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Equitable Distribution of Ownership of a Law Firm

August 16, 2017

Divorcing a lawyer? A recent decision by a New Jersey appellate court explains the process by which a person’s interest in a law firm is valued for purposes of equitable distribution.  In Slutsky v. Slutsky, years of matrimonial litigation and post-judgment motions culminated in a consolidated appeal which addresses, in part, the valuation of the husband’s interest as equity partner in a large, New Jersey law firm.  Specifically, this decision examines the intricacies of valuing such an interest, including how courts can (and should) address the goodwill component of the divorcing lawyer’s interest.

In Slutsky, the parties were married for thirty years when the wife filed an action for divorce.  At the time, the husband was an equity partner, employed in the tax department of a prominent New Jersey law firm.  The husband joined the firm in 1978, following his graduation from Harvard Law School, and became an equity partner in 1984, owning one share of stock.  In 2013, the firm changed its corporate structure, and the husband was required to provide a $300,000 capital contribution, financed through a four-year note. To determine the fair value of the husband’s interest as of May 20, 2008, the date of complaint, both parties submitted expert testimony from their respective forensic accounting experts.  The husband’s relationship with the firm was governed by a shareholder agreement, which outlines the firm’s obligation to purchase stock when a shareholder stops being employed by the firm, and contains a formula fixing the amount of payment. During employment with the firm, an equity partner’s interest is calculated by the termination credit account (TCA).  This calculation does not factor in seniority, but is based on billable hours, bills collected and origination of new business.  The husband admittedly did not bring in substantial original business, but instead serviced many of the firm’s existing clients’ tax needs and received significant business referrals from his partners.

Pursuant to the shareholder agreement, at age 65, the law firm’s board of directors determines whether the equity partner should move to a salaried, senior status position or continue to participate in the allocation TCA system.  If moved to senior status, that partner’s TCA would be paid out over time.  Moreover, after 30 years of partnership, under the agreement, a shareholder becomes eligible for a longevity bonus of 25% of his or her average salary of the five highest-paid years over the last ten years.  In this case, the husband’s 30-year bonus vested after the date of complaint, but prior to trial.

The wife’s valuation expert initially valued the husband’s TCA at $350,830.  Following cross-examination, agreeing with some of the husband’s expert’s challenges, he revised his TCA value to $292,908.  This calculation was based on the assumption that the husband would retire at the age of 70.  However, the wife’s expert also added a value for the firm’s goodwill.  Her expert calculated a differential between reasonable compensation and the distributions made to the husband.  The wife’s expert valued the husband’s individual interest in the firm’s overall business goodwill at $1,198,077, and following cross-examination, adjusted his valuation of the goodwill to $1,185,304.

The defendant’s valuation expert took a similar approach to value the husband’s TCA, but did not include a separate goodwill interest in his firm ownership. He opined that the husband’s allocation from the TCA was consistent with reported reasonable compensation data, and therefore, there was no additional goodwill component. Ultimately, he valued the husband’s interest in the firm at $285,000.00.  He disagreed with the wife’s expert in several respects, most importantly, his valuation of goodwill which was separate and apart from the TCA.

The trial judge found it “incredible” that the firm had no goodwill value and rejected the husband’s expert’s opinion.  Although the trial court’s opinion identified the flaws in the wife’s expert’s testimony, which were ultimately corrected with downward adjustments following cross-examination, the trial court accepted the wife’s expert’s original figures, $350,083 and $1,198,077. The trial court reduced the husband’s interest by his $300,000 capital contribution and awarded the wife 50% of the remainder as equitable distribution.

In vacating this specific portion of the trial court decision, the appellate court found that the trial court improperly accepted the wife’s expert’s original numbers, though he agreed that his reasoning was flawed and a downward adjustment was warranted following cross-examination.  The court found that intangible goodwill may attach to an attorney’s interest in a professional practice, though the trial court here failed to make factual findings to support the value of goodwill ultimately accepted by the trial court.  The court held that goodwill must be valued, representing the likelihood of repeat patronage and a certain degree of immunity from competition.  The method of valuation will depend on the nature of the business. For example, the method for valuing a solo law practice will differ from valuing the goodwill in a large law firm.  Where there is a shareholder agreement, the court found, reference must be made to its terms in calculating the value of goodwill. Here, for example, the court found that the trial court misunderstood and therefore improperly discredited the husband’s expert’s explanation that the goodwill of the firm was rolled into each equity partner’s TCA.  Here, you have to look at the shareholder agreement to determine whether it provides a measure of valuing the firm which includes goodwill.  If so, goodwill need not be valued separately, as it is already accounted for in each equity partner’s allocation.  In this case, where the husband had little original business of his own and instead relied on in-firm referrals for a bulk of his business, a lower valuation for individual goodwill may make sense. Reluctant to delve into these intricacies on appeal, the appellate court remanded to determine the husband’s individual interest in the firm’s goodwill.

On remand, the appellate court instructed the trial court to take a closer look at the husband’s projected term of employment.  The wife’s expert assumed retirement at age 70.  However, the shareholder agreement provided a key event at age 65, which could trigger a substantial change in earnings.  Ignoring this key fact called into question the wife’s expert’s overall valuation.

Moreover, the appellate court admonished the trial court for failing to make specific findings as to why the court awarded the wife 50% of his business interest.  The court noted that the inquiry is not complete once the husband’s business interest (goodwill included) is determined.  Next, the court must identify the wife’s interest therein.  It is not automatically 50%, as the trial court found without explanation.  The appellate court instructed the trial court to utilize the equitable distribution factors in the alimony statute on remand to determine to what percentage of the husband’s interest the wife had a claim for equitable distribution.

Though this decision is instructive to a narrow class of divorcing parties (one of you needs to be a lawyer for this portion of the decision to have real relevance), it is instructive in identifying the complexities of this one facet of business valuation in an industry-specific context. Unsurprisingly, the court did not fashion a formula or bright-line test for making such valuations.  The process of business valuation, specifically, identifying a goodwill component, are too fact-specific to permit a cookie-cutter approach.  Such reasoning can also be applied to business valuations in other settings and industries.  In valuing a law firm, for example,  the starting point is the shareholder agreement, if there is one.  From there, Slutsky makes clear that various, well-reasoned valuation approaches can be entertained by the court. This decision in reality paves the way for more creative ways to approach such valuations.

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