Goodwill And The Elderly Businessperson

by Mark Kohn, CPA , CVA

Goodwill represents the present value of certain future economic benefits that-are expected to ma terialize. How is goodwill influenced in the case where the primary economic force behind the business is elderly, and who will probably leave the business soon for health reasons? Assume, for example, the valuations of two different law practices, the lawyers both having the same excess earnings. But one is 40 years old and the other is 70 years old. Would they have the same goodwill?

Would the answer be the same for two owners of a hardware store, one 40 and the other 70? If the goodwill is different in either of these cases, how are those differences calculated?

How Personal is the Business?

In Marriage of Lopez1 the California Supreme Court lists the age and health of the business owner as factors properly considered in determining goodwill. In certain businesses those factors have little impact. For example, the sale of a typical accounting or dental practice is often based on the annual fees, the number of clients and the types of clients. The seller is essentially selling his clients, the buyer is buy ing the clients, and the age of the seller is not a primary factor. Upon sale the seller will usually remain in the busi ness for a year or two as a transition to soften the effect of the change of ownership. After that, however, the owner's health and work presence are usually irrelevant.

At the other extreme is the famous heart surgeon, whose business is based on the personal reputation that she earned, and whose business would collapse were she to become unable to perform surgery. In this case, the "presence" of the owner-surgeon is the most significant factor in any sale or valuation. Accordingly, the age and health of the busi ness owner plays a primary valuation role only in the situa tion where the business owner will continue to work at that business. Therefore, the first step in applying this "Lopez" factor is to make that determination. In businesses where the value depends on the number and type of clients or some other similar criterion that doesn't involve the per sonal services of the owner, this Lopez factor would not be applied because the age and health of the owner are not factors.

The impact of the owner's age and health would normally depend on the degree to which the owner's services are personal to his business. The more personal the services, the lower the goodwill, because that particular business cannot be easily sold. The less personal the services, the higher the goodwill because a much larger pool of buyers are able to purchase the business.

Differences in the degree the owner's services are per sonal can exist in the same type of business. To illustrate, assuming all other factors identical because of the more per sonal relationship associated with the latter practice, an ac counting practice that has 1,000 tax clients with annual billings of $500,000 will sell for more than an accounting practice that has ten clients with annual billings of $500,000. In the former practice, the 1,000 clients who pay an average of $500 annually for tax return preparation have little significant business relationship with the CPA. On the other hand, com pare that relationship with the relationship between the CPA in the latter practice and his 10 clients who pay an average of $50,000 annually. The 1,000 clients care little who is prepar ing their tax return and so the change of ownership should not cause a major defection in clients. A buyer would pay more for that goodwill. He will more likely retain that good will. The buyer of the 10-client firm will pay less for goodwill. He knows that he might not retain all of the clients once he acquires the practice, because the relationship between each of the ten clients and the seller CPA may not transfer to the purchaser.

The following illustration shows the relationship between the goodwill and the nature of the relationships.

Goodwill of business operated by an elderly person

Personal Impersonal
Lower goodwill ------------> Higher goodwill

Investment Value vs. Fair Market Value

In any discussion of the Lopez factor, the type of value method used is just as important as determining the degree to which the owner's services are personal to the business. Investment value describes the value of the business to the owner, even if it cannot be sold. This method recognizes that while the business will not be sold, it has economic value to the owner. Typically, this is the value ascribed to a law practice that generates income far more than the norm. The business generates significant income to the owner, and that ability to generate above normal income is an asset that can be valued just as an appraiser would value the income flow from any other investments. Fair market value is the price at which the business would change hands be tween a willing seller and a willing buyer, when neither is compelled to buy nor sell, and both have reasonable knowl edge of the relevant facts.

In a divorce valuation, these types of value often overlap. Investment value is clearly the value used when valuing a law practice or other business that cannot be sold. Fair market value is usually used in determining the value of businesses that could be sold, although everyone recognizes that no sale will actually take place.

Some valuation experts argue that if fair market value is the criterion, then the valuation must be done as if a willing buyer was ready to purchase the business.

That buyer would presumably continue operating the business. Therefore, the age and health of the seller are irrelevant, because the new buyer will step in and replace the seller. On the other hand, if investment value is the criterion, then one must value the business as it is now, measuring the potential income that it could generate as it is now. In this case, the age and health of the current owner are very relevant to the value.

The impact of these two value approaches can be shown as follows:

Goodwill of business operated by an elderly person
Investment value Fair market value
Lower goodwill ------------> Higher goodwill

Note that the comments above regarding the degree to which the business is personal coalesce with the comments regarding the type of valuation method, which should be used. The more personal the business, the less likely it can be sold, and therefore, the more likely that investment value will be chosen as the valuation method. Assuming all other factors between the two lawyers are identical, the goodwill of a 70-year old lawyer will therefore be lower than that of a 40-year old lawyer. Again, assuming all other factors be tween the two owners are identical, the goodwill of a hard ware store owned and operated by a 70-year old will be very similar to that of a hardware store owned and operated by a 40-year old.

How to Measure the Age and Health Factor

To understand how the impact of age on the goodwill would be calculated, one must first have an overall under standing of goodwill. Assume that goodwill of a famous heart surgeon is being calculated by use of a simplified excess earnings method. In concept, the forensic accoun tant would compare the earnings of the famous heart sur geon with other heart surgeons and note the difference. That difference, often called "excess earnings," is then evalu ated for risk and other factors to arrive at a goodwill value.

Assume that the famous heart surgeon earns $250,000 more annually than the typical heart surgeon. Assume that the risk associated with his continuing to earn that amount is 25%. This means that when comparing the rate of return earned by certificates of deposits and other "safe" invest ments, the appraiser concludes that the probability of con tinuing to earn $250,000 annually more than "the average" heart surgeon is about four times more risky than the risk associated with the earnings from certificates of deposit. Most appraisers, using these assumptions, capitalize the $250,000 by 25% to arrive at a value of $1,000,000 or four years of the excess earnings. That is, the appraiser divides the $250,000 by 25%, which is the same as multiplying the $250,000 by 4. Although not expressed, what is really hap pening is that the appraiser is making a present value calcu lation using a 25% discount rate.

A present value calculation determines how much money is needed to be invested today at a specified rate of return to arrive at a specified dollar amount at some specified time in the future. Schedules 1, 2 and 3 are three different present value calculations for our famous heart surgeon. Schedule 1 assumes the surgeon continues to practice for the next 30 years; Schedule 2 assumes continuing practice for only 20 years; Schedule 3 assumes the surgeon only practices 10 more years from the date of value. Each sched ule assumes that the initial investment amount--goodwill value--earns 25% compounded annually. Notice that the total earnings in each of the three instances during the first ten years are identical. For example, assuming $81,920 is invested at 25%, compounded annually, it becomes $250,000 in five years which is the amount shown on all three sched ules. Similarly, in year ten of each of the three schedules, the $26,844 invested at 25% for 10 years becomes $250,000.

Because with more time a smaller amount invested at the same rate can yield the same as a larger amount in less time, logically enough in Schedule I as the years go on, the present value becomes less and less. The difference be tween 30 years and 20 years is not that significant---only $11,000 or the difference between the $999,000 total of Schedule 1 and the $988,000 total of Schedule 2. Thus, virtually anything longer than 20 years is irrelevant in a valuation context. Similarly, the difference between a 20-year life (Schedule 2) and a 10-year life (Schedule 3) is $95,000. This also is not a dramatic difference -- about 9% -- when compared with the 999,000 total on Schedule 1.

Finally, had Schedule 1 continued for an infinite num ber of years, the total almost becomes $1,000,000. This shows that capitalizing the $250,000--dividing the sum by 25%-- is the same as a present value calculation using a 25% dis count rate.

These schedules show that if the famous heart surgeon is expected to perform surgeries for another 10 or so years--and that risk is built into the 25% rates--then the goodwill value is unaffected by the age of the surgeon. That is, it hardly makes a difference if the surgeon lives for another 20 years, or another 30 years. The difference between his living for 20 more years vs. 30 more years is a mere $11,000 out of $999,000.

Therefore, using this same methodology, the effect of age on goodwill can be calculated for any business owner. The forensic account would simply convert the capitaliza tion rate into a present value calculation and then deter mine at what point the additional time becomes irrelevant.

Conclusion

In Lopez, the California Supreme Court said that the age and health of the business owner must be considered in valuing the business for divorces. In cases where the busi ness owner's services are not personal to his business or customers, this factor should not play a significant role. Also, in cases where it is appropriate to use a true fair market value method, the age and health of the owner may not be that significant. In those particular businesses where the forensic accountant determines that age is a significant factor in valuing the business, the effect of age on goodwill can be calculated mathematically