Massachusetts Divorce Business Valuations: Are “Good Will” Discounts Allowed?

Are "good will" discounts allowed in business valuations for divorce cases? A recent unpublished Appeals Court opinion includes a departure from disfavoring discounts like “good will” in business valuations.

Valuing a business is often necessary to achieve the division of assets in a divorce case. Back in 2019, I blogged about the challenges faced by Probate & Family Court judges, attorneys, and litigants seeking to determine the value of a small business in Massachusetts divorce cases. As I noted in that blog, “[d]etermining the value of a small business in a divorce case is among the most complex tasks that family law attorneys face.” Much of my 2019 blog focused on business valuation “discounts” under the now legendary 2007 case, Bernier v. Bernier (2007):

Put simply, the main holding in Bernier prohibits valuators from applying certain “discounts” when valuing a company that the business owner does not intend to sell anytime soon. Such businesses are known as “ongoing concerns”, and for decades, business appraisers who have valued such businesses have decreased the value of such companies based on “discounts” …

The discounts disfavored by Bernier included minority discounts, marketability discounts, and so-called “key man” discounts. Business valuators typically use each of these discounts to decrease the fair market value of a business. For example, a marketability discount applies to minority shareholders with limited rights to sell their share of a business. Marketability discounts are like a minority discount but can also apply to majority shareholders in a small business or partnership and focus on a partial owner’s inability to sell their share of a business easily. Finally, a “key man” discount is applied when the business owner is so crucially important to a company’s success that the value of the business would be reduced if it were sold.

Under Bernier, each discount method is expressly disfavored when valuing a business that a spouse intends to continue owning/operating after the divorce. Despite Bernier’s broad disapproval of discounts in the business valuation context, a recent unpublished opinion of the Appeals Court, Kwak v. Bozarth (2023), suggests that a discount for “good will” can fit within the Bernier framework.

How is a “Key Man” Discount Different from a “Good Will” Discount?

As noted above, a “key man” discount centers on a small business where the owner plays such a central role in the business’s operations that the value of the business would be seriously reduced if the business were sold to a new owner. For example, if the only employee of “Al Smith Plumbing” was Al Smith, it stands to reason that much of the value of the business is bound up in Al Smith himself performing the plumbing tasks. Intuitively, we understand that if “Al Smith Plumbing” is purchased by a non-plumber named Mike Jones, the business is not going to be as valuable. Hence, the “key man” discount.

As noted above, the Bernier decision has become almost legendary due to its perceived complexity. However, a cursory review of Bernier reveals that the Supreme Judicial Court did not reject the concept of a key man discount in every divorce valuation; it only rejected a key man discount in the context of the Bernier case:

It is appropriate to assess a key man discount when an individual’s “continued services are critical to the financial success: of the business being valued and may be or will be lost. … Here, however, given the husband's uncontradicted testimony that he would maintain total ownership and control of the supermarkets, it is beyond reason to conclude that the business’s value should be reduced to account for loss of the man who is “the whole show.” … The [Bernier] husband's role in the supermarkets, in contrast, is that of chief executive; his services are critical but not unique or irreplaceable, and in any event, as we have previously noted, the husband was not likely to be “lost” to the enterprise. In the circumstances of this case, the judge should not have adopted a key man discount in valuing the supermarkets.

The main takeaway from Bernier is that key man discount may be appropriate when the loss of the owner-employee would be potentially catastrophic to a business. The loss of a merely “critical” CEO, on the other hand, does not pass muster in the divorce valuation context.

Although there are similarities, there are also important distinctions between a “good will” and “key man” discount. Economists have distinguished "key man" and "good will" discounts as a contest between "personal goodwill' vs. "enterprise goodwill" through the multivariate utility theory:

The multivariate utility theory includes a process of assigning goodwill to various attributes or factors of the Business that create goodwill, attributing and weighting those attributes to the enterprise or the professional based on the appraiser’s informed judgment, and calculating an indication of the allocation of goodwill between the enterprise and the professional.

Under the multivariate theory, a series of factors are weighed in the context of belonging to the individual vs. the business. Professional or personal goodwill can be attributed to the efforts of or reputation of an owner spouse of the business. Meanwhile, enterprise goodwill may be described as the intangible value belonging to the small business regardless of the presence of the owner-spouse.

In more general terms, a “key man” is often not an owner, but rather, is an extremely important employee like a CEO or general manager, whose loss would hurt the management or operations of the business (think of a general manager of a car dealership who built the place from the ground up and whose loss would hurt the business, but who does not actually sell cars to customers). In the context of a divorce valuation, “good will” often focuses on the value of a professional owner, like a doctor, lawyer, or dentist, who has a specific list of revenue-generating clients who would leave the firm if the owner professional left.

Theoretically, a key man can be replaced by a similarly skilled individual. The individual would need to be able to perform the “key man” tasks, but anyone with sufficient skills can hypothetically do the job. In contrast, nothing is likely to persuade all of the long-term clients of a specific doctor, attorney, or dentist to stay with a business if that professional leaves to start a new business.

Even when the “key man” is an owner of the business, there is generally an assumption that the individual would choose to stay to protect the value of his or her business. In contrast, another key man can leave anytime they want, which would hurt the value of the business.

The Good Will Discount in Kwak

In Kwak, the Appeals Court defined "good will" as follows:

"Good will is necessarily attached to a going business and relates to the name, location and reputation, which tends to enable the business to retain the patronage" of its customers (quotations and citations omitted).

The Court credited the opinion of the husband's qualified business valuation expert, David Consigli, Jr., CPA, ABV, CDFA, who opined that the wife's practice was worth approximately $2,230,000, after applying a discount good will:

Here, the judge rejected the wife's valuation of $662,452, finding that her methodology (which involved subtracting the business's debt from sixty percent of its average gross receipts) was not a "recognized business valuation method." By contrast, the judge found Consigli's use of the income approach (which involved a capitalization of earnings methodology dividing the business's normalized cash flow by the risk-adjusted rate of return) to be generally appropriate. .... The judge also credited Consigli's application of a twenty-one percent good will discount, reflecting the estimated loss of clients that would occur if the wife left the practice.

Here, Consigli testified that for the purpose of his valuation, good will represented the percentage of patients at the practice who “come to just [the wife] and wouldn't go to anybody else” if she were to leave the practice following a sale of the business. He determined that the appropriate good will discount was twenty-one percent, and reduced the value of the business by $587,726 accordingly.

....

[T]he judge implicitly credited the following testimony. Consigli testified that he calculated professional good will as the difference between (1) the fair value of the practice using a capitalization of earnings methodology, which he determined to be approximately $2.8 million (before applying the good will discount); and (2) the value of the practice ($2.2 million) using an alternative valuation methodology derived from multiplying the practice's 2017 adjusted pre-tax income by the average EBIDA multiple for dental practices. Consigli testified that the difference between those two valuation figures was equivalent to approximately twenty-one percent of his calculation of the business's fair value using the capitalization of earnings methodology, and represented the good will attributable to the wife. He further testified that his calculation of good will was consistent with the wife's representation that she was responsible for approximately forty percent of the total collections at the practice, and it was reasonable to estimate that around half of her patients might not remain at the practice if she left.

Although a good will discount is somewhat analytically distinct from a key man discount, both concepts measure similar phenomenon: How much the value of a business would suffer if an important owner-employee leaves the business. It is an open question whether the reduction in business revenue – i.e. the amount of the good will discount in Kwak – is meaningfully different from the 10% “key man” discount rejected by the Court in Bernier. So why did the good will discount in Kwak pass muster when the similar key man discount in Bernier was rejected?

Does the Kwak Opinion Meaningfully Change Bernier’s Limitation on Valuation Discounts?

One key structural factor in the Kwak decision is that Consigli’s good will discount actually benefited the business-owning wife:

Indeed, had [Consigli] not used that alternative method, it is unclear whether he would have applied a good will discount at all, which would have resulted in a higher valuation to the wife's detriment.

In contrast, in Bernier, the key man discount harmed the position of the wife filing the appeal by reducing the value of the husband’s business. In other words, the wife in Bernier was better positioned to challenge the key man discount directly, where the discount directly harmed her position. In Kwak, the business-owning wife was poorly positioned to attack a good will discount that benefitted her position by reducing the value of the wife’s business by more $500,000. As noted by the Court, rejecting the good will discount “would have resulted in a higher valuation to the wife's detriment”.

Had the wife's expert in Kwak valued the business using a "recognized business valuation method", such as the income approach utilized by Consigli, the wife may have been in a better position to argue against the use of a good will discount. Moreover, if the business being valued had been owned by the husband - such that Consigli's good will discount benefited the husband rather than the wife - it seems possible that the Appeals Court could have ruled differently.

The different legal postures of the respective wives in Kwak and Bernier make it difficult to say whether the Kwak Court’s allowance of a good will discount fundamentally alters the Bernier Court’s disapproval of the similar key man discount. Moreover, while Bernier is a published opinion of the Supreme Judicial Court (SJC) and binding precedent in Massachusetts, the Kwak decision is an unpublished opinion of the Appeals Court. Such unpublished opinions may be cited for persuasive value but are not binding on lower courts like that of an SJC decision like Bernier.

How Will Kwak Impact Business Valuations in Future Massachusetts Divorce Cases?

Despite the questions surrounding the scope of Kwak's applicability, there is simply no question that a decision by the Appeals Court (even an unpublished opinion) that favorably affirms a good will discount in the business valuation context is apt to “move the needle” in some Probate & Family Court cases involving similar issues. After all, the Kwak Court could have noted that good will discounts are generally disfavored in Massachusetts, but the Court chose not to. Instead, the case will likely serve as an example of when good will discounts may be appropriate in business valuation cases, despite the Bernier holding. Such examples – which illustrate exceptions to the ordinary rule – can significantly impact how individual Probate & Family Court judges approach a similar issue at the trial level.

It is fair to say that the Bernier decision has triggered a fair amount of criticism over the years, particularly by business valuators who feel that the decision's prohibition on discounts undermines their ability to accurately calculate the value of a business in Massachusetts divorce cases. While Kwak is not binding precedent, the decision should provide encouragement to attorneys and business valuators who believe that “good will” discounts provide flexibility for appraisers to calculate a truer picture of a business’s value within Bernier's otherwise rigid framework.

About the Author: Jason V. Owens is a Massachusetts divorce lawyer and family law appellate attorney for Lynch & Owens, located in Hingham, Massachusetts and East Sandwich, Massachusetts. He is also a mediator and conciliator for South Shore Divorce Mediation.

Schedule a consultation with Jason V. Owens today at (781) 253-2049 or send him an email.