Goodwill As It Evolves. By: David D. Riley

Transcription

1 Goodwill As It Evolves By: David D. Riley Disclaimer: This article is distributed with the understanding that the information contained does not constitute legal, accounting or other professional advice. It is not intended to be responsive to any individual situation or concerns as the contents of the publication are intended for general informational purposes only. Readers are urged not to act upon the information contained in this article without first consulting competent legal, accounting or other professional advice regarding implications of a particular factual situation. Introduction: The concepts of goodwill have greatly evolved over the past decade. Practitioners and academics persevere in their quest of breaking down what was once a simple concept of a bundle of unidentified intangible assets into the more complex concepts of identifying and measuring the individual components of goodwill. Accountants presently define goodwill as: the excess of the purchase price compared to the net assets acquired. The accountant s goodwill has five individual components. These are: Marketing-related intangible assets, which can include trademarks, trade names, noncompete agreements, and internet domain names. Customer-related intangible assets include customer lists and existing customer relationships, whether or not they are contractual in nature. Artistic-related intangible assets are the assets that arise from contractual or legal rights such as those provided by copyright. Contract-based intangible assets are those that arise from contractual arrangements, such as permits, franchise agreements, licensing and royalty agreements, and other contractual rights granted. Technology-based intangible assets relate to innovations or technological advances. The future economic benefits of those assets are often protected through contractual or other legal rights. Under the accountant s viewpoint, goodwill cannot be realized until an entity is sold. Economists generally define goodwill as the value of the intangible advantages a company has over its competitors (e.g. excellent reputation, strategic location, operating processes, business connections) represented in a higher market value if the company were sold. 1

2 Warren Buffett s 1983 explanation of economic goodwill continues to hold true today as: Businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. As such, the most raw definition of economic goodwill is: The Net Present Value of an Entity s Future Earning Streams Less: The Fair Market Value of an Entity s Net Tangible Assets Economic Goodwill Under the economist s viewpoint, goodwill is merely a component of an investment opportunity. Domestic Courts are not immune in the pursuit of dividing goodwill into meaningful components. In the 2003 Supreme Court of Appeals of West Virginia decision May v. May (No ), total goodwill of a solo dental practice was bifurcated into two separate components: 1. Personal goodwill - a personal asset that depends on the continued presence of a particular individual and may be attributed to the individual owner s personal skill, training or reputation. 2. Enterprise goodwill - an asset of the business and may be attributed to a business by virtue of its existing arrangements with suppliers, customers or others, and its anticipated future customer base due to factors attributable to the business. Since 2003, the majority of the State Jurisdictions separate total goodwill into the components of personal goodwill and enterprise goodwill. These jurisdictions take the position that: Personal goodwill is intrinsically tied to the attributes and skills of an individual and is not marital property. Enterprise goodwill is attributable to the business itself and is marital property. This concept of personal goodwill and enterprise goodwill has matured and expanded to other jurisdictions. In fact, some cases have argued that personal goodwill extends beyond the realm of professional practices into other closely-held enterprises. In fact, one such case in Illinois (Marriage of Talty 166 Ill.2d 232, 652 N.E.2d 330 (1995)) attempted to attribute a portion of total goodwill to the owner in an automobile dealership. Minnesota is a jurisdiction that challenges both the Family Courts and the valuation professionals to address the personal goodwill and enterprise goodwill issue -- whether goodwill should be bifurcated between personal goodwill and enterprise goodwill, and, if so, how such bifurcation should be computed, quantified and presented. Due to the vast scope of goodwill within the context of marital dissolution matters, this article limits itself to three key discussion points from my observations throughout the years. 2

3 Observation #1: Personal Goodwill is Not a New Thing: Personal goodwill is not a foreign concept in Minnesota s Family Court system. Since the 1980's, Family Courts of Minnesota have taken the position that key person discounts must be applied in valuing businesses when the owner-spouse has key person status in the business. Key person status in a business generally denotes a person whose individual abilities, character, efforts, and relationships are critical to the success of a given business. The risk associated with the loss, or hypothetical loss, of such a person reduces the total value of the business. This reduction in total value is captured through the application of a key person discount. In other words, "when the success of a business is highly dependent upon one person, the likelihood of the business being a continued success in the hands of a willing buyer is significantly decreased." In the business valuation environment, a key person discount is "an amount or percentage deducted from the value of an ownership interest to reflect the reduction in value resulting from the actual or potential loss of a key person"(international Glossary of Business Valuation Terms). Competent valuation analysts have historically captured key person discounts in one or more of the following ways: Applying a key person discount rate to total calculated value as defined by the International Glossary of Business Valuation Terms. Adjusting the discount or capitalization rate for additional company specific risks due to reliance on a key person. Adjusting future earnings to reflect the risk of losing of a key person. Economically speaking, the magnitude of the key person discount is the difference in the present value of net cash flows with the key person and the present value of net cash flows without the key person involvement. So although there has been a great deal of debate within the legal and valuation and professions regarding the treatment of personal goodwill in the context of divorce, personal goodwill in Minnesota has historically been captured through key person discounts. As such, both theoretically and economically, the key person discount represents the personal goodwill attributed to an entity. Value Less Key Person Discount = Value Less Personal Goodwill 3

4 By reconciling key person discount to personal goodwill, one can readily see that often personal goodwill is overstated through double counting or understated due to the narrow focus on dividing total goodwill into person and institutional goodwill. Also, it is important to note that case law regarding key person discounts provides a longer history of guidance than case law dividing total goodwill into the components of personal goodwill and institutional goodwill. Observation #2: Personal Goodwill May No Longer Be the Same as Professional Goodwill: The term personal goodwill has often been treated as a synonym to the term professional goodwill. In fact, early cases dealing with professionals were predicated on the assumption that any existence of goodwill within the practice was attached to the professional of that practice. This assumption has led to the belief that all goodwill in professional practices is personal goodwill to the exclusion of enterprise goodwill. The business environment is constantly striving to increase the efficiency and profitability of an enterprise through the creation of systems. These systems have successfully contributed to the restructuring of professional practices into turn-key operations. Technology, staff training and best practices have assisted professionals in creating business models that are less reliant on one individual or another. As such, much of the professional (personal) goodwill is often transferred to institutional goodwill. One only has to compare a modern day dental practice to a dental practice of yore. In the past, the dentists spent significantly more time with each patient and had a greater opportunity to establish patient rapport. Today s dental practices, however, have systems that leverage the dentist s time with each patient. System examples include: scheduling and patient management technology, Staff training that allows hygienist and dental assistant to provide more patient care duties, and best practices for managing insurance coverage. These systems tend to lessen the economic impact an individual dentist has on total goodwill and reallocates a portion of personal goodwill to enterprise goodwill. Another issue is whether business systems, both tangible and intangible, are salable and/or transferable. One argument states that enterprise assets are salable/transferable and personal assets are not salable/transferable. As such, valuations performed using traditional market approach captures only salable/transferable assets and no adjustments are to be made to recognize personal assets (goodwill). According to actual transactional data, sole professional practitioners consistently sell their practice for over its net asset value. These professionals have been able to organize their tangible and intangible assets into systems that often create significant enterprise goodwill. As such, any existence of goodwill within the practice may not be entirely attached to the professional of that practice. 4

5 Observation #3 The Term Fair Market Value is a Malleable Term: Valuation professionals from their first day in training have learned and dutifully memorized the definition of Fair Market Value as: Fair Market Value the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms-length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. (Source: International Glossary of Business Valuation Terms) The domestic Courts also use the term of Fair Market Value (FMV) to describe their jurisdiction s standard of value. Generally, these Courts may flex and adapt the term in order to reach overall equitable findings for the parties involved. As such, often when the Court s opinion of FMV is compared and contrasted to the International Glossary of Business Valuation Term, significant differences may exist. One concept that case law is attempting to reconcile is the interplay of a willing seller and the notion of personal goodwill as evidenced by a non-compete agreement. Embedded in the term FMV is that both the selling party and the buying party have the goal of maximizing their economic position throughout the transaction. As such, congruent to the maximization goal, the seller cooperates with the buyer to efficiently transfer all tangible and intangible assets (e.g. passwords to technology, keys to buildings/vehicles, employee and customer records, trade secrets, etc.) If the seller does not cooperate, the buyer has no choice but to reduce payment (e.g. further negotiation or law suit) or walk away from purchase. As such, one argument states that the traditional FMV definition classifies a non-compete-agreement as evidence of a willing seller cooperating in the transfer of assets. The other argument states that, even though the valuation is a simulation of a hypothetical sale, there exists no willing seller in the context of a marital dissolution. This debate will continue to evolve. Family law practitioners and valuation analysts must be aware of the meaning of their jurisdiction s term of fair market value. Conclusion: Even though the meaning of goodwill seems to be a moving target, case law dictates that family practitioners take aim at hitting this ever changing and elusive target. David D. Riley, CPA, ABV, CFF, CFE, ASA, CVA, CMA, CBA, MBA is a member of Eide Bailly LLP s Forensic and Valuation Services Group. He is responsible for litigation, valuation and forensic accounting services. Services include performing as an expert on a variety of litigated matters, conducting business and intangible valuations, and forensic accounting assistance. Contact Information: Phone: driley@eidebailly.com 5