Goodwill in a professional partnership poses unique challenges for valuators and courts, especially in a divorce setting. In a recent Texas case dense with valuation issues, it came down to corporate goodwill. “Logic tells me there is some,” the trial court said, “but it’s probably impossible to quantify.” The finding triggered an appeal.
The husband was a principal at KPMG, one of the Big Four accounting firms. A partnership agreement provided that a principal’s sole interest in the firm was his required contribution to a capital account. In case of “separation,” by which the agreement meant death, withdrawal, or retirement, the member would receive the balance of his capital account, excluding any amount he owed under a loan he took out to fund his interest in the firm. At year-end 2010, the amount in the husband’s capital account was $715,000, and the loan amount was $700,900.
At trial, the wife argued that KPMG was a partnership, not a corporation, and that fair market value was the proper valuation. Under the applicable case law, if the asset is an interest in a partnership, any increases in the asset’s value that accrue during the marriage may be a community asset, whereas increases in a corporation’s net worth are not an asset of the community of each of the corporation’s shareholders.
Excess earnings: The wife's expert, an ASA, did not perform an appraisal under the USPAP but did perform a calculation under the ASA standards. His report did not mention the agreement; it referred to tangible value but did not use the term “goodwill” or differentiate between commercial and professional goodwill. Under an excess earnings approach, he determined that the husband owned a tenth of one percent partnership interest and that, of his $1.5 million average annual income, $700,000 was reasonable compensation and $800,000 was income attributable to the KPMG ownership interest. Applying a 33.3% cap rate, he concluded that the fair market value of the interest was $2.4 million. The buyer of the share would be someone with “the skill set to be able to step in and receive the salary plus the excess income,” he explained.
The husband’s expert acknowledged that a large professional practice might possess commercial goodwill but emphasized that “corporate governance” was critical to valuing interests in a firm such as KPMG. According to him, “the only way to obtain value for your partnership interest is to sell it back to the firm.… You get the capital account, you pay off the debt[,] and that’s what you get.” Here, the interest was $14,100, the value of the capital account, minus the loan against it.
“I don’t find that the contract controls,” the trial judge stated. At the same time, the court found only professional goodwill. Even if there were commercial goodwill and it could be quantified, the husband could only access it by remaining employed in the future, the court added. Perhaps, if the company were to liquidate in the future, “he might get some piece of the value.” It emphasized that the wife’s expert did not use the appropriate method to determine fair market value and concluded that the partnership interest was worth $14,000. After a thorough review of case law, the Court of Appeals affirmed, pointing to the “vague and conflicting” expert testimony as to the existence and availability of commercial goodwill.
As appraiser Jim Alerding (Alerding Consulting) sees it: “This is almost a ‘what side of this do you want me to argue’ situation. Without a doubt, a KPMG partner makes more than the average accounting firm partner makes; consequently, there is likely excess income generating excess value and it’s reasonable to attribute the excess value to the enterprise and not to the individual. But you can also claim that the partnership agreement should govern the value for such a large enterprise that is likely not to ever sell. Looking at FMV, there really are no hypothetical buyers for KPMG. There also is no hypothetical buyer for this partner’s interest in KPMG because interests are not bought and sold on an individual basis.”
Find an extended discussion of Hill v. Hill, 2014 Tex. App. LEXIS 292 (Jan. 9, 2014), in the April issue of Business Valuation Update; the court opinion will be available soon at BVLaw.