§ 10.03 Goodwill

• Jurisdiction: United States
• Publication year: 2021

§ 10.03 Goodwill

[1]—Definition and General Calculation

For a definition of goodwill, courts frequently refer to a definition that dates back to 1868:

"Goodwill may be . . . described to be the advantage or benefit, which is acquired by an establishment, beyond the mere value of the capital stock, funds or property employed therein, in consequence of general public patronage . . . which it receives from constant or habitual customers, on account of its local position, or common celebrity, or reputation for skill or affluence, or punctuality. . . ."²⁴⁶

This description is sometimes reduced to the statement that the goodwill of a business is the expectation of continued public patronage.²⁴⁷ From this perspective, "goodwill" is the increased value of the business, over and above the value of its assets, that results from the expectation of continued public patronage.

Commentators have noted, however, that the "expectation of continued public patronage" goodwill definition is not always accurate. For example, it has been noted:

"A business can have substantial established trade and still be worth only its book value. . . . Clientele have no economic value if they will not pay market rates for services or products. Frequently, clientele are attracted by low market prices, which make them very loyal, but only so long as the business owner loses money. Thus, established trade does not imply goodwill value."²⁴⁸

Economists describe goodwill in terms of any excess return on the tangible assets of the business, over and above a "fair" return on these assets.²⁴⁹ The accounting definition of goodwill is the difference between the value of the business and the value of the tangible assets.²⁵⁰

An enterprise may develop goodwill due to the location of the business or a good reputation,²⁵¹ or established relationships.²⁵² However, goodwill traditionally only attached to the business. To the extent the reputation was associated with an individual, it has not traditionally been considered part of goodwill.²⁵³ Goodwill is to be distinguished from the future earning capacity of the owner of any other person, and it does not include the future earning capacity of any person.²⁵⁴ To the extent additional profitability is due to an individual, the individual will be able to negotiate higher wages from the business, or will obtain such wages from a competitor.²⁵⁵

Divorce courts sometimes conclude that a business has goodwill even if there is no customer loyalty.²⁵⁶ For example, in a Washington case,²⁵⁷ the court found that the spouse's business had goodwill. The business obtained employment by bidding for work, and orders were only obtained if the bid was the lowest submitted. The ability of the company to obtain a bond and financing was emphasized.

A Kentucky divorce court found that a spouse's professional practice did not have goodwill, and emphasized that the radiology practice was based on connections with a hospital; there was no patient contact. The appellate court affirmed this finding of no goodwill, but was critical of the analysis regarding the significance of no patient contact.²⁵⁸

A Connecticut case involved a spouse's radiology practice. The spouse obtained almost all of his business from referrals from other doctors; he had no prior relationship with the patients themselves, and had little repeat business. The court concluded that the business had goodwill; the court determined that, if the spouse wanted to sell the practice, the buyer could retain 90% of the practice, as long as the selling spouse facilitated the transfer by spending three to six months introducing the buyer to the referring doctors.²⁵⁹

It is traditionally said that an employee does not have goodwill.²⁶⁰ It will be discussed below that it is not always clear when a spouse has established a "business" that could have goodwill.²⁶¹

A number of methods have been employed to value the goodwill of a spouse's business. One relatively simple valuation method is market value.²⁶² Under this approach, a divorce court would attempt to find the price for which the business could be sold at divorce, without assuming that the owning spouse would continue to render services to the business. The difference between this price and the value of all other assets of the business would be the goodwill value.²⁶³ Some courts consider evidence of recent sales of similar businesses to determine a market value.²⁶⁴

Another method used to calculate goodwill relates to the excess earnings of the business.²⁶⁵ Under this approach, the total net value of the tangible assets of the business is determined.²⁶⁶ A "reasonable" annual rate of return on the tangible asset value is computed and compared to the annual earnings of the business. Divorce courts generally prefer to use pre-divorce earnings in this calculation rather than predictions of post-divorce earnings.²⁶⁷ (An average of a few years' earnings is often used.²⁶⁸ ) To obtain the amount of the adjusted earnings, the actual earnings²⁶⁹ must then be adjusted before comparing them to the calculated return on tangible assets. The compensation of the manager spouse, plus fringe benefits, must be compared to what a reasonable salary would be for the services rendered. If the owner's actual compensation is higher than such a "reasonable" salary, the difference should be added to the firm's actual profits; if the actual compensation is less than the "reasonable" salary, the difference should be subtracted.²⁷⁰ Also, if the spouse who is not the primary manager also provides services to the business, the same adjustment should be made for these services.²⁷¹ If the spouses used funds from the business to pay personal expenses, these expenditures should also be added to the firm's profits.²⁷² Adjustments should be made for extraordinary transactions.²⁷³ Some courts have ignored years where the earnings of the company were abnormally high or low.²⁷⁴

If the adjusted earnings are greater than the calculated "reasonable" return on the tangible assets, there are excess earnings. A capitalization rate must then be selected to capitalize the full value of the excess earnings. If the profitability of the business is relatively secure, the rate chosen will be lower; if the risks are greater, the rate should be higher.²⁷⁵ The capitalized excess earnings are then added to the net asset value to determine the total value of the business.²⁷⁶

For professional practices, courts using this approach have compared the average earnings of the professional spouse to the average income of similar professionals. If the spouse's income is higher than average, it includes excess earnings, which is then multiplied by a capitalization rate.²⁷⁷

Of course, it is not always easy to determine what a "similar professional" is. In a California case involving a plastic surgeon in Southern California, the expert for the spouse who was not the doctor used a national figure for all surgeons in the Western U.S., whereas the expert for the doctor averaged earnings of plastic surgeons in Southern California.²⁷⁸

Other valuation formulas have been based upon some fraction of the annual net profits²⁷⁹ or gross receipts²⁸⁰ of the business.

A buy-sell agreement affecting the spouse's stock can affect the value of the spouse's shares. Some have treated the value set forth in a buy-sell agreement as controlling for purposes of valuing the interest at divorce.²⁸¹ Others have concluded that it is a factor to be considered when calculating the value of a business at divorce.²⁸² Transfer restrictions can also be relevant.²⁸³ If the spouse owns only a portion of the business, the valuation is further complicated. A control premium may be appropriate if the spouse controls the company²⁸⁴ ; a minority discount can be necessary if the spouse is a minority owner.²⁸⁵ (Some courts have rejected minority discounts.²⁸⁶ ) In addition, stock value can be affected by whether there is a public market for the company's shares.²⁸⁷ Some courts have applied a lack of marketability discount if there is no public market²⁸⁸ ; others have rejected such a discount if a sale is not contemplated.²⁸⁹ Other shareholders, or the company, may have the option to purchase another shareholder's stock at a specified price if the shareholder wants to sell, which can also complicate the valuation of stock.²⁹⁰

If a spouse sells a marital property business during marriage but shortly before divorce, all compensation received normally would be marital property. One California court held that if the owner signed a covenant not to compete in connection with any such sale, and the term of the covenant ran beyond the time of the divorce, the community should bear the full amount of the post-divorce income the spouse would lose due to the covenant.²⁹¹ The rationale is that the spouse's right to earn money after divorce is separate property, so funds received for the waiver of that right should be separate property.²⁹²

A number of courts agree that a covenant not to compete may in part be a means of conveying goodwill. To the extent that the covenant not to compete restricts the spouse from earning money after divorce, however, and is not merely a mechanism for conveying goodwill, many courts agree that this portion of the proceeds should be the selling spouse's separate property.²⁹³

Courts generally have not discounted the value of the practice by the amount of tax that would be due if the business would be sold.²⁹⁴

A recurring problem in the goodwill cases is whether the business should be valued in terms of how much would be received if the business would be sold, or how much the business is worth to the owner.²⁹⁵ To the extent the former is the standard, things like buy-sell agreements would be important, and minority discounts and marketability discounts should be possible, where appropriate. If the latter is the guideline, however, the calculation could be much different. Cases from two states highlight this...