Valuing a Professional Practice Requires In-depth Analysis

Goodwill can be a significant asset for a professional practice. It may include both "personal" goodwill that's attributable to individual owners and "business" goodwill that can be transferred to third parties. When accountants and other types of professionals divorce, the amount of goodwill to include in the marital estate can become contentious (and may vary depending on state law). If expert testimony on the issue is inadequate, a court might look elsewhere for help, as it did in a recent Texas divorce case, Hill v. Hill.

A critical balance

The husband in the case became a principal at a Big Four accounting firm shortly after getting married. The partnership agreement provided that his sole interest in the firm was his required capital contribution.

In the case of "separation" - death, withdrawal or retirement - he would receive the balance of his capital account, less any amount he borrowed from the partnership. At the end of 2010, the husband's capital account held $715,000, and his loan balance was $700,900.

Experts disagree over value

At trial, the wife's expert used what was essentially an excess earnings method to value the husband's partnership interest. The expert found that the husband owned a 0.1% interest in the firm and his $1.5 million average annual income included $700,000 in replacement compensation based on comparable positions. This left $800,000 in income attributable to the husband's ownership interest (goodwill). The expert applied a 33.3% capitalization rate and concluded that the fair market value of the interest, including goodwill, was approximately $2.4 million.

The husband's expert conceded that a large professional practice could possess business goodwill, separate from individual partners' personal goodwill. But he stressed that the practice's governance was important when valuing interests in the firm. The expert opined that the only way the husband could access the value of his interest was to sell it back to the firm in case of separation. He therefore valued the interest at $14,100 - the difference between the capital account and the outstanding loan amount.

Courts weigh in

The trial court didn't agree with the husband's expert that the partnership agreement controlled the interest's value. However, it ultimately relied on the agreement to value that interest. In light of the lack of reliable evidence presented on the values of business and personal goodwill, the court concluded that the value of the husband's interest to include in the marital estate was $14,100.

The court of appeals affirmed, characterizing the expert testimony on the existence and availability of business goodwill as "vague and confusing." It pointed out that the wife's expert failed to distinguish between personal and business goodwill, while the husband's expert acknowledged business goodwill could exist but deemed the partnership agreement controlling.

Minimizing litigation risks

The appellate court in Hill observed that part of the problem was that the firm's partnership agreement lacked provisions addressing the valuation of a partner's interest. Ensure that your clients' buy-sell agreements stipulate a clear method for valuing ownership interests, ideally via an independent appraisal.