by Steven D. Popell
This article originally appeared in Active Garage, January 5, 2010
The Excess Earnings Method is the most commonly used approach to valuing a sole practitioner practice in family court. In this method, “Excess Earnings” equal practice earnings in excess of the sum of reasonable compensation and a reasonable return on the practice’s Net Assets. Excess Earnings times a multiplier (reflecting the relative risk of the earnings stream) equals Goodwill. Goodwill plus Net Assets equals the total value of the practice.
Since Goodwill typically represents the majority of value, the excess of practice earnings over reasonable compensation (what the practitioner could earn if employed elsewhere in the same specialty) is the key element in this process. Unfortunately, an often substantial portion of practice earnings is counted twice in a court settlement: first, in the valuation of the practice and, second, in determining support payments. This problem of “double dipping” raises serious questions about the fundamental fairness of the method.
How It Works
Let’s say that a female CPA (the primary breadwinner in the household) earns $200,000 per year after all expenses in her solo practice. Her firm’s Net Assets equal $50,000, and a reasonable return on those assets would be 10%. If she were to do the same work for a comparable practice, she would earn $120,000. Therefore, practice earnings exceed reasonable compensation by $80,000 per year. Since her practice earnings stream appears to be relatively secure, the multiplier is set at 4. The calculation of practice value would be as follows:
Excess Earnings $80,000 ($200,000 minus $120,000)
Minus 5,000 (10% of $50,000)
Goodwill $ 75,000 (Excess Earnings)
Times 4 (Multiple)
Practice Value $300,000 (Goodwill)
Plus 50,000 (Practice Net Assets)
So far, so good. But, now, the question becomes how much of her earnings are used to calculate spousal support? If the entire $200,000 is part of the calculation, $80,000 of that total is being counted twice: first, in determining Goodwill and, second, in setting support payments.
Put another way, she has already “purchased” her community property half of the $80,000 annual earnings stream from her spouse for $150,000 (the value of his 50% community property interest in Goodwill) and will pay for it again as part of spousal support. Small wonder that many sole practitioners believe that they are getting a raw deal.
Since the culprit in this situation is the double counting of Excess Earnings, the solution lies in ensuring that Excess Earnings are counted fully only once – either in practice value or in spousal support, but not both. Importantly, there is no compelling philosophical argument for mandating either choice in all cases. In fact, practice value and spousal support are often negotiated as trade-offs in community property settlements.
For example, if short-term income is the supported spouse’s principal need, then additional spousal support may be far more important than higher practice value. This couple may agree on maximum spousal support and a somewhat smaller value for the practice. On the other hand, if the spouse has a high-paying job, the opposite may be true. This second couple may agree to a maximum value for the practice (that the spouse can use as an investment or retirement vehicle) along with somewhat reduced spousal support.
The critical element in all this is that each party identifies and articulates his or her principal priorities. By so doing, they are “enlarging the pie.” In other words, rather than playing a zero sum game (my win in your loss and vice versa) they collaborate to help one another to achieve their most important objectives.
Double dipping is inherently unfair, because it requires the sole practitioner to pay twice for the same income stream (the amount by which practice earnings exceed what s/he could earn as an employee of a comparable practice.) An approach that allows the parties to choose the most reasonable and appropriate combination of practice value and support payments will best serve the long-term interests of all concerned.
The couple’s ability to reach agreement on the value of the business (a typically nettlesome issue) will often “lower the temperature” in the room, thereby facilitating agreement on other issues – including non-financial ones, such as custody and visitation. It’s not often that one gets the chance to take two bites out of such an important apple. Go for it!