BVWire.com reported this week on a recent California case where the issue of double dipping was examined in the context of divorcing business owners:

The husband owned a produce company in California, valued at $5.6 million, ostensibly under the capitalization/excess earnings method. After a marriage of “long duration and substantial standard of living,” the trial court awarded the wife $20,000 per month in spousal support plus half ($2.8 million) of the business. The husband appealed, urging a blanket prohibition against double dipping—i.e., using the same stream of earnings to determine business value/property division and also support.

In Blazer v. Blazer (No. DR 38292, Aug. 25, 2009), the California Court of Appeals discusses the excess earnings method and, in particular, the myriad ways to distinguish personal from enterprise goodwill. It also considers the double-dipping precedent from other jurisdictions as well as its own cases concerning pension divisions. In the end, the court sidesteps the issue by finding insufficient proof that the husband’s expert in fact valued the business by capitalizing his future income stream. Moreover, “the earnings of an ongoing business…do not always derive solely from the personal efforts of its operator, nor is there evidence that such is the case here.” The court explicitly confirmed the equity of the spousal award in this case as well as the trial court’s implicit determination that there was no double counting of the husband’s income.

Thus, the question remains open in California and elsewhere—especially for cases concerning owners of a professional firm or solo practice whose interests are valued under the excess earnings method. Look for a full summary of Blazer and our continuing analysis of double dipping in the November Business Valuation Update™.

This weekend I am in Chicago to attend the BVR Divorce Conference. I will read the case and many others while I am there, so I will have much to report about when I return!

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.

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.

Apparently the new frontier in divorce litigation is personal goodwill. Following closely on the heels of May (W.Va.2003) and other divorce decisions, the Supreme Court of Kentucky held recently that the non-transferrable goodwill of a professional practice was properly excluded from the marital estate.

The subject business in Gaskill v. Robbins (2/17/09) was an oral surgery practice, operated by the wife, without associate professionals. The wife’s expert presented an asset-based valuation, giving no value to goodwill because “Gaskill’s role in the business amounted to a ‘non-marketable controlling interest.’” The wife’s expert reasoned that no buyer would pay more than the fair market value of hard assets when the wife could set up shop down the hall and attract her patients away from the old practice.

The husband’s expert considered several approaches: capitalization of earnings, excess earnings, net asset value, and market comparables. He averaged these approaches to arrive at a valuation that included goodwill and a non-compete agreement. He also criticized the opinion of the wife’s expert who had doubled the compensation of the wife’s non-professional staff, thereby depressing earnings.

The trial court adopted the valuation of the husband’s expert, reasoning that the salary adjustment made by the wife’s expert was unreasonable, and noting that Kentucky law did not recognize a distinction between enterprise goodwill and personal goodwill.

The Kentucky Court of Appeals reversed, holding that not all businesses have goodwill; and the Supreme Court of Kentucky affirmed that reversal on other grounds.

In its Opinion, the highest court of Kentucky examined the fair market value standard and the meaning of “goodwill” in the context of business valuation. The Kentucky court noted that none of its prior decisions had specifically considered the difference between enterprise goodwill and personal goodwill but none had prohibited such an analysis. The Court recognized that the reputation and skill of this professional practice were closely associated with the wife and might not be transferrable to a buyer. The Court also noted that professional degrees are not regarded as marital property to be divided upon divorce under Kentucky law.

The Kentucky Supreme Court also considered the decision of the West Virginia Supreme Court in May v. May (2003), which contained a survey of cases dealing with goodwill nation-wide. May, in turn, relied heavily upon the Indiana Supreme Court’s decision in Yoon v. Yoon (1999), which distinguished between transferrable enterprise goodwill and non-transferrable personal goodwill. Ultimately, the Kentucky court aligned itself with these courts in reaching that distinction.

See also Helfer (W.Va.2007); Stewart (Idaho 2007); Hess (Maine 2007).

Gaskill joins a long list of cases that distinguish personal goodwill from enterprise goodwill in the context of professional practices. It will be interesting to see, in the future, whether these courts will extend this rationale to other types of businesses, where the reputation, skills and efforts of the business owner spouse are not so easily associated with the goodwill of the business.