Divorce Valuations for Business & Real Estate

---

 In calculating goodwill, a common practice is to average the more recent years' income and expenses to arrive at an average net income, which then forms the basis for a goodwill calculation. In calculating goodwill, it is usually appropriate to eliminate all atypical income and expense for the company, because the purpose of the valuation is to determine the value of the business without the effect of unusual events which might cause temporary fluctuations in the market for the goods or services. 

 A prospective buyer, for example, would probably ignore unusual occurrences such as earthquakes, floods and fire in determining business value. The buyer will want to know the value of the business under normal circumstances. The appraiser must therefore eliminate the effects of unusual, non-recurring income or losses from the company's financial statements. For example, the costs of non-recurring litigation should be "normalized" by the appraiser, as should the financial effects of an earthquake. The appraiser should determine if anything unusual has happened during the years being considered, and the necessary adjustments should be made. 

 Goodwill is usually found where a business both generates and appears likely to continue generating income which exceeds the norm for that type of business. One commonly-used goodwill calculation incorporates at least two steps - a determination of the business' excess income and an assessment of whether the excess income is likely to continue. An appraiser may be valuing an accounting or legal practice using methods that are perfectly appropriate to the valuation of those practices, but the result will be flawed if those practices are unusual in nature. 

 For example, a law practice may be highly specialized with a unique referral source. A law firm focused primarily on asbestos litigation, for example, which was at one time a lucrative area of practice, typifies the problem. The likelihood of continued future earning at previous levels in such a firm would be much different from the earnings of a law firm with a wide area of practice which is not dependent on a single or atypical referral source. A manufacturer may be very successful, and his product may be similar to others in the industry, but the success may be dependent on a patent that is about to expire. A retail store may be very successful, but the neighborhood may be full of people who work at the nearby General Motors plant, which has just announced it is about to close. A local hardware store may be thriving, but a hardware chain may be building a massive store nearby. 

 Furthermore, using the prior example, it is not even necessary that the General Motors plant announce a closing to affect the valuation of the retail store. Even if no such announcement were made, one must at least consider that the success of the retail business may depend on the General Motor plant's continued operation. The risk factor for the retail business must consider the risk factor of that General Motors plant. 

 Certain assets and liabilities are easily overlooked because of their nature. One such asset is "work in progress." Work in progress is a form of accounts receivable for services rendered, for which no invoices have yet been issued. For certain businesses, work in progress can form a substantial portion of the accounts receivable. For example, a construction company typically bills only when a significant part of the job is completed. The value of those unbilled services needs to be reflected as an asset of the business. 

 Another asset to be considered is the value of a lease. A below-market lease may be a considerable asset and should likewise be reflected in assessing the business' value. 

 A buy-sell agreement may form part of a firm's partnership agreement, governing the terms of a partner's buy-out if the partner leaves or dies or a new partner wants in. A buy-sell agreement may also be used to determine the value for the transfer of shares in a stockholders agreement. In family law valuations, depending on the circumstances, it is sometimes appropriate to use buy-sell agreements. In the valuation of professional practices, for example, the courts have held that a buy-sell agreement may be considered, but will not be determinative. Marriage of Slater (1979) 100 CaI.App.3d 241, 160 CaI.Rptr. 686. A recent case, Marriage of Nichols (1994) 27 CaI.App.4th 661,33 CaI.Rptr.2d 13, concluded that it was not an abuse of discretion for the trial court to value the husband's shareholder interest in his law firm based on the formula set forth in his firm's stock purchase agreement. 

 The Nichols stock purchase agreement excluded the value of accounts receivable and work in progress although in Marriage of Lopez (1974) 38 Cal.App.3d 93, 113 Cal. Rptr. 237, the court held that these should be included in valuing a law practice interest. The court in Nichols, supra, found that the stock purchase agreement, which the firm had consistently adhered to with every shareholder who had retired or left, was an appropriate valuation method in this particular case. The Nichols court recognized that the law firm at issue was a large firm where the shareholder did not share in the firm's earnings, but was compensated as an employee based upon his own productivity and length of service to the firm. In assessing whether a buy-sell agreement should be determinative, the Nichols Court set forth the following criteria: 

• The proximity of the date of the buy-sell agreement to the date of separation to ensure that the agreement was not entered into in contemplation of marital dissolution;
• The existence of an independent motive for entering into the buy-sell agreement, such as the firm's desire to protect all partners from the possible effects of a partnership dissolution; and
• The similarity of the value resulting from the agreement's purchase price formula to the value produced by other approaches.

 Mrs. Nichols was, however, awarded an interest in her husband's professional goodwill. The court reasoned that the stock purchase agreement did not determine the lawyer's goodwill, and that Mr. Nichols had personal goodwill whether he remained with the firm or not. In effect, the court said, goodwill cannot be eliminated merely by a recital in a buy-sell agreement. "It is a community asset because husband's experience, reputation and skill, which enabled him to command this high income, were developed while he was married to wife. It directly creates excess income for husband whether he stays with his firm or strikes out on his own" Marriage of Fenton (1982) 134 CaI.App.3d 451,463, 184 CaI.Rptr. 597.  

 Because Nichols upheld a buy-sell agreement as to accounts receivable and work in progress, but not as to goodwill, it appears that trial courts will have to examine carefully, on a case-by-case basis, the facts behind individual buy-sell agreements.  

 Business appraisals require close attention both to theoretical and practical considerations. Attorneys and clients typically want a speedy, low-cost appraisal, but that approach invites errors such as the ones described above. In appraising businesses in family law actions, the appraiser should keep in mind these possible errors and avoid such pitfalls. 

Divorce Manual : A Client Handbook - This publication produced by the American Academy of Matrimonial Lawyers covers the divorce process, reconciliation, counseling, selecting a divorce lawyer, estate planning considerations, and the lawyer-client relationship.