Valuation of Law Firms, Medical Practices and Other Professional Firms

The valuation issues pertinent to professional practices may appear relatively straigthforward and simple. Yet, that is rarely the case.

There are unique issues attendant to the valuation of a professional practice such as a law firm, medical practice and other professional entitities where the value drivers of the firm are dependant on the founders and/or managing practitioner.

Personal goodwill is intangible value based solely on the efforts or reputation of a business owner. In some instances, it may also include profits that would be lost if that individual weren’t present. For example, a surgeon who is well known for her ability and experience would have personal goodwill because patients will likely come to her specifically for those skills.

On the other hand, practice goodwill is a firm’s intangible value that’s not attributable to its owner. Over time, as a business grows in size and structural complexity, its goodwill typically begins to change from personal to practice.

When a firm is small, the majority of its goodwill comes from the owner’s personal relationships, know how, reputation and personality. But as it develops, a greater portion of the goodwill relates to factors such as contractual relationships, location, facilities and work force.

The objective of a typical valuation is to estimate a company’s equity, including its tangible and intangible value. And traditional appraisal methods don’t differentiate between personal and practice goodwill, which sometimes isn’t a problem.

Other times, however, it is — particularly in divorce proceedings, where the personal vs. practice goodwill debate continues to rage. In some states, courts don’t consider personal goodwill a marital asset subject to distribution between the two parties. As a result, a valuator must quantify the portion of value attributable to personal goodwill and exclude it from the value of the business.

Yet some courts have concluded that personal goodwill should be marital property. In Dugan v. Dugan, for instance, the Supreme Court held that both personal and practice goodwill are marital property because ignoring the nonowner spouse’s contributions to the company’s development would be inequitable. Clearly, it’s important to understand the state case law in the jurisdiction applicable to the subject business.

Another instance that requires distinguishing between personal and practice goodwill is the allocation of purchase price for tax or financial reporting purposes. In cases involving the purchase or sale of a business, determining whether either — or both — types of goodwill exist in significant amounts can influence how the deal is structured.

For example, a buyer negotiating to have the seller sign a separate, personal noncompete agreement may indicate substantial personal goodwill because the agreement presumably restricts the seller from using his or her skills to generate similar value for a competitor. This may affect the appraisal methods applied as well.

When valuing a business using an income approach, there’s an implicit assumption that all of the intangible value reflected in the company’s earnings stream is transferable. Yet personal goodwill may not be transferable and would need to be quantified and deducted from the value of the business.

One of the methods a valuator may use to estimate personal goodwill is first examining the factors that relate to practice vs. personal goodwill and calculating the percentage of each. Then he or she can apportion the total goodwill of the business to personal and practice goodwill according to those percentages.

In some jurisdictions, disagreement remains regarding the measurement of personal goodwill for a commercial business owner vs. that for a professional practice owner.

Many observers believe personal goodwill typically arises solely in the context of a professional practice. And, they say, even if a commercial business has only one owner, it’s difficult to attribute much of the value to personal goodwill.

For example, in Frazier v. Frazier, an Indiana appellate court dealt with the
valuation of a single-location retail furniture store. The owner spouse’s attorneys claimed that most of the goodwill was personal.

After the facts were reviewed, however, very little of the value could be attributed to the owner spouse. Many of the customers were from the general public and the owner spouse didn’t have a special relationship with any of them — or with the company’s suppliers.

At the end of the day, an appraiser needs to examine both the nature of a commercial business and its standard industry practices to determine whether personal goodwill exists.

A number of other landmark cases have dealt with professional goodwill. In Lopez v. Lopez, a California appellate court’s decision identified several factors that valuators should consider before expressing an opinion. These include the professional’s:

Also important are the nature and duration of his or her role in the practice, either as a sole proprietor or as a contributing member of a partnership or professional corporation.

A Tax Court case, Norwalk v. Commissioner, also sheds light on the issue. Here the court indicated that, generally, to transfer the goodwill of a professional practice, the parties must sign off on an enforceable noncompete covenant or other such agreement.

But this creates a challenge in that there are no “standard” methods to distinguish between the two types of goodwill. In addition, different jurisdictions approach the matter differently.

Ultimately, whether goodwill of any kind exists and how to divide it equitably depends on the facts and circumstances of each case. And any methods a valuator decides to rely on should be well supported and well documented to withstand scrutiny.