You and your partners have a successful medical or legal practice. You manage the practice well and have relied on legal counsel to prepare you for potential changes and issues that may arise in the business. You set up your practice as a Professional Corporation or as a Professional Limited Liability Company to reduce potential personal liability. You and your partners signed a buy-sell agreement that requires any partner to offer their interest to the company or to the other partners at a predetermined price before they can sell to an outsider. Now your spouse wants a divorce. You’re not worried about your practice because the value of your interest in the business is set by the buy-sell agreement. Think again.
All the hard work of your corporate lawyer is effective between you and your partners and with respect to outsider purchasers. However, in Virginia the measure of the value of your interest in a professional practice in divorce is not fair market value and the terms of a buy-sell agreement or other restriction on sale are merely facts for the court to consider when it determines the value of the business. In the context of a divorce, when there are restrictions to transfer of stock, the task before the court “is to arrive at a fair market value for a stock for which there is no market.” Under Virginia law, divorce judges are charged with fairly dividing the value of marital assets acquired by the parties during the marriage with due regard for both their monetary and nonmonetary contributions to the acquisition and maintenance of the property and to the marriage. With respect to a spouse’s interest in a professional practice, Virginia’s courts have decided that the inquiry is not into the fair market value of the interest in the business, but to “determine from the evidence that value which represents the property’s intrinsic worth to the parties upon dissolution of the marriage.”
What exactly is “intrinsic value” and how is it determined? Unfortunately, there is no precise answer. In one of the leading cases discussing it, Howell v. Howell, the Virginia Court of Appeals said this:
Intrinsic value is a very subjective concept that looks to the worth of the property to the parties. The methods of valuation must take into consideration the parties themselves and the different situations in which they exist. The item may have no established market value, and neither party may contemplate selling the item; indeed, sale may be restricted or forbidden. Commonly, one party will continue to enjoy the benefits of the property while the other must relinquish all future benefits. Still, its intrinsic value must be translated into a monetary amount.
The parties must rely on accepted methods of valuation, but the particular method of valuing and the precise application of that method to the singular facts of the case must vary with the myriad situations that exist among married couples.
How does one place a subjective value on property that takes into consideration the parties themselves and their situation? Three methods are commonly used by experts to calculate the value of a spouse’s interest in a professional practice – the income or excess earnings approach, the asset valuation approach, and the market value approach. The method used most often is the income or excess earnings approach. To begin, the income of the professional is compared to the average income of a peer group. That portion of the professional’s income that is greater than the peer group is excess earnings due to the professional’s ownership interest in the practice. The valuation expert then projects the excess earnings over the professional’s expected career and uses a discount factor to calculate the present value of the total future excess earnings.
The excess earnings approach is filled with subjective choices made by the expert that can have a substantial impact on the valuation.
• Who makes up a physician’s peer group?
• Solo practitioners in the same specialty in the same geographic area?
• What if there are none?
• Practitioners in the same specialty at teaching hospitals?
• National average incomes from Department of Labor statistics?
In an industry undergoing changes from the Affordable Care Act and other regulatory and technological changes, how can an expert project earnings for the remaining work life of the spouse with any degree of confidence? Any errors resulting from those subjective determinations can then be compounded by selection of the discount factor to reduce the future stream of income to a present value. Depending on the number of years remaining in the physician’s expected work life, a small variation in the discount rate can make a huge difference in the present value that the court may use to value the physician’s interest in his practice.
To illustrate the potential for greatly varying valuations, consider the case of Wright v. Wright, decided by the Virginia Court of Appeals in 2013. There, two experts valued the husband’s interest as a partner in a large law firm. Wife’s expert found the interest to be worth $1,492,000 and husband’s expert valued his interest at $502,887. That’s right, the wife’s valuation was nearly three times that of the husband’s valuation. The trial court adopted the wife’s valuation. If the trial required the husband to pay one half of the value to wife, the wife received $494,556 more than if the court had used the husband’s valuation.
The majority of the value of any professional practice is goodwill. Goodwill that is attributable to the individual professional is personal goodwill and is that spouse’s separate property in a divorce case (and therefore not subject to division by the court). On the other hand, good will that is attributed to the practice or business is commercial goodwill and can be marital property. Like determination of value of the professional practice in general, determination of personal goodwill is imprecise at best. Records of referral sources and comparison of the number of long-term patients of the owning spouse with other partners may be helpful to establish that some portion of the good will is personal.
Valuation of a professional practice in a divorce is an imprecise, amorphous exercise. Early preparation and analysis in addition to retaining a valuation expert and an attorney with experience in valuing professional practice in divorce are critical components to obtaining a satisfactory valuation, regardless of whether you are the owning spouse or the non-owning spouse.
Click here to download the pdf reprint of this article, or on the image below.
If you have any questions about business valuation or Virginia divorce, please contact Sands Anderson’s divorce and business litigation attorney, Rob Partin.