Perhaps few cases illustrate the primacy of first defining the standard of value to be used than the valuation of a law practice or a law partner’s interest in the practice for equitable distribution in divorce. When most people think of value, they are thinking in terms of fair market value, which is defined in the international glossary of business valuation terms as:
“The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms-length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”
Fair market value would include discounts for lack of control and lack of marketability when valuing a partner’s interest if it represented a minority of the total ownership interests (such as a law partner in a firm of ten partners, each with equal ownership interests). However, when valuing law firms for divorce, things are not that simple.
State laws may restrict or prohibit the sale of law practices. In New Jersey (where I do a significant portion of my valuations), a sole practitioner could not sell his law practice goodwill to another lawyer. So under fair market value, the value of the practice would be zero. Under fair value for divorce, however, the answer can be dramatically different.
Fair value for divorce is a legally derived standard of value whose definition varies from state to state, depending on the state’s marital dissolution statutes and their implementation in the state’s case law. In most cases, fair value does not include the discounts for lack of control and lack of marketability that are used under the fair market value standard. Thus for a law partner minority ownership interest, fair value is closer to a pro-rata share of the value of the business as a whole than it is to fair market value.
Fair value for a law practice or law partner’s interest in divorce may diverge from fair market value’s emphasis on a price set between a willing buyer and seller as well. Fair value in some states is based on a “value in exchange premise” where a hypothetical transaction between a buyer and seller is envisioned. Under this premise, major differences in value can arise based on whether one assumes the seller will stay and assist in the transition of the law practice to new ownership, or whether the seller will instead be free to compete with the law practice immediately. The valuation expert needs to be informed as to which assumption applies in the state.
This raises the related issue of valuing goodwill. Goodwill could be considered the potential value of the law practice above the net tangible asset value. When valuing a law partner’s ownership interest, it would be the potential value of the ownership interest above the value of the partner’s capital account. Goodwill could arise from factors such as a lawyer’s extensive customer relationships or a lawyer’s reputation in the profession. Goodwill can be divided into two components, personal goodwill which adheres to the individual, and enterprise goodwill, which is an asset of the practice. The question then arises: “What portion of goodwill is related to the law practice or partnership interest and what portion is personal goodwill?” This can vary depending on the personal attributes of the attorney, his legal specialization, and the role of the attorney in the firm. The issue is especially relevant when state law favors a “value in exchange” premise, as the issue of whether personal goodwill can be transformed into enterprise goodwill by means of a non-compete contract and an agreement to stay on and transition the customer base may need to be considered. The issue of distinguishing between personal and professional goodwill is less important in states where a “value to the owner” premise is the law.
In states that use a “value to the owner” or intrinsic value premise, it is not assumed that the practice will be sold. Instead it is assumed that the practice will continue to enjoy the benefits of the law partner’s continued employment in the practice. This premise produces a value that is intrinsically tied to the owner. This intrinsic value premise is often used when state law seeks to compensate the spouse for the economic benefits the law partner will reap from the practice, whether or not these benefits can be easily sold. In states where the “value to the owner” premise applies, it is usually not necessary to separate personal goodwill from professional goodwill.
To summarize, we begin a valuation of a law practice or law partner’s ownership interest by first determining the relevant standard of value applicable in the state. Next we determine the premise of value and consider whether goodwill needs to be categorized as personal or enterprise goodwill. Now we are ready to consider applying valuation methodologies, which we will discuss in my next blog.