Separating Professional Goodwill from Practice Goodwill

Valuators frequently confront the issue of valuing goodwill in a professional practice for purposes of divorce or a sale to a third party. Professional goodwill is that future income producing capacity which attaches to the individual practitioner, while practice goodwill is that which attaches to location, workforce-in-place, phone number and perhaps other intangibles which may be sold to a third party or considered an asset of the marital estate subject to division. Logically, professional goodwill should be addressed in a marital dissolution through support payments based upon future income since the practitioner will be unable to sell it and maintain his or her income stream. Notwithstanding the logic, State laws and local judges may have different views of which elements of intangible value are allocated to professional or practice goodwill.

It is common amongst physicians to find arrangements where a specialist has excess office capacity and 'rents' the space to one or more specialists who can provide services compatible with but not in conflict to his or her own. A typical arrangement would be to have the 'renter' pay 50% of the receipts generated from such services for rent. (Note: Valuators should be aware of the Stark laws which regulate relationships among healthcare providers and provide for severe penalties if illegal referral payments are made. See Valuation of Medical Practices, Some Thoughts On Stark II In Physician Comp Arrangements for more information). Several examples follow: An ophthalmologist who rents space to another ophthalmologist who is a retina specialist. A dermatologist who rents to a plastic surgeon who perhaps does liposuction or removes large skin growths outside the skill of the dermatologist. A general surgeon who rents to a vascular surgeon.

While it may be true that the ability to recruit other physicians into the office and the direct patients to them is tied to the professional's reputation, the rent payments represent a separate source of revenue not directly tied to the professional's services. How can this revenue stream be valued? Assume the following facts

Owner' Receipts	600,000	75.0%
Renter Receipts	200,000	25.0%
Total receipts	800,000	100.0%
Variable expenses	240,000	30.0%
Fixed expenses	60,000	7.5%
Renter Expense	100,000	12.5%
Total expense	400,000	50.0%
Owner's Net Income	400,000	50.0%

Several approaches may be taken to determine the income attributable to the renter payments. The simplest approach on the surface would be to conclude that the income netted from the renter is 100,000 and that this is the income stream subject to valuation. This approach implies that all of the operating expenses would have existed without the renter, and that the 50% of the renter's receipts retained is 'pure' profit. Depending upon the risk associated with the future use of the location by the renter and with income for the particular specialty, a capitalization rate might range from 25% to 40% or more. For sake of illustration, assume that the cap rate is 33.3% and the value of this practice goodwill is therefore $300,000.

Another approach would be to argue that all the fixed costs are attributable to the owner, and that the true profit from the renter is total revenue less variable cost less the renter payment, as illustrated below.

	Without	Renter	With
Owner' Receipts	600,000	200,000	800,000
Fixed Expenses	60,000		60,000
Variable expenses	180,000	60,000	240,000
Renter expenses		100,000	100,000
Total expense	240,000	160,000	400,000
Net Income	360,000	40,000	400,000

This clearly will yield a very different result. Using the same 33.3% cap rate from above, a value of $120,000 is generated.

The final approach to look at (although infinite variations are possible) is that of fully allocating costs to both the owner and the renter, as illustrated below:

	Without	Renter	With
Owner' Receipts	600,000	200,000	800,000
Fixed Expenses	45,000	15,000	60,000
Variable expenses	180,000	60,000	240,000
Renter expenses		100,000	100,000
Total expense	225,000	175,000	400,000
Net Income	375,000	25,000	400,000

The difference is striking. Using the same 33.3% cap rate from above, a value of $75,000 is generated, one-fourth of the $300,000 derived from the 'pure profit' approach.

Which method is most accurate, if any? The pure profit approach seems highly unlikely, unless the renter is bringing all the supplies, staff and other items normally part of variable expense (which should, of course, be ascertained) and the owner has excess physical space that would be paid for in any event. The latter argument strikes the author as being akin to strategic value since taking advantage of excess capacity in a buyer or seller is normally seen as a synergistic adjustment. It is, of course, virtually impossible to perform additional services in any business with absolutely no increase in marginal costs.

The second approach is defensible on a contribution margin basis although this continues to have synergistic overtones. An analysis of historical results may indicate that all fixed costs are, in fact, fixed for the indicated range of volumes with and without the renter, and the owner's compensation increased by $40,000 due to the rental arrangement. If the historical analysis points to a conclusion, it should be followed.

The third approach is the most conservative and reflects the normal view of fully allocating costs to income producing divisions within a business. It can certainly be defended on conceptual grounds, although it seems unlikely that a historical analysis would support it unless the owner had expanded the physical plant to accommodate renters. As in all valuation engagements, the extent of the valuator's investigation is critical to reaching the correct valuation conclusion.

Thanks to Dave Gannett, CPA, Needham, MA for suggesting the concept for this article.