What do you do about business valuation when the client is a lawyer? Sylvia Golden interviews attorney Sanford K. A and Stuart Rosenberg on the subject in this podcast.
Business Valuation When the Client is a Lawyer
Sylvia Golden: What is it like to have a lawyer as a client – particularly in an emotionally-fraught situation like divorce?
Sandy Ain: Representing lawyers is challenging at times, but also easy in many respects. Lawyers tend to be bright and inquisitive; if you educate them about divorce law, they can be very helpful in bringing their case to a successful conclusion. Education is the principal ingredient in representing lawyers: the more you educate them, the better client you have. Many lawyers do not hire experts until they’re well into the case: sometimes, so shortly before the trial that discovery has ended. That’s a grave error. I often engage an expert at the initial meeting with the client. Once the client and I have decided to work together, I will frequently call an expert during the course of that meeting and engage them. That’s part of the education process in representing lawyers, but it’s important in representing any client.
Stuart Rosenberg: As far as controlling an attorney-client, I leave that completely up to their attorney – other than trying to convince a Type A personality attorney that their situation isn’t unique, that the judges have seen it before, we have seen it before, and the lawyers involved have seen the issues before. It might be overwhelming or unique to them because they’re emotionally involved, but it’s not unique to the experts, lawyers, and judges involved in the case.
Golden: To what extent does the valuator have direct contact with the client?
Ain: In practice, much of the information is conveyed through counsel, but it is very important for the business valuator to establish a personal relationship with and gain knowledge of the client for a variety of reasons. You want the client to understand the process and have confidence that both the lawyer and the business valuator are doing their job. When the client has direct contact with the valuator, they’re more likely to feel comfortable about both the process and the outcome of the valuation. If the business owner participates in the process, they’ll understand that there are factors that go into business valuation that they may not have considered. They feel they’ve been heard and that the valuator is on their side – even if the conclusion is different than what they would have liked.
Golden: What documentation do you require from the client to perform the valuation?
Rosenberg: Over the years, we’ve developed a reasonable information request list. Unlike some litigation situations, where the purpose of a discovery request might be to annoy or harass the parties, we’ve come up with a list of about 19 items that allow us to be credible in doing our valuation. Number-one on that list is a partnership agreement or shareholders agreement. A description of the compensation system of the firm is very important; usually, we ask for K1s or W2s for the past five years. The information on the income statement and balance sheet has some relevance, but not great relevance – especially for large law firms. The footnotes to financial statements are often a great source of information that describes how the partnership itself operates as it relates to distributions, capital, and retirement plans.
We ask for information going back five years regarding certain attributes of the individual partners, such as what their chargeable hours are, their total hours, billing rate, fee origination, and allocation of profits and owner distributions. Then we ask the firm to compare that to the average for the firm as a whole so we can see how an individual partner compares to the firm itself.
Then we ask for (but often don’t receive) information regarding fees related to either groups of clients or particular clients that are redacted. There’s usually resistance when we start getting into information regarding clients. Having a standard request that we utilize whether we’re representing the partner or the partner’s spouse makes the whole process much simpler.
Golden: In divorce cases, two key issues are the standard of value and personal goodwill. Can you explain what the term “standard of value” means in your jurisdiction, and how that expresses itself in a case?
Ain: I’m licensed to practice in Maryland, the District of Columbia, and Virginia, and regularly practice in all three jurisdictions in addition to being hired by people in other states and working with local counsel. In our local jurisdictions, the standard of value in Maryland and Washington D.C is fair market value, which is common around the country. Virginia is unusual in that the standard of value is the intrinsic value, which is defined as the value of the interest in the enterprise to the parties – which may be greater and in some rare cases less than fair market value. We use business valuators who are very familiar with how to arrive at either fair market value or intrinsic value; Stuart can explain the differences between the two.
Rosenberg: Most of the work I do is in Maryland and Virginia and, as Sandy stated, they have two different standards of value. Although they have different definitions, there’s not as much of a difference in the approaches to the valuation as one might think. In fact, in one of the landmark cases in Virginia, it states that the parties must rely on accepted methods of valuation. However, the particular methods of valuation and the precise application of the method to the singular facts of the case must vary with the myriad of situations that exist among married couples. The approach and the methodologies are practically the same, as they may be under a fair market value standard. The biggest difference is in the back-end of the valuation where discounts are often applied under fair market value. Intrinsic value says that if you have a restrictive agreement stating you can’t sell your interests at all, or at least back to the operating company, that’s not something that gets taken into consideration. In Maryland, we’re under the fair market value standard; provisions that could restrict sale could lead to larger discounts.
Golden: The next issue is personal goodwill, which one court called “the most intangible of intangibles”. What is personal goodwill and how do you capture it?
Ain: Personal goodwill is distinct from enterprise goodwill. Personal goodwill is not divisible as marital property in most jurisdictions. When courts are evaluating personal goodwill, they have to distinguish it from enterprise goodwill – that is, the goodwill of the entity. It’s up to the business valuation professional to come up with a rational distinction between the two. Trial courts are frequently reversed by appellate courts when the distinction between enterprise goodwill and personal goodwill is not based on a rational foundation. It’s up to the expert to explain the distinction to the courts, and doing so is more of an art than a science. The best business valuators are able to distinguish between enterprise and personal goodwill in a way that a layman or woman – that is, the judge – would understand so that they can back out the personal goodwill from the value that the divorcing party has.
Rosenberg: The first step is to evaluate if there is goodwill of any type. From an accounting perspective, goodwill really means the value above the adjusted fair market value of the net assets. Just because an entity is big or profitable doesn’t necessarily mean that there is goodwill. After establishing whether there is goodwill, the big issue in divorce is, who does it belong to? Does it belong to the individual or does it belong to the enterprise?
The hardest part of doing this analysis is determining why somebody makes the amount they make. In the instance of a law firm, it could be very obvious or it could be very opaque. It’s distinguishing their skills, training, expertise, and reputation, versus what the firm has to offer, including their financial capacity, management, and so forth. You have to understand what and why the lawyer earns, and then come up with a method to compare that to their peer or comparison group. That is also very difficult and greatly depends on the size of the law firm involved.
Ain: In assessing personal or professional goodwill as compared to enterprise goodwill, the real difference is distinguishing the characteristics of the individual – including their experience, training, knowledge, age, health, reputation, and work ethic – compared to looking at the enterprise as a whole. It involves the workforce, the facility, the size of the enterprise, the financial capacity of the enterprise, the investment that the enterprise has made in capital, the depth of the management, the name recognition of the enterprise, and the customer base of the enterprise – those are the primary characteristics that are distinguished between the personal goodwill and the enterprise goodwill. A business valuator quantifies each of those elements, both personally and for the enterprise, to come up with a distinction. There might be personal goodwill that could be traced to the enterprise.
Golden: How do non-compete agreements and employment contracts fit into situations where personal goodwill can never be traded?
Ain: In certain professions, that might be the case. A retiring dentist might be able to transfer relationships with his patients to a new dentist, who would pay for this. It’s very difficult with law firms since many client relationships cannot be sold. Some law firms have creative non-compete agreements embedded in their agreements; you very rarely see a binding non-compete agreement in a law firm situation. In that sense, a lawyer is in a different position than another professional might be – say, a doctor or an accountant who might also be practicing at a larger firm.
Rosenberg: The general rule is the more specialized the profession, the less transferable those relationships are.
Golden: How is viewing the personal goodwill of a partner in a large law firm different from the personal goodwill of a solo practitioner?
Rosenberg: From my perspective, the largest of the law firms generally have agreements that are very complex and written so that no one – including the partners of the firm – really understands them. The large firms usually have a compensation system where a lot of statistics are analyzed by a small group of people and the result is conveyed to the partners in a very cursory way. In a large law firm, trying to determine why somebody’s making what they’re making can be very difficult, and oftentimes the party doesn’t know themselves.
With large law firms, it can be difficult to find reliable information to determine what a lawyer’s peer or comparison groups is. Most of the data either deals with mid-size or small law firms. If you look at the Amlaw Top 200, the average partner compensation in the top 200 firms is $960,000; in the top 50 firms, it’s $1.5 million. It’s pretty hard to find comparable information to determine whether a lawyer is making more, less, or the same as their peer group.
Golden: We’ve seen decisions in court citing the most concrete evidence they have as the partnership agreement and they designate the amount, based on the least speculative amount. What has been your experience?
Ain: We handled the case in the District of Columbia (DC) that addressed this issue and distinguished DC from most other jurisdictions. Under the McDiarmid case, DC now looks to the agreement between the partners in a law firm; if it was executed at arm’s length, not in contemplation of divorce – in other words, it’s not a fraud on the marriage – the judge will look to what the partner is entitled to receive when they leave to determine the value of the partner’s interest in the law firm. In Maryland and Virginia, judges will listen to the experts for both parties and then do what they think is right. Sometimes it’s a combination of accepting the value of one party and giving the other spouse a lower percentage of a higher value; sometimes it’s taking a lower value and giving the other party a higher percentage. The judges end up doing what they think is right and justify their opinion based upon the finding that one expert was more credible than the other. In DC, we have the benefit of a more limited discretion on the part of the judges in interpreting valuations of professional interests.
Are the decisions of DC trial judges overturned less than trial judges in other jurisdictions?
Ain: There are far fewer appeals in the District of Columbia than other jurisdictions. More importantly, far fewer of these cases go to trial. The range of results is so much narrower in DC that people are better able to settle cases. They don’t have the sort of crapshoot that they have in other jurisdictions with one party trying to prove a high value and the other party trying to prove a low value to the judge. In DC, we’re governed by whatever the agreement says, so there is less incentive to go to court – which makes it easier to settle cases.
Golden: What other divorce and valuation-related issues are you keeping your eyes on?
Ain: One of the big topics in divorce valuation is the concept of professional or celebrity goodwill. What’s the value of someone’s celebrity status? There are cases from New York and New Jersey that have dealt with celebrity goodwill in a favorable way; in most other jurisdictions, it either hasn’t arisen or hasn’t been decided favorably. As time goes on, we’re going to see more of that concept being argued and litigated.
Rosenberg: Related to the goodwill issue, we see more and more cases with non-traditional businesses and parties making arguments that they have personal goodwill – such as a manufacturing or a sales business that you wouldn’t necessarily consider to be a typical professional practice. Oftentimes, the owner of the business will make the argument that the business will fail without their involvement. I’ve represented owner-chefs of restaurants that say that the restaurant would fail without them – then you have the other side wondering how can they be in ten restaurants at the same time cooking every meal.
The other issue that continues to be difficult to deal with in certain jurisdictions is the increase in the value of a business during the marriage and what that’s attributable to. If the increase is attributable to passive factors, that’s not considered to be a marital asset, whereas if its attributable to the personal efforts of one party, it is considered to be a marital asset – which is kind of the opposite of personal goodwill where an owner of a business who doesn’t want the value to be a marital asset claims that it was just luck or market forces. Sometimes they even try to make both sides of the argument at the same time, claiming that it is personal goodwill and they had nothing to do with it. Most of the litigation that actually goes to trial involves an increase in the value of assets during the marriage.
Read the second part of this interview on using prenuptial agreements to protect a business. Click here.
Sanford (“Sandy”) K. Ain is a principal and co-founder of Ain & Bank. He has practiced family law for more than 40 years and has successfully resolved some of the most notable and complex family law cases in the country. He is a frequent lecturer, speaker, and panelist on family law issues throughout the country.
Stuart A. Rosenberg is a partner in Aronson LLC’s Forensic & Valuation Services group. An expert who has spent more than 30 years in the industry, Stuart specializes in litigation support services, including valuations of closely-held businesses, financial analysis and investigations, and related expert testimony and forensic support services.
Sylvia Golden is the legal editor at Business Valuation Resources. She prepares the monthly litigation updates and writes articles for Business Valuation Update on cases that discuss expert testimony and financial evidence; in addition, she contributes to BVWire and co-hosts a regular case law discussion for Business Valuation Resources.
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