California becoming battleground for goodwill valuation

BVWireIssue #61-1
October 3, 2007

Just about three years ago, the Agency for the City of Inglewood, California began condemnation proceedings of an auto lube business.  At trial, the Agency’s valuation expert applied the “excess profits” test to determine the absence of compensable goodwill, arguing that in the previous five years the business had posted a profit only in the last one (2003).  But the owner attributed the downturn to the construction of a major shopping development across the street, including a Target and Home Depot.  Once the construction was complete, he said, the business returned to profitability and its future looked bright.  His expert, Chris Pedersen, CBA (Affiliated Business Appraisers), agreed, using the “cost to create” method to conclude $239,000 of goodwill.  A potential buyer would pay that “within a matter of days,” Pedersen believed, based on what the owner spent “over the five…difficult years to place the business in the enviable position it enjoyed upon completion” of the shopping development.

The trial court agreed—as did the California Court of Appeals, which published the portion of its opinion deeming the “cost to create” approach permissible to value goodwill, “where, as here, a nascent business has not yet experienced excess profits but clearly has goodwill within the meaning of the [California] statute.”  Attorneys for the Agency have filed a letter with the state Supreme Court to “de-publish” the opinion, citing Shannon Pratt for the general definition of goodwill as “the ability to earn a rate of return in excess of a normal rate on…net assets.”  Click here for a copy of the letter and the case. 

Attorneys for the auto business assert the definition is taken out of context, and enlisted Dr. Pratt to write to the California Supreme Court in the fight to keep the case published.  “[T]he quotes from my books do not support the request to depublish the case,” Pratt writes.  “In fact, I believe that publishing the case is very useful as guidance to attorneys and business appraisers for future cases with similar facts and circumstances.”

The Agency’s efforts, especially if they lead to an appeal, could help create “bad case law…one of the biggest obstacles to applying sound appraisal methodology,” Pedersen says.  “That is why it is so important to get involved, as it takes years to overturn or clarify bad law.”  Email any comments, on one side of the battle or the other, to the editor.

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