LOSS OF GOODWILL UNDER CALIFORNIA
EMINENT DOMAIN LAW
 

By Thomas E. Pastore, CEO
and Nevin Sanli, President

The valuation of intangible assets, including goodwill, represents a particularly complex area of business valuation. Under California Code of Civil Procedure Section 1263.510 business owners are entitled to any loss of goodwill resulting from the taking of property by the government as part of eminent domain proceedings.   However, compensation for goodwill is often a forgotten or ignored item in the eminent domain process.  Agencies often do not include it in their budgets.  Sometimes agencies will adopt a wait-and-see policy and not deal with compensation for goodwill until it is actually claimed by the business owner. 

This reactive approach can spell disaster for agencies as business owners may make claims for pre-condemnation damages and inverse condemnation.  In the worst cases, there can be multimillion-dollar differences between the agency’s offer and the business owner’s demand.  If the agency does not make a fair offer for lost goodwill, it can be potentially liable for the business owner’s attorney’s and experts’ fees.

The best policy is to be proactive.  A little bit of good planning at the beginning of the eminent domain process can save the agency a lot of time and money.

The purpose of this article is to inform the reader about what goodwill is, how to measure goodwill loss, why a business owner has a duty to mitigate the loss of goodwill, and how to select a qualified goodwill loss valuation expert.
 

From a practical business standpoint, goodwill is the amount that a buyer is willing to pay for a business in excess of the total fair market value of the business’ tangible assets.  Goodwill typically results from some or all of the following:

• Established name recognition and reputation;

• Established customer base;

• Location attributes;

• Assembled and trained work force;

• Policies and operating procedures in place; and

• Avoidance of start-up costs (and losses) in setting up a new business.

The above factors can contribute to higher profitability (i.e., money above and beyond a fair return on and of the business’ tangible asset values); therefore, a buyer may be willing to pay more than the value of fixtures, equipment, inventory, and other identifiable assets.  The existence of goodwill depends largely on the existence of profits after paying for the tangible assets.

 

The capitalization rate (R) represents the investment rate of return required by a purchaser of a business. It is directly related to the business’ operating risk.

To calculate goodwill, you would deduct all tangible and non-goodwill intangible assets from the total business value (V).  As indicated by the above formula, the value of a business and its goodwill is directly related to earnings (I) and inversely related to the capitalization rate (R).  The higher the earnings the higher the goodwill value and vice versa.  The higher the capitalization rate the lower the goodwill value and vice versa.

In the real world market of business transactions, profits are the driving force of business value.  Market participants in business mergers and acquisitions, as well as competent valuation professionals, rarely rely on rule of thumb valuation methods that do not consider or analyze profits.  Any business with several years' operations and an adequate accounting system is valued on the basis of capitalized earnings or cash flow.  In fact, experienced venture capitalists use projected earnings estimates to value start-up companies with little or no operating history. Accordingly, little if any merit should be given to monthly sales multipliers, commissions multiples, percentages of book value and so on.[1] 

Goodwill is appraised at fair market value which is defined under Section 1263.320 as:

(a)    The fair market value of the property taken is the highest price on the date of valuation that would be agreed to by a seller, being willing to sell but under no particular or urgent necessity for so doing, nor obliged to sell, and a buyer, being ready, willing, and able to buy but under no particular necessity for so doing, each dealing with the other with full knowledge of all uses and purposes for which the property is reasonably adaptable and available.
 

(b)    The fair market value of property taken for which there is no relevant, comparable market is its value on the date of valuation as determined by any method of valuation that is just and equitable.

To determine if goodwill is compensable, the valuation consultant must establish that: (1) goodwill value existed at the condemned site; (2) the owner made reasonable efforts to prevent the loss of goodwill through relocation of the business or other appropriate procedures; and (3) the loss is caused by the taking of the subject property.

MEASUREMENT OF GOODWILL LOSS

Calculating the loss of goodwill under Section 1263.510 represents one of the most challenging tasks for a business valuation consultant. This is particularly true where the business is about to relocate or has recently relocated.  In this situation, there is only limited operating data at the relocation site and factors other than relocation (such as depressed industry or economic conditions) are affecting the business’ performance after condemnation.  In addition, for goodwill to be compensable, the business valuation consultant must analyze the efforts made or that should have been made by the business owner to mitigate the loss of goodwill. 

California Code of Civil Procedure Section 1263.510 (a) 2) states:

“The loss cannot reasonably be prevented by a relocation of the business or by taking steps and adopting procedures that a reasonably prudent person would take and adopt in preserving the goodwill.”

Typically, goodwill loss is calculated by first computing goodwill at the subject site, prior to condemnation, and comparing this amount to the goodwill at the relocation site.  If goodwill after relocation is less than goodwill prior to relocation, then the difference represents the amount of compensable goodwill loss.

A loss of goodwill will usually result from one or all of the following: (1) a decline in sales at the relocation site; (2) an increase in operating costs at the relocation site; and (3) an increase in the operating risk of the business at the relocation site.

Everything else being equal, decreased sales after relocation lead to a decline in operating profits and goodwill value.  However, a decline in sales could be due to other factors such as economic or industry downturns, increased competition or a change in management perhaps due to the death of the owner.  Typically, relocation is likely to have an impact on small family-owned businesses such as retailers.  In contrast, larger retail chains, manufacturers and distributors are less likely to incur decreases in sales.  However, they may experience increased operating expenses because of the forced relocation.

The eminent domain case The People v. George H. Muller, et al.[2] dealt with the issue of increased operating expenses and their effect on goodwill.  Dr. Muller, a veterinarian, was forced by Caltrans to relocate his practice.  While Dr. Muller conceded that he had not lost any patronage or revenues, he presented evidence of increased occupancy expenses and a corresponding decline in profits.  Dr. Muller claimed a loss of goodwill for the decline in his practice’s revenues.  Caltrans argued that only a loss of patronage, not a loss of profits due to increased expenses, was compensable under the goodwill statutes.  The court ruled in favor of Dr. Muller.  The key quotes of this case are:

“Courts have long accepted that goodwill may be measured by the capitalized value of the net income or profits of a business or by some similar method of calculating the present value of anticipated profits.”

“… the Legislature intended to compensate losses such as Dr. Muller’s which are attributable to increased rental expenses resulting from a forced move.”

Expenses that can increase include rent and other occupancy costs, insurance and labor. These increased costs result in lower operating profits and, therefore, lower goodwill.  However, increased costs after relocating do not always result in goodwill loss.  For example, relocation to a larger facility with increased occupancy costs may benefit the business.  The increased size of this facility can lead to higher production capacity and higher sales.  These higher sales could offset or even exceed the increased occupancy costs.  Hence, there would be no loss of goodwill in this circumstance. 

When a business relocates, its operating risk may increase. Significantly lower operating profits at the relocation site can negatively affect a business’ cash flow and its ability to pay vendors. Key employees may be lost. A new customer base may have to be established.  Operating risk is reflected in the capitalization rate (R) in the valuation formula V=I /R.  An increase in operating risk results in an increase in the capitalization rate.  An increase in the capitalization rate causes a decrease in the value of total assets (V).  After deducting tangible and non-goodwill intangible assets from the lower total asset value, there will be a lower goodwill value and a loss of goodwill. 

Determining increases in operating risk requires a thorough analysis of the business’ operations before and after relocation. 

In certain cases, the benefits associated with a redevelopment project may actually enhance the value of real property and goodwill.  For example, a project involving the construction of a Home Depot may increase the patronage and goodwill values for retailers, restaurants and banks located on the project site.  This can occur because the Home Depot adds a substantial number of additional people, its employees, who use the services of the businesses operating on the project site.  In addition, Home Depot could draw more customers from a wider trade area than the other businesses on the project site.  This can result in increased patronage and goodwill value for the other businesses.

In August 1997, in the case Los Angeles County Metropolitan Transportation Authority vs. Continental Development Corporation, the California Supreme Court abolished the distinction between “special” and “general” benefits associated with redevelopment projects.   The court created a new rule, which required consideration of any conditions caused by the project that affect the value of property.  Goodwill valuation consultants must now consider any potential project benefits that may offset the loss of goodwill for a business as long as the project benefits are reasonably certain and nonspeculative.  The evidence presented by the goodwill valuation consultant cannot be conjectural or speculative.

DUTY TO MITIGATE

The California eminent domain statutes and case law make it clear that the business owner must make reasonable efforts to mitigate the loss of goodwill.  As mentioned above, California Code of Civil Procedure Section 1263.510 (a) 2) states:

The owner of a business conducted on the property taken, or on the remainder if such property is part of a larger parcel, shall be compensated for if the owner proves all the following [3]:

                                (1)          . . .
 

                                (2)          The loss cannot reasonably be prevented by a relocation of the business or by taking steps and adopting procedures that a reasonably prudent person would take and adopt in preserving the goodwill.

                                (3)          . . .

                                (4)          . . .

Under case law, a condemnee is obliged to mitigate damages according to Albers v. County of Los Angeles, (1965), 62 C2d 250, 269.  In addition, a condemnee must take reasonable steps to mitigate the loss of goodwill, Redevelopment Agency of Emeryville v. Arvey Corp., (1992), 3 CA 4^th 1357, 1361. 

The duty to mitigate is not unique to condemnation actions.  In fact, mitigation of damages has long been part of our judicial system.  In tort cases, jury instructions include specifically the duty to mitigate:

“A person whose property has been damaged by the wrongful act of another is bound to exercise reasonable care and diligence to avoid loss and to minimize damages and may not recover of losses which could have been prevented by reasonable efforts or by expenditures that might reasonably have been made.”  BAJI 14.68 (Jury instruction for tort cases)

Very few goodwill appraisers express opinions on the mitigation issue.  In fact, most appraisers simply express an opinion of total goodwill without any consideration to the amount that is or will actually be lost.  Such appraisals are arguably incomplete and not responsive to the statutes, which say that only goodwill loss is compensable. An incomplete appraisal could possibly even be excluded from the court as being misleading evidence.  In the event of such a strategic disaster, the agency would be confined to the unenviable position of solely defending and rebutting a claim versus presenting its own version of the facts.

Goodwill loss valuations can be prepared to address the ultimate issue in an eminent domain case.  Even when a business fails to relocate, it may be possible to show that reasonable steps could have been taken in order to preserve all or most of the goodwill. The study of reasonableness of efforts may include extensive relocation searches, costs analyses, income projections, market and competition research and substantial industry and economic reviews.  Well-researched and well-supported goodwill loss opinions have been received by courts and may be used to resolve these important issues.

A notable success for redevelopment and government agencies was obtained in Los Angeles County Metropolitan Transportation Authority vs. Pose With The Stars, et al. (LASC No. BC 105 203).  In this matter, the MTA condemned on Hollywood Boulevard, adjacent to the Mann’s Chinese Theater, property on which the defendant, Regency Outdoor Advertising, Inc. (“Regency”), operated two billboards.  Regency claimed substantial loss of goodwill.  The MTA argued that Regency could have successfully relocated its bulletin boards elsewhere on Hollywood Boulevard so as to preserve all of Regency’s goodwill.  After listening to extensive expert testimony and legal arguments by both sides, the judge ruled in favor of MTA.  The goodwill expert for the MTA, Mr. Nevin Sanli, President of Sanli Pastore & Hill, Inc., testified that had the business relocated to a site which was available, it could have preserved all of its goodwill.  The judge agreed with Mr. Sanli and denied the claim.
 

CHOOSING A GOODWILL VALUATION EXPERT

Goodwill valuation is a separate and extremely complex specialty which is a subset of business valuation.  Experts in this field have a thorough understanding of finance, economics, accounting, products and services, analysis of management and personnel, competition and industry research and investigations about reputation of a business.  This is not real estate or equipment appraisal or work for a CPA.

The goodwill valuation expert should be an Accredited Senior Appraiser – Business Valuation Discipline with the American Society of Appraisers.  This person must have performed hundreds of business and goodwill loss valuations.  However, adequate credentials and valuation experience by themselves are not sufficient to prevail in litigation proceedings.  The goodwill valuation consultant must have a proven track record of deposition and trial testimony. 

It is necessary to make presentations, i.e. reports and court exhibits, that will withstand third party scrutiny and persuade juries and judges.  The goodwill expert must have access to sufficient resources (a large in-house library, on-line databases and Internet services) to conduct proper research and due diligence.  The goodwill expert’s firm must have a sufficient number of well-trained analysts and administrative staff to perform the extensive research required to produce quality materials under tight deadlines.  Proper staffing enables the goodwill expert to meet tight deadlines on projects where multiple businesses are subject to an agency’s eminent domain proceedings.  In these cases it is necessary to provide several goodwill valuations within a short period, typically two to four months, so the agency can make timely and fair offers to the business owners.

A meeting with the goodwill valuation expert is strongly recommended.  Request the expert to bring several goodwill valuation reports to ascertain quality and presentation of work.  Obtain client references, particularly those in which expert witness testimony was provided.  Prepare questions to ask the expert about her or his professional background and testimony experience.  At a later time, you may conduct a mock cross examination to determine how the person holds up under the type of pressure a deposition or trial will produce.  Visit this person’s offices and observe the breadth and quality of the library and the computer network system and equipment which are used to produce research and court exhibits.

CONCLUSION

Calculating lost goodwill due to condemnation is one of the most challenging engagements for a business valuation consultant.  Measuring loss of goodwill involves the valuation of goodwill both before and after relocation.  The goodwill valuation consultant must also determine whether the business owner has made reasonable efforts to mitigate the loss of goodwill.

Selecting a qualified goodwill valuation expert is a critical part of the eminent domain process.  Verify the quality of the expert’s work and track record in litigation.  Determine whether the expert’s firm has sufficient office resources and staff to produce quality materials under strict deadlines.

Agencies should be proactive and retain the goodwill expert at the beginning of eminent domain proceedings to ensure sufficient time to prepare a sustainable opinion and avoid unnecessarily harmful economic consequences.

For additional information on SP&H’s valuation services, please contact one of our principals:

Mr. Nevin Sanli is President and co-founder of Sanli Pastore & Hill, Inc., a business valuation firm specializing in the valuation of compensable goodwill loss under California Eminent Domain Statutes.  He has been involved in financial consulting since 1986.  His professional experience includes business valuations, litigation consulting, economic and financial research, statistical analysis, investment analysis and mergers and acquisitions.  Additionally, he has extensive experience in developing cash flows and financial projections, conducting industry and market studies, analyzing financial statements and valuing businesses.  

Mr. Thomas Pastore is the Chief Executive Officer and co-founder of Sanli Pastore & Hill, Inc. and has completed several hundred goodwill loss valuations.  He has been involved in financial consulting since 1982.  Extensive experience encompasses investment and financial analysis, litigation consulting and public accounting.  He has valued numerous businesses in a wide range of industries including retail, services, manufacturing and holding companies.

Mr. Forrest Vickery is Manager of Northern California operations with Sanli Pastore & Hill, Inc. (SP&H).  Mr. Vickery has been involved in business valuation since joining SP&H in 1995.  His experience includes business valuation, support for litigation, economic and financial research and statistical analysis.  Mr. Vickery has extensive experience in developing cash flows and financial projections, conducting industry and market studies, analyzing financial statements, performing sensitivity analyses, and valuing businesses.  Mr. Vickery primarily works from SP&H’s Sacramento office, servicing clients in Northern California.

Southern California                                                     Nevin Sanli, ASA (nsanli@sphvalue.com)             Thomas Pastore, ASA, CFA (tpastore@sphvalue.com) 1990 S. Bundy Drive, #800 Los Angeles, CA 90025                                           Tel: (310) 571-3400

Norhern California Forrest Vickery, ASA 701 University Ave, #108(fvickery@sphvalue.com) Sacramento, CA 95825 Tel: (916) 614-0530