Consideration of Goodwill

It is Not Just for Divorce Anymore

Personal and enterprise goodwill are not just relevant in marital dissolution cases; they are important considerations in bankruptcy, tax, business succession planning, execution of buy-sell agreements, and transactional matters. These other matters present practitioners with additional ways of differentiating their services. In this article, the author shares the importance and opportunity of recognizing the other ways goodwill becomes a factor and the opportunity this realization presents practitioners.

Perhaps the title to this article may be a bit misleading since it implies that goodwill is only newly relevant in applications outside of family law. I apologize for that bit of click-bait or leeway; however, I hope that you were drawn into this article to learn about when you may need to consider goodwill valuation and apportionment in non-divorce work. I do not intend to mislead you in that regard; since you are here, let’s get to it.

There is much discussion around personal goodwill in the context of divorce: see the publication formerly known as Goodwill Hunting (now Charting Goodwill Jurisprudence), Business Valuation Resources’ (BVR) Special Report on Valuing Goodwill published in 2011, etc. Though it is not marketed exclusively for family law, BVR’s Guide to Personal v. Enterprise Goodwill is heavily weighted to application in matrimonial litigation. It is a great resource, regardless, and it does go beyond the scope of family law to include an article on bankruptcy and entries discussing tax case law. In fact, there is a wide body of case law dealing with personal goodwill and tax law. Maybe you were aware. Have you considered the implications for other areas of practice that this case law presents? Have you considered how goodwill—and personal goodwill—can impact a transaction? Have you thought about how goodwill considerations might inform your discussion with business owners and help you elucidate complex issues or resolve conflicts between buyers and sellers? What if the identification and valuation of personal goodwill could help design buy-sell agreements that properly compensate beneficiaries in the event of a triggering event, without putting the business at risk? Would that be valuable to your clients? Would it make you a more valuable consultant or advisor?

Impact on Transactions

Let’s review a fictional scenario to consider the impacts of personal goodwill on transactional consulting. We have an equipment leasing company doing $5 million in annual revenues. The current owner has a handful of employees but makes the sales calls himself. He has longstanding relationships with customers and a reputation with large businesses that he will take care of their needs and keep them up-and-running. He is in his 70s and would continue in the business, but his wife would like for him to settle down and tend the farm. He would like to sell the business and is willing to stay on with a buyer to help transfer the relationships. A buyer has been identified and this buyer is confident that the personal relationships of the seller are transferrable. The parties are not far apart in their expectations of value, but they are both stubborn and unwilling to budge on their predetermined price—the buyer is unwilling to pay more than $4,500,000 and the seller is unwilling to walk away for less than $4,750,000. If you sat down and looked at the value of the company, you would have determined 20 percent of the company’s value was due to goodwill, and 50 percent of that was personal goodwill. Perhaps the prospect of an amortizable asset will sweeten the deal for the buyer, while also providing a lower tax bill for the seller. $450,000 to $475,000 of goodwill could go a long way to negotiating the price gap.

It is important to note that simply classifying part of the purchase price as personal goodwill does not mean that the IRS must accept the allocation as fact. There are certain hurdles that must be met—discussions of goodwill need to be had early and often, the documentation must be sufficient and support the existence of personal goodwill, personal goodwill cannot have been previously transferred to the corporation, the allocation cannot be an afterthought for the sole purpose of reducing a tax liability, etc. We are presuming in this scenario that the personal goodwill is a true, economic reality; the transference of which opens up additional possibilities for deal structures.

Impact on Buy-Sell Agreements

Consider another fictitious scenario. This time for an IT services company with three partners, with equal ownership. The partners are each married with families. Each would like to ensure that the family left behind is provided for in the event of an untimely demise. Each is also concerned about the sustainability of the company in the event of a partner’s untimely demise. A buy-sell has been established for the company to buy out a partner’s interest upon a triggering event such as death.

To better illustrate the latter, assume the following example. Assume the enterprise value of the company is $21 million. Mathematically, 1/3^rd share would be worth $7 million. Disregard for a moment lack of control issues and changes in marketability for partial interests in a privately held company vs. 100 percent interests. Is it enough to assume a $7 million payout upon a triggering event? This may fairly compensate the poor partner’s family, but is the company adequately covered without the key person? If the key person lacks significant personal goodwill, all may be well. What if, however, the partner is the only remaining founding member of the company, the two other partners were admitted into partnership within the last five years, and 75 percent of revenues are personally tied to the senior partner? What are the company’s prospects without this key person? If the goodwill of each of the partners was not fully considered when establishing (or reviewing before a triggering event) a buy-sell agreement, the relationships of the parties involved as well as the future of the company and the employees that depend on it are in jeopardy. The junior partners are now fully realizing fears they earlier only had vague notions about when they were signing the buy-sell agreement. Their uncertainty about the future is valid, and the company could have certainly been discounted for its reliance on a key person; but it may be hard for a bereaved widower to see it this way. It may not seem so reasonable and honest when he is perfectly familiar with the historical earnings of the company for the past 25 years and has been briefed on typical market multiples. If only this company retained you during the development phase of the buy-sell agreement, you could have discussed appropriate levels of insurance in the untimely exit of the rainmaker; conversations could have been started about the value with and without the personal goodwill values of each of the partners; and maybe, whatever the outcome, at least no one would have been surprised about the valuation consequences. Discussion of personal goodwill can not only bridge the gap between partners with bearish concerns about the outlook (and value) of a company without a key person and a widower expecting to see the full financial rewards of his spouse’s life’s work but may also help drive important discussions regarding contingency planning, which ultimately buoys the company value for everyone left behind.

I know I am not the first to write about the broad scope of importance that goodwill can have for valuation analysts. Alan Zipp wrote an article entitled, “Personal Goodwill Should Be Considered in All Business Valuations,” that appeared in BVR’s Guide to Personal v. Enterprise Goodwill at least 10 years ago. Still, it seems we mainly typecast personal and entity goodwill considerations for family law engagements. If this is the case in your practice, maybe you will now offer new roles for goodwill consideration to play in your valuations and, as a result, differentiate your service provided to clients.

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Janae Castell, CVA, MAFF, has practiced in the valuation industry since 2007. She focused her career path on her efforts to become highly skilled and highly specialized in The Core Body of Knowledge for Business Valuations. She has been qualified as an expert witness for commercial litigation and family and domestic proceedings. During her career, Ms. Castell emphasized projects with issues of dividing goodwill between corporate and personal attributes. She has conducted valuations for a variety of industries including healthcare, information services, oil and gas, manufacturing, insurance, and construction. She enjoys assisting startups and cultivating the entrepreneurial scene in Tulsa, which has been recognized as one of the strongest communities in the nation for young entrepreneurs. She has spoken in front of attorneys, students, bankers, business owners, accountants, financial officers, and business consultants to help educate them about business valuation. Within the valuation profession, Ms. Castell has been active in the training and qualification of other practitioners, as well as helping them stay up to date on the latest trends and best practices in the industry.

Ms. Castell can be contacted at (919) 280-8570 or by e-mail to Janae@RabahValue.com.