Excess earnings method "better isolates" law firm partners' goodwill

 Wright v. Wright, 2013 Va. App. LEXIS 53 (Feb. 19, 2013)

This divorce case represents another challenge to the use of the excess earnings methodology to value a spouse’s professional practice, including personal and business goodwill for equitable distribution purposes.

The husband was an equity partner in a leading law firm. At divorce, his earnings were in the third-highest compensation level for equity partners, out of sixteen.

Under state law, only goodwill that was attributable to the business entity, the husband’s law firm, qualified as community property, whereas goodwill resulting from the individual’s efforts qualified as the owner spouse’s separate property.

To derive the marital share of the value of the husband’s practice the wife retained an expert, who used the excess earnings method—which the court called “bottom up” method—to calculate the value of his professional goodwill. Both sides and the court acknowledged that the same expert, using the same method, had testified on behalf of the prevailing party in a precedential divorce case that also involved an equity partner’s interest in the same law firm. See Howell v. Howell, 523 S.E.2d 514 (2000)(available at BVLaw).

The court does not provide details about the analysis the expert performed in this case, but refers to Howell to explain the methodology. There, the expert compared the husband’s average income for three years to that of a peer group. The difference between the two reflected the excess earnings stemming from the husband’s association with the law firm, not from his personal efforts. “It was the additional income he received from being associated with his law firm.” He then projected excess earnings over the husband’s expected career with the same firm and used the discounted future earnings method to calculate the present value of the husband’s total future excess earnings.

In the instant case the expert testified that this approach was preferable to other methods and was the “approach that I’ve used in valuing virtually every professional practice, large or small, certainly for the last 10, 15 years.” The marital value of the husband’s interest here was almost $1.5 million, he concluded. His assessment did not include a value for the husband’s personal goodwill.

The court also does not provide details about the valuation the husband’s expert performed, but notes that he made adjustments and applied discounts based on testimony that his client was subject to a reduction in income and planned to retire at age sixty-one. He found that the marital value of the husband’s interest was $503,000, that is, roughly a third of the value the wife’s expert’s determined.

The trial court accepted the valuation of the wife’s expert, calling his opinion “better reasoned and more credible” than the competing testimony. His approach showed a “better focus on intrinsic value,” and his estimation of goodwill was more persuasive because he “better isolated institutional goodwill by determining what an attorney’s law firm interest value with husband’s skill, knowledge, and experience value would be if he was in a firm that lacked the attributes of husband’s law firm.” The court found the various adjustments and discounts the husband’s expert applied “arbitrary.”

Although the court did not discuss the husband’s personal goodwill, its final decree stated that it “[could] only take cognizance of institutional goodwill. (Emphasis in original).

Available financial data. In his appeal to the Virginia Court of Appeals, the husband claimed the trial court erred in crediting the wife’s expert’s defective valuation. Specifically,

• There was no justification for using the excess earnings method in this case. Unlike in the earlier Howell case in which the expert resorted to it because he did not have access to partnership financial data, here the husband provided the relevant financial data;
• The expert neither valued nor accounted for the husband’s personal goodwill;
• His valuation did not “tax-effect for accounts receivables and work in progress”;
• The comparison group of firms and attorneys was not comparable to the husband and his practice;
• The valuation assumed an increase in the husband’s income, including post-separation earnings; and
• It failed to consider testimony regarding a reduction in income and early retirement.

The appellate court disposed of the arguments quickly. It agreed that the testimony of the wife’s expert “strongly suggests” that he had more financial information at his disposal than was the case in Howell. But, it continued, there is no controlling authority that instructs trial courts to limit the use of the excess earnings method to cases in which pertinent financial information is unavailable. Whether to accept the approach is a factual issue “within the sound discretion of the trial court.”

The Court of Appeals also agreed that the wife’s expert did not compute a value for the husband’s personal goodwill. But given the trial court’s explanation in its final decree, the appellate court determined “that no part of husband’s personal goodwill was included” in the distribution award calculation. Finally, as the fact finder, the trial court had no obligation to give weight to the early retirement testimony. For all these reasons, the appellate court affirmed the $1.5 million marital value of the law practice interest.