Valuing a Law Practice
Published in the Maryland State Bar Association Newsletter

Professional vs. Practice Goodwill

By Jolie Gelman Weinberg and Marni B. Schwartz of Weinberg & Schwartz, L.L.C., a Howard County Family Law practice.

One of the most difficult questions brought forth by a client in a domestic case is "does my spouse have an interest in my law firm?" The answer is always more complicated than the question and involves many layers of analysis.

In order to answer the client, the attorney must first understand the terms of "goodwill", "professional goodwill", "practice goodwill" and "fair market value." Many valuation experts divide goodwill into two components: professional goodwill, the goodwill attached to the practitioner which relates to the individual's reputation and personal success in the profession; and practice goodwill, the goodwill attached to the business's reputation and its capacity to continue to generate or maintain business without the presence of a particular professional. A simple definition of fair market value is, what a willing buyer would pay and what a willing seller would accept, with neither acting under duress for the sale of a business.

In Maryland's leading case on goodwill, the Court defines goodwill as the advantage or benefit which is acquired by an establishment beyond the mere value of the capital, stock, funds or property employed therein in consequence of the general public patronage and encouragement, which it receives from constant or habitual customers, on account of its local position or common celebrity or reputation for skill or affluence, or punctuality, or from other accidental circumstances or necessities, or even from ancient partialities or prejudices. Prahinski v. Prahinski, 75 Md. App 113,540 A.2d 833 (1988) aff'd, 321 Md. 227,578 A.2d 784 (1990). In Prahinski, the court first determined whether Mr. Prahinski's business was a title business or a law practice. Upon finding that the business was a law practice, the court then examined the definition of goodwill, and whether or not goodwill is marital property subject to equitable distribution. While the Court of Appeals affirmed the Court of Special Appeals‚ finding that goodwill has value, is marital property and is subject to equitable distribution, it concentrated its focus on the solo law practice of Mr. Prahinski and concluded that "a lawyer's goodwill is not a salable asset", relying heavily upon Rule 5.4 of the Rules of Professional Conduct which prohibits lawyers from entering into the practice of law with a non-lawyer, thus prohibiting an equitable distribution of goodwill, arguably acquired during the marriage, to a non-lawyer spouse. Id. 75 Md. App.at 361-362. Interestingly, the three dissenting Court of Appeals Judges discouraged the intertwining of the Rules of Professional Conduct with the concept of marital property, opining that the prohibition on the valuation of goodwill in a law practice should apply to the solo practitioner only.

Maryland courts have defined goodwill simply as "the probability that the old customers will resort to the old place," and "those advantages which may inure to the purchaser from holding himself out to the public as succeeding to an enterprise which has been identified in the past with the name and repute of his predecessor." Id. 75 Md. App at 126-127. The current State of Maryland law on the valuation of law firms is that the goodwill is personal to the individual practitioner and goodwill in such circumstances is not severable from the reputation of the practitioner regardless of the contribution made to the practice by the spouse or employees, and in order for goodwill to be marital property, it must be an asset having a separate value from the reputation of the practitioner. In contrast, the Court in Hollander v. Hollander, 89 Md. App. 156, 597 A.2d 1012 (1991), found that the goodwill of a dental practice may be considered marital property. The court distinguished the practice of law from other professional businesses by stating that "professionals such as dentists and physicians have no prohibitions against selling their goodwill." Id. 89 Md. App at 166.

Arguably, the concept of practice goodwill, the reputation of the business and its capacity to continue to generate and maintain business without the presence of a particular person, may be applied readily to the large or even medium-sized law firm without running afoul of the Rules of Professional Conduct and personal goodwill. May practice goodwill be considered marital property? After all, practice goodwill is an asset having separate value from the reputation of the practitioner and is therefore, marital property, even under the restrictive holding of Prahinski. Assuming the concept of segregating professional goodwill from practice goodwill is adopted by the Maryland Courts, both the components of goodwill will need to be identified and valued in order for a monetary award to be granted to the non-lawyer spouse. The bottom line in determining if practice goodwill exists in a given law firm is the number of clients that would remain with the firm if a particular lawyer leaves. Client relationships can represent the single most valuable form of goodwill in a law practice. The value of these relationships manifests itself in referrals. There are three types of referrals: client referrals, which are a measurement of the satisfaction of individuals and, depending on the circumstances, attributable to either professional or practice goodwill; professional referrals, which exist because of relationships between professionals and are generally attributable to professional goodwill; and marketing programs or location-generated business and telephone number-generated referrals, which are less dependent upon the reputation of an individual practitioner and therefore fit into the practice goodwill category.

The valuation of goodwill was discussed by the Court of Special Appeals as Skrabak v. Skrabak, 108 Md. App 633, 673 A.2d 732 (1996). Here, the Court found that the excess earnings method was an appropriate valuation method to determine the value of the goodwill in a medical practice. The excess earnings method is a common method for valuing goodwill in which the difference between the actual earnings of the business at hand and the earnings of an average or reasonable business is multiplied by a factor between one and five. The goodwill value is then added to the value of the sum total of the tangible assets to reach the total value of a particular business. Id. at 108 Md. App 642.

For an expert to establish the existence or absence of goodwill, she must analyze the elements of the business to determine professional and practice goodwill. An accountant, preferably one with a background and certification in business valuation, must then delve into the business records including, but not limited to, client files, engagement contracts, tax returns, balance sheets, income statements, tangible assets, accounts receivable, works in progress, liabilities and other related information. After analyzing such data, the expert then selects one or more methodologies to determine the fair market value of the business.

Although this article serves as an overview of professional and practice goodwill as they relate to the valuation of law firms, it is clear that the Maryland Courts have not yet adopted this concept in the valuation of professional businesses. If the Maryland Courts do choose to differentiate between professional and practice goodwill, then, arguably, the practice goodwill of medium and large-sized law firms may be considered marital property, subject to equitable distribution.

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