Posted on Nov 13, 2015 by Jeffrey L. Payne
A recent South Carolina court ruling has adopted the emerging majority approach utilized by the courts nationwide, and for the first time has recognized the distinction between “enterprise goodwill” and “personal goodwill” for equitable distribution purposes in a divorce action. While the ruling was adopted in the context of a divorce matter, the decision will have ramifications for “business divorce” cases, especially those involving professional practices.
The decision reinforces the need to review any agreements that address the situation of an owner leaving the business to make certain that it addresses the issue of goodwill in the manner desired by the owners.
The issue is to what extent goodwill can be considered by the courts in the disputed valuation of a closely-held business. For years, South Carolina courts have said that goodwill — the intangible value of a business over and above net assets — is too speculative to be used by the courts in valuation. Case law in South Carolina usually has addressed goodwill in the context of dividing marital assets in divorces, and courts have followed these precedents in ruling on the value of disputed shares in “business divorces." As a result, a partner leaving a professional services firm, such as a large medical practice or accounting firm, often found that her share of the business did not reflect the true value of the business if it was sold on the open market.
In the recent marital divorce case, the South Carolina Supreme Court for the first time said that the goodwill in a business may constitute a marital asset subject to division between the parties. In its newfound recognition of long-established accounting principles, the court recognized the difference in enterprise and personal goodwill, and declared that the courts could consider only the former in valuations.
Enterprise goodwill reflects a business' potential to earn income in the future regardless of who comes and goes in management. Coke's secret formula is enterprise goodwill, as is any business' reputation and brand, distinct processes or technology, and other factors that make it worth more than the sum of its assets.
Personal goodwill comes and goes with the individual. A one-man dental practice branded with the doctor's name has all of its value over assets wrapped up in personal goodwill.
Implications for professional services firms
With this new direction from the court, a professional services firm that fires one of its partners may have to compensate the partner for his share of the business based on a valuation that includes enterprise goodwill. In the past, professional services firms have been successful in arguing that all of their goodwill was personal — dependent on the contributions of each partner — and therefore not subject to court valuation. Although the court provided guidance on distinguishing between personal and enterprise goodwill, expect to see business valuation experts in marital and business divorces differ markedly in their views of what proportion of goodwill is enterprise or personal.
That's what happened in a divorce case in which the South Carolina Supreme Court ruled. A husband and wife had built a home lighting fixtures business together, and the husband wanted the wife to pay him for his share of the business as part of their division of marital assets. Her experts maintained that much of the goodwill was personal — the product of her work, previous professional experience, ideas and personal contacts. His experts said all of the goodwill was enterprise, and thus a marital asset.
While this divorce was contentious with competing versions of how the husband and wife contributed to the business, experts in any situation are likely to differ on the value of goodwill, and how to apportion it between personal and enterprise.
Takeaway: Update buy-sell agreements
The takeaway for closely-held business owners is that the court's decision to include goodwill when disputed valuations end up in litigation drastically increases potential payouts. That means businesses must have an agreement in place that sets terms for compensating a partner for a share of the business. This is particularly true for businesses that can't readily be sold, since there may be no benchmark to determine what a willing buyer would pay.
Don't rely on an agreement that simply sets the valuation at "fair market value." Many older agreements were drafted based on the assumption that goodwill would be excluded as has been previously determined by the courts. However, that of course is no longer the case. Thus, if goodwill (personal or enterprise) is to be excluded make sure the agreement specifically excludes it.
We recommend that partners in a business agree once a year to a reasonable value for the business that includes the division of goodwill (or the outright exclusion of it), and sets payment terms. Of course if you exclude goodwill outright in any valuation you never know who will receive the benefit of that exclusion. You never know who will die first, etc. While many business owners don't anticipate a falling out, unexpected events, such as a severe illness or death, can trigger buyouts. Don't leave it to a judge to determine the value of your business.
Jeffrey L. Payne is a shareholder in Turner Padget’s Florence, S.C., office. He focuses his practice on commercial litigation, with an emphasis on business torts, construction, commercial collection, eminent domain, foreclosures, banking and probate disputes. He may be reached at (843) 656-4432 or by email at firstname.lastname@example.org.