Valuing a Business’s Goodwill in a Divorce

How is a business’s goodwill valued in a divorce?


When the marital community in a divorce includes a business, that business must be divided in the division of assets (unless the parties agree otherwise or agree to a buyout). Most commonly, the spouse running the business buys out the other spouse’s ownership in the business.


To determine how much that buyout is, judges must figure out the monetary value of the business. Business valuations take various factors into consideration such as operating expenses, profits, equipment, and quite possibly the most subjective factor is the goodwill in the business.


What is “goodwill” in a business?

Goodwill is the value added to the business by the good reputation of its owner(s) or “the expectation of continued public patronage.” People are more prone to return to a business if they trust its proprietors. For example, if you feel like your auto mechanic treated you fairly, you are more likely to return to that mechanic the next time you have a car problem.

The goodwill in the business is not valueless. In fact, it can be highly valuable, as repeat business is essential to almost any business’s long-term success. And because it has value, when a business is being divided up as part of a divorce, the goodwill must be accounted for in the overall valuation of the business.

In 1987, the Arizona Supreme Court wrote, “[B]ecause the professional practice of the sole practitioner or partner will continue after dissolution of the marriage, with the same goodwill as it had during the marriage, we find that a refusal to consider goodwill as a community asset does not comport with Arizona’s statutory equitable distribution scheme. We prefer to accept the economic reality that the goodwill of a professional practice has value, and it should be treated as property upon dissolution of the community, regardless of the form of business.” Mitchell v. Mitchell, 152 Ariz. 317 (1987).


Does goodwill only apply to the owner(s) of a business?

Yes. One of the cases the Arizona Supreme Court cited to in Mitchell holds the answer. The case, In re Marriage of Hall, 692 P.2d 175 (Wash. 1984), is from the state of Washington, and is one of the leading cases on goodwill.

Both spouses were doctors. Husband was a well-respected cardiologist who co-owned a private practice with another doctor. Wife was employed as a professor at the University of Washington Medical School. At trial, the court valued the goodwill in Husband’s business at $70,000.00 and ordered that amount be divided between the spouses. The court did not find that Wife possessed any goodwill because she was a salaried employee.

On appeal, Husband argued that this was not fair. Both spouses had the same education, reputations, and earning capacities, why should he have to pay her $35,000 for his goodwill and receive nothing from her in return. Because, said the Washington Supreme Court, she is an employee. Employees goodwill is not considered in the valuation of the business.

The Court reasoned that Father’s argument failed to appreciate the difference between professional goodwill and personal earning capacity. The Court wrote, “Goodwill is a property or asset which usually supplements the earning capacity of another asset, a business or a profession. Goodwill is not the earning capacity itself. It is a distinct asset of a professional practice, not just a factor contributing to the value or earning capacity of the practice.” The Court went on to explain that when an employee retires or dies, their earning capacity also retires or dies. But when a business or practice is discontinued, the goodwill carries on and can be transferred or sold to another business.


But goodwill is such a speculative concept, how can you attach a value to it?


In Hall, the Washington Supreme Court reviewed five ways goodwill can be valued when being divided as part of a divorce:


  1. Straight Capitalization Accounting Method.


Step One: Determine the average net profits of the owner/practitioner.

Step Two: This amount is then “capitalized” by applying definite rate (e.g. twenty percent) applied to the average net profits to get the book value of the business.

Step Three: Subtract the value of the business’s assets from the book value of the business. The resulting figure is considered the amount for goodwill.


  1. Capitalization of Excess Earnings Method.


Step One: Determine the business’s average net income from the last five years.

Step Two: Determine the annual salary of an average employee/practitioner with similar experience to that of the owner/practitioner.

Step Three: Subtract the annual salary of an average employee practitioner from the business’s average net.

Step Four: Capitalize the remaining amount by applying a definite rate to the resulting figure.


  1. IRS Variation of Capitalization of Excess Earnings Method.


Step One: Determine the business’s average net income from the last five years.

Step Two: Subtract a reasonable rate of return based on the business’s average net tangible assets.

Step Three: Subtract a comparable net salary.

Step Four: Capitalize the remaining amount by applying a definite rate to the resulting figure.


  1. Market Value Approach.


You’ll recognize this approach if you’ve bought or sold real estate or watched any home flipping TV shows.

Step One: Determine what the business would be worth on the open market by finding what similar businesses have recently sold for or are in the process of being sold for. Arrive at a value based on the comps.


  1. Buy/Sell Agreement Method.


This one is similar to #4 except it requires that they use either an actual sale or an unexercised buyout option in the business formation documents to arrive at a number.  


The Washington Supreme Court goes on to note, “These five methods are not the exclusive formulas available to trial courts in analyzing the evidence presented. Nor must only one method be used in isolation. One or more methods may be used in conjunction with the Fleege factors to achieve a just and fair evaluation of the existence and value of any professional’s goodwill.”


What are the Fleege factors?

The factors include the owner/practitioner’s age, health, historical earnings, and professional reputation.


More Related Articles

Meister v Meister – Business Valuations in Divorce

In Divorce, Sometimes a Gift is no longer a Gift

Benefits of a Prenuptial Agreement for Business Owners


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