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IN A DIVORCE, a business valuation is
unlike most others.[1] Financial valuations
traditionally define the value of an
investment as the present value of a future
income stream, or its expected benefits
divided by risk.[2] However, in a family law
valuation, the court may not value the future
earnings of the spouse who owns the
business, as they are separate property.[3]
This difference which can be the most
valuable asset of a medical practice.

A brief definition of "goodwill" is "the
expectation of future patronage."[4 ]
Business valuation professionals define
goodwill more precisely as "that intangible
asset arising as a result of name,
reputation, customer loyalty, location,
products and similar factors not separately
identified." [5] Family courts measure
goodwill by "any legitimate method of
evaluation that measures its present value
by taking into account some past result," so
long as the evidence "legitimately
establishes value." [6]
Lawyers sometimes choose a standard of value that is not applicable in dissolution in California. In a
marital dissolution, the standard of value is not "fair market value," as the term is traditionally used for a
hypothetical sale between a willing buyer and a willing seller. In dissolution, however, the buyer (also
known as the in-spouse, the spouse inside the business, or the operating spouse) is under a compulsion
to buy out the other spouse's interest in the business. [7] Appraisal reports should therefore clearly state
and define the standard of value that is being applied. [8]
Los Angeles Divorce Lawyer
Business Valuation in Divorce in California
VALUATION OF PROFESSIONAL AND BUSINESS
PRACTICES

by WARREN R. SHIELL AND JB RIZZO
This article was originally published in the Los Angeles Lawyer (September 2013), a publication of the
Los Angeles County Bar.


INTRODUCTION
A CAVEAT IN EVALUATING GOODWILL

A medical practitioner may have no interest in a practice's goodwill that can be valued for divorce
purposes. Corporate governance documents may provide that the partners or shareholders are not
entitled to receive an interest in receivables, work in progress, and goodwill. ( See Marriage of Iredale v.
Cates 121 Cal. App. 4th 321, 328 (2004); Marriage of Nichols 27 Cal. App. 4th 661, (1994) In Marriage of
Nichols, the stock purchase agreement of the husband, a lawyer, provided that he had no interest in the
law firm's accounts receivable, work in progress, or goodwill. The court rejected the wife's contention that
the stock purchase agreement merely measured a shareholder's contractual withdrawal rights and that
therefore the agreement was inapplicable because the husband was not withdrawing from the firm. The
court of appeal held that, although the trial court was not valuing the husband's contractual withdrawal
rights, it had discretion as to whether to use the stock purchase agreement to determine the community
interest in the business.

In assessing whether to use a formula set forth in a buy-sell agreement, the court of appeal stated that
the courts should consider 1) the proximity of the date of the agreement to the date of separation to
ensure that the agreement was not entered into in contemplation of marital dissolution, 2) the existence
of an independent motive for entering into the buy-sell agreement, such as a desire to protect all
partners against the effect of a partnership dissolution, and 3) whether the value resulting from the
agreement's purchase price formula is similar to the value produced by other approaches. In Nichols and
Marriage of Iredale and Cates, the courts decided that, even though there was no professional goodwill
in the law firms in question, there remained personal goodwill. That result, however, may be in question
since Marriage of McTiernan and Dubrow decided that there is no goodwill in a person apart from a
business.(See Marriage of McTiernan and Dubrow, 133 Cal. App. 4th 1090 (2005)).

Marriage of Slivka, 183 Cal.App. 2d 111159,163-4 (1986) illustrates how one of the first steps that a
valuator must take is to examine employment contracts and corporate governance documents. In Slivka,
the husband was employed with Kaiser Permanente as a radiologist. He became a class three partner in
Southern California Permanente Group (SCAPE), a medical group partnership. The Kaiser Foundation
Health Plan, Inc., was a health maintenance organization that contracted with SCAPE to perform medical
services. The husband testified he made no capital contribution to the medical group on becoming a
partner and had no assets to take with him on withdrawal from the partnership. He would receive no
payment on his departure and could not sell his partnership interest. The medical group's only practice
came by contract with Kaiser; there was no other patient base. The partners were prohibited from
earning outside income. The husband saw only patients who used Kaiser, and the compensation he
earned was from the medical group for the work he did at Kaiser. It consisted of a base salary, extra pay
for extra hours, and incentive bonuses and accruals. The court likened his situation to an employee who
has no ownership interest and is paid for services rendered. The court found that the husband therefore
had no goodwill in the practice that could be valued in the divorce, professional or otherwise.


PROFESSIONAL PRACTICE VALUATIONS

Business valuation theory recognizes three general approaches. First, asset-based approaches seek to
adjust the balance sheet items of a business to market value. Second, income-based approaches arrive
at a business's value by calculating the present value of a benefit stream (earnings) that a business is
expected to provide. Methods under this approach include the capitalization of benefits (or earnings)
method and the discounted cash flow method. Third, market-based approaches seek to value a business
by comparison to sales of similar businesses. Methods include the guideline public company method and
market data transactions method. Family law valuations often combine all three approaches. Courts have
emphasized that there is no set approach for valuing goodwill, which can be measured by "any legitimate
method of evaluation." [9]

So-called rules of thumb are not recognized as legitimate valuation methods, although CPAs use rules of
thumb as a check for reasonableness.[10] A rule of thumb is an industry-specific mathematical formula
for deriving value based on experience, observation, hearsay, or a combination of these. For a medical
practice, a rule of thumb is that the value of the goodwill equals gross receipts for the most recent three
months. These approaches may be applied to a hypothetical case.


A CASE STUDY

Dr. Elaine J. is a general surgeon at a university hospital. Elaine was in a 20-year marriage to plastic
surgeon Dr. Jerry J., who owns 90 percent of a cosmetic surgery practice. Structured as a California
regular C corporation, it is a community property business employing a receptionist, a nurse, and
another surgeon, who is the 10 percent shareholder.

Attorneys for the divorcing parties agree that the date of valuation should be the date of separation,
which is December 31, 2012, instead of the date of trial.[11] However, they are unable to agree to a joint
forensic accountant under Section 730 of the Evidence Code.[12] They hire experts, who value Jerry's
practice according to the different methods described above.
(
Read more)


OTHER CONSIDERATIONS

Valuators should also consider additional factors listed in Marriage of Hewitson, which draws upon the
IRS Valuation Guidelines in Revenue Ruling 59-60. They are:
The nature of the business and the history of the enterprise from its inception.
The economic outlook in general and the condition and outlook of the specific industry in particular.
The book value of the stock and the financial condition of the business.
The earning capacity of the company.
The dividend-paying capacity.
Whether or not the enterprise has goodwill or other intangible value.
Sales of stock and the size of the block of stock to be valued.
The market price of stocks of corporations engaged in the same or a similar line of business having their
stocks actively traded in a free and open market, either on an exchange or over-the-counter[41].
In the case study, for example, a consideration under factor "a" is that the practice has a relatively long
history of performing facial reconstructive surgery as well cosmetic surgery. Under factor "b," the patient
base is stable, as it is either affluent or covered by insurance. Jerry's interest (factor "g") is a little more
complicated. Elaine's attorney took the position, based on Jerry's relationship with the 10 percent
shareholder, that the valuation should cover 100 percent of the business, not 90. Jerry acquiesced.

Reducing normalized earnings by a hypothetical income tax, also known as tax-affecting the earnings
stream, is a complex issue. [42] In the case study, the valuator did not tax-affect the practice's
earnings.[43]

As shown in Table 8, the three different approaches to the valuation of Jerry's medical practice yield
different results. Jerry's valuator subjectively weighs the reliability of the different valuations, placing
more reliance on the goodwill registry market method and the capitalization of earnings method. Many
valuators present an opinion based on a weighted average. Elaine's valuator may expect
cross-examination regarding the significant divergences in the values, which place more reliance on the
capitalization of excess earnings method and less on the goodwill registry market method. Jerry's
valuator contends that the market approach is more objective and accurate because it is less impacted
by valuator's adjustments and judgments, and because in the market in question there is significant data
for comparable plastic surgeries. The court agrees and adopts a value of $1.3 million.


FOOTNOTES
Contact a Los Angeles Divorce Attorney at Law Offices of Warren R. Shiell to discuss your
property division issues.
Please call to make an appointment at 310.247.9913.


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