Law firm's attempt to use buy-sell agreement to value firm fails in AZ

By Sylvia Golden, Legal Editor, Business Valuation Update 

Walsh v. Walsh, 2012 Ariz. App. LEXIS 162 (Ariz. Ct. App.)(Oct. 2, 2012)

The husband directed the litigation department of a large national law firm in Phoenix. At his divorce trial, his expert relied primarily on the firm’s stock redemption agreement, which limited the value of the husband’s partnership interest to the $140,000 in his capital accounts. Although the expert admitted that the husband had “personal” goodwill with the firm, he determined its value was neither realizable nor transferable. In particular, any goodwill value related to the husband’s employment depended on his continuing to work at the firm and earn substantial compensation following the divorce.  “This raises the question regarding the existence of goodwill should [the] husband elect to leave the practice,” the expert wrote in his report. Although the husband might continue to earn “significant compensation,” if he left, it would be inappropriate to attribute value to “a distributable marital asset” that depends entirely on his “post-marital” earnings. (Emphasis in the report.)

For these reasons, the expert excluded any goodwill value, personal or professional, from the value of the husband’s law firm interest, and ultimately concluded it was worth no more than the $140,000 return of capital. On further examination, the expert admitted the husband enjoyed great success with clients, had a 96% collection rate, a strong skills set, and a good reputation, such that any firm would consider him an asset and would have to pay a large amount to replace him.

By contrast, the wife’s expert attached little value to the firm’s buy-sell agreement. Instead, he applied a capitalization of earnings approach, examining the husband’s tax returns, historical income performance, earning sustainability, reputation, and client loyalty. He also adjusted the husband’s compensation to account for his higher-than-average productivity. In all, the wife’s expert valued the husband’s interest in the law practice at nearly $1.3 million.

The trial court rejected this approach as too speculative. It would require the court to assume that the husband could leave his present practice and continue to earn substantial income, without accounting for the difficulties arising from such a move, including client-related conflicts of interest as well as the new firm’s “platform” for bringing in new clients. Importantly, the court also relied on prior case law that restricted the value of a law firm to its “realizable benefits.” (See In re Marriage of Molloy, 888 P.2d 1333 (Ariz. App. 1994)(Molloy II), available at BVLaw.) Accordingly, it limited the value of the husband’s interest to the $140,000 in the buy-sell agreement, and the wife appealed.

Is the standard ‘realizable benefits’? As a preliminary matter, the Arizona Court of Appeals clarified the case history of Molloy:

• Initially, in Molloy I, the trial court precluded the wife from presenting evidence regarding the husband’s goodwill interest in his law firm.
• On appeal, the reviewing court recognized that “future earning capacity per se is not goodwill.” However, it also found that when “future earning capacity has been enhanced because reputation leads to probable future patronage from existing and potential clients, goodwill may exist and have value.”
• On remand, the wife presented evidence of both the firm’s goodwill value and its net tangible asset value, but, this time, the trial court considered only goodwill.
• In Molloy II, the appellate court found that, in addition to goodwill, a law firm’s value must also include its realizable benefits.

Thus, read together, the two Molloy decisions require a trial court to consider “the value of the husband’s entire interest” in the law firm, the appellate court explained, both the net tangible asset value and the goodwill value.

Given this backdrop, the trial court misread Molloy by limiting goodwill to its “realizable” value, or “something that can be bought or sold on the open market,” the appellate court said. In fact, additional state precedent (see Wisner v. Wisner, 631 P.2d 115 (App. 1981)) specifically permits a trial court to value private practice goodwill by considering such factors as the practitioner’s age, health, past earning power, reputation in the community, and comparative professional success. The appellate court added “expert testimony [can] help guide the court in its examination of enhanced future earning capacity.”

Under Wisner, the partnership agreement may also be a factor to consider in valuing goodwill, but in general such agreements “are designed to deal with particular aspects of the business, and simply do not address the considerations involved in [a] valuation” for purposes of divorce, the appellate court observed.

For all these reasons, the trial court “should have considered [the] husband’s personal goodwill in valuing [the] husband’s law practice beyond his stock redemption interest in the firm,” the court held. Here, even though the court recognized that professional practice goodwill was “the most intangible of intangibles,” it found evidence that the husband’s law practice interest exceeded the $140,000 stock redemption value.

Arizona remains firmly in the minority.  In the alternative, the husband argued, even if the appellate court rejected the “realizable benefits” approach, any valuation of his law firm interest should at least exclude “personal goodwill.”

The court acknowledged that a majority of states recognize the distinction between personal and enterprise goodwill, but Arizona does not. To the contrary, the Wisner factors demonstrate that Arizona does “in fact consider qualities that are attributable to the individual in determining community property values,” the court held, and affirmed the minority rule in the state.

Noting that state law “allows great flexibility on a case-by-case basis in the choice among valuation methodologies,” the court remanded for a new valuation of the husband’s law firm interest.