Competition and the Value of a Business are Closely Tied

  • Enterprise goodwill is the expectation that a business has in the continued patronage by its customers, regardless of the individuals involved. Personal goodwill is the expectation of continued patronage because of an individual’s continued participation in the business.

  • Personal goodwill is not an asset owned by a business, but it may be acquired through contractual arrangements including employment contracts and agreements not to compete with the business after employment.

  • As post-employment restrictive covenants become more difficult to enforce, the equity value of small, service-oriented businesses will be lowered.

  • Whether the closely held business is the owner of the goodwill that produces its revenue is a critical issue when valuing the entity.

Lawyers who are prohibited by the rules of professional ethics from any restriction on competition.  A real estate management company where the principals each work their own book of business.  A design-build firm in which a single principle generates the vast majority of the business.  An outside sales organization in which the owners divide profits based on origination.

All of these examples raise the thorny issue of who owns the goodwill that is responsible for the future earnings capacity of the business.  Does the reputation of the business belong to the business, or to the individuals?  As one commentator put, does the goodwill of the business go home for dinner every night?

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The issue of who owns the goodwill — the enterprise or the individuals— is likely to become even more important as the general sentiment is turning away from enforcing agreement not to compete and various states and federal agencies are taking steps restrict the imposition of agreements that restrict competition after employment.

The simple fact is that the business — particularly the services company — that has no economic moat around it accumulated goodwill has a problem.  If anyone, including the owners, can leave at anytime and take the customer’s with them, that competition diminishes the value of the equity in the business.

The Value of Goodwill in the Closely Held Business

Good will is the reputation that drives revenue for the service-oriented business.  It is an intangle asset, one that can be bought or sold.  Goodwill in a business in the value that goes beyond its physical assets.  It is the value that is attributable to the expectation of continued customer patronage.  It is also in many cases what we fight very hard to protect.

But what if the goodwill is not an asset of the company?  Approximately 25 years ago, the U.S. Tax Court held in Martin Ice Cream Co. v. Commissioner that the father-to-son transfer in 1979 of a 51 percent interest in a Bloomfield, New Jersey premium ice cream business did not include the father’s personal goodwill.

The father, Arnold, had started in the premium ice cream business after World War II and had build a network of relationships with supermarket owners.  The company ultimately became a distributor for Haagen-Dazs.  Martin, however, worked in the office, leaving the development of new business and relationships to his father.  Eventually, the business was sold to Pillsbury, which by then had acquired Haagen-Dazs. In a dispute overt the failure to pay capital gains tax on the goodwill transferred in the transaction, the court said:

This Court has long recognized that personal relationships of a shareholder-employee are not corporate assets when the employee has no employment contract with the corporation. Those personal assets are entirely distinct from the intangible corporate asset of corporate goodwill.The transaction was actually two: the tangible assets and the book of relationships that the father had developed over approximately 40 years in the business.  “T]he first, and much more valuable, was the intangible assets of Arnold’s rights under his oral agreement with Mr. Mattus [the former owner of Haagen-Dazs] and his relationships with the owners and managers of the supermarkets, which formed the basis of his ability to direct the wholesale distribution.”

Modern Application of the Enterprise Goodwill Doctrine

Courts today distinguish between the enterprise goodwill owned by the company and the personal goodwill of those affiliated with the business.  The issue arises consistently in decisions concerning the division of assets in a divorce.  In most states the spouse’s share of enterprise goodwill in a business is will be included in an equitable distribution of marital assets, personal goodwill is not distributable.

And of course, the distinction between personal and goodwill continues to be an issue in income tax disputes and is incorporated into many business transactions.  (See Personal Goodwill: Opportunitities for Buyers and Sellers) But it turns up in other circumstances as well.  A federal court in the Northern District of Oklahoma recently granted summary judgement against a business broker claiming a commission on a transaction for the sale of a key employee’s personal good will.

The issue is often whether the goodwill will continue without the individual individual involved.  This is often an easy call with professional businesses, but the line may well blur in other sales-driven businesses, and it will often depend on the size of the business and its own institutional reputation.

Business Governance Documents May Overlook the Value of Personal Goodwill

We see the issue with some frequency as the corporate governance documents of small businesses will often overlook the critical issues of assigning ownership of intellectual property to the enterprise and quite frequently, for whatever reason, will not contain restricts that prevent owners from leaving and taking customers with them.

The easy cases have been those in which there is a restrictive covenant in place prior to the dispute or some restriction on competition is incorporated into the transaction that winds up the dispute.

Nonetheless, it is not unusual that an owner involved in the compelled purchase and sale of an equity interest will insist that the value of the business immediately preceding the dispute must be the basis of the compelled buyout, even though it prices in an intangible asset that the businessd may not own.

Courts have consistently held since the Martin decision that personal goodwill is transferred to a business and becomes enterprise goodwill by an employment contract or an agreement not to compete.  The dividing line may not be so distinct in any given case, however.  Even though an owner may not be restricted from competition, a large, well-known personal services firm may have enough of a reputation that one cannot fairly argue that it has no enterprise goodwill.  The distinction between personal goodwill and enterprise goodwill may well be determined by the peculiar factual circumstances.

Valuation experts will take different approaches in addressing the issue of personal goodwill. One approach is to value the personal good will of the owners and deduct that good will from the intangible assets of the business.  Another approach that I have seen applied involved an estimate of the probable loss of sales due to the withdrawal of a rainmaker from the business.

The Effect that Outlawing Restrictive Covenants Will Have on Business Values

The hard fact is that competition decreases the equity value of the small business.  It is a zero sum equation.  If an owner can leave, or be fired, and still hold onto the customers from his or her old business, then the old business will decrease in value to exactly that extent.

State legislatures and the federal government are making it less certain that closely held businesses can use contractual limitations on competition to proetect the value of the owner’s equity.  The carve-outs for restrictions on competition related to the goodwill owned in a business is at best ambiguous.

In the same way, the closely held business with a limited number of employees stands to lose far more more in its proportionate value as a result of a defection by a key employee or the withdrawal — forced or voluntary — of a key rainmaker for the business.

If the trend against enforceability of agreements not to compete with a former employer continues — and there is every indication that it will — then the metrics of valuing a closely held business are likely to change as well.  Most likely to the detriment of the current generation of business owners.

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