Do Sole Proprietorships Have Goodwill?

In 1983, in the only decision rendered by Delaware until that time on the subject of goodwill, the Court ruled that no business or professional goodwill exists in a sole proprietorship law practice. Fast forward 37 years, when the Court ruled that goodwill is, in fact, includible in a sole proprietorship financial services practice, stating that the 1983 decision should not be interpreted as excluding professional goodwill from the valuation of every sole proprietorship.

So, where are the differences in these two opinions? Does the 2020 opinion supersede the 1983 opinion? Are the fact patterns different? What is the court looking to in future valuations for purposes of divorce litigation?

Let’s consider, first, the fact pattern in the 1983 decision. In the valuation of the husband’s sole proprietorship law practice, the parties conceded that “goodwill should be disregarded.” The Court then turned to the methodologies of valuation utilized by each of the parties’ experts and concluded that the capitalization of income method or discounted cash flow method (both income-based approaches) were not appropriate methodologies to consider. The Court specifically stated that the sole proprietor’s earning capacity from future income flow was not relevant to the determination of the present value of the sole proprietorship and that an asset-based approach (taking into consideration accounts receivable and work-in-progress) was the appropriate valuation methodology.

How does this fact pattern compare to the 2020 decision? Instead of a law practice, the sole proprietor here had a financial services practice, with the Court noting, “…the practice and means of generating income are different [between a law practice and a financial services practice]”. The sole proprietor’s (husband’s) expert opined to a value of $255,000, relying upon an asset-based approach, conditioned on the premise that goodwill did not exist in a sole proprietorship. The husband’s expert did not include receivables or amounts earned but not yet received. The opposing expert (wife’s) opined to a value of $3,488,000, utilizing both an income-based approach and a market-based approach, according equal weight to both and attributing 95% of total goodwill to enterprise goodwill and 5% to personal goodwill.

The Court noted several other important points before rendering its 2020 decision:

1. The sole proprietor (husband) “was able to extract over $4,000,000 from the sole proprietorship between [the date of] separation and [the date of] hearing [on this issue].”
2. The husband’s expert testified “in response to a question from the court that if Husband could transfer the income stream to a buyer than he could receive the amount assigned by Wife’s expert of $3,488,000.”
3. The husband had previously listed the value of the sole proprietorship as $10,000,000 in the two years leading up to the separation.

In considering the foregoing, the Court determined goodwill to be the central issue of dispute between the experts, concluding that the wide disparity was due to the husband’s expert’s opinion, limited by his belief that goodwill could not exist in a sole proprietorship. The Court ultimately rejected his opinion and accepted Wife’s expert’s opinion in full, citing that, “the sole proprietorship received significant amounts which resulted in income to the Husband…[which] resulted in benefits to Husband which exceeded both values arrived at by the experts. Given the immense value actually received by Husband…the Court has determined that the value arrived at by Wife’s expert is the more realistic value.”

Thus, the Delaware Court has made clear that goodwill in a sole proprietorship is determined on a case-by-case basis. The Court’s analysis underscored the importance of each case’s unique facts and application of the most appropriate valuation methodology or methodologies to those facts. But does this opinion give rise to any other valuation-related issues? Selection of the valuation date? Consideration of facts known or knowable at that date?

Ponder those questions until we meet next quarter!