should we rely on them for the business valuation?

The New Jersey court noted that if a different valuation methodology had been applied, there might be no normalization adjustment to the owner’s salary. That is true, in the case of an asset approach. However, an asset approach assumes liquidation of the company, not ongoing concern value. The owner’s excess compensation does not get capitalized under the asset approach, so there is no possibility of double dipping. In the market approach, normalization of the income statement or cash flow is performed before applying a multiplier. Therefore, the potential inconsistency perceived by the Court is illusory.

In a vigorous and well-reasoned dissent, three of the seven Justices enunciated a compromise position: that the trial court need not use normalized compensation when computing the owner’s alimony obligation but should have discretion to adjust the value of the business or the alimony award to alleviate the double dip.

BVWire recently published a follow-up to its teleconference, Valuing Dental Practices, by raising a question about business valuation using the excess earnings method (also known as Treasury Method).

Where do you get your cap rates under an excess earnings method? It’s a question that came up at the recent BVR teleconference, Valuing Dental Practices, featuring BV experts James Andersen, Ron Seigneur, and Stephen Persichetti, a practicing dentist and professor of dental practice management. In answer to the query, one panelist explained, “When you’re using excess earnings, it’s appraiser’s judgment. I’ve seen reports that use Ibbotson or D&P. But your cap rate has to be larger, and sometimes significantly higher, as much as 40% and 60%.”

The BVWire™put the question to Seigneur, who cautioned, “There is no holy grail for developing the capitalization rate under the excess earnings method.” That said, he offered the following insights as a “reality check” for BV experts:

When breaking the economic returns of an enterprise out between the returns on tangible assets and the returns on the intangible assets, it is commonly accepted theory that the returns on the tangible asset base is less risky, and therefore, require a lower economic return to justify the risks associated with the tangible assets. On the other hand, the rates of return required for each class of assets (be they tangible, like cash, inventory, fixed assets, etc., or intangible, such as the reputation of the business, the customer base, etc.) must collectively reconcile to the overall economic return (e.g. capitalization rate) on the overall, all in, benefit stream of the entity.

For example:

If the enterprise is assumed to justify a 30% overall capitalization rate, the returns on the various categories of tangible assets will likely each be below this 30% combined return. The returns required to capture the risks of the various intangibles will likely each be above 30%, with the overall weighted or blended rates tying back to the 30% overall risk adjusted rate associated with the entity take as a whole.

I’m not sure I know the answer to this one, so I’m throwing it out there for comments.

One of my favorite email blasts, BVWire (published by BVResources), described several free resources that might interest professionals who are interested in the value of their medical practices.

1. Kaiser Family State Health Facts. In addition to excellent statistics on all things healthcare, this resource includes a chart showing Nonfederal Physicians per 1,000 Population in 2008 and the concentration of physicians in the Northeast U.S.

2. Centers for Medicare & Medicaid Services. Table 23 of the 2007 CMS Statistics, “Practitioners per CMS Region,” shows the number of practitioners per 100,000 population.

3. Merritt Hawkins & Associates. Their 2008 Survey of Primary Care Physicians is another must-see.

Additionally, BVWire provided a link to the free 2009 ASC Valuation Survey Results by HealthCare Appraisers, Inc., which contains valuation multiples and transaction activity as well as extensive practice survey results.

The current economic recession has had a profound adverse impact on many businesses. So, in cases where we are asked to value businesses on a valuation date prior to the recession, how can we ignore what we know will happen? One of my favorite lecturers, Mel Abraham, answered this question in the BVResources newsletter this month by recalling an interaction he had with a California judge a few years ago. In that case, the business had lost its largest (60%) client six months after the valuation date, and Abraham had factored the risk of client loss into his discount rate and DCF calculations. When the judge argued that this was a subsequent event, Abraham agreed but countered, “The loss of the client was definitely a subsequent event, but the risk of losing the client was known and knowable as of the date of valuation.” Looking back to valuation dates, particularly in mid-2008, you cannot include loss of revenues or other damages that actually occurred as the result of this current economic downturn, he added. However, conditions known as of the valuation date (like heavy leverage, declining assets, or other high-risk indicators) could, should, and would have been known or knowable even prior to the stock market meltdown.