When property is taken by eminent domain, the owner of a business operated on the property is entitled to compensation for any “business goodwill” lost due to the taking.  Usually, “goodwill” translates into a business’s profitability.  However, earlier this week, the California Supreme Court denied review in People ex rel. Department of Transportation v. Presidio Performing Arts Foundation, C.A., 1st; A145278 which held that a business operating at a loss before the taking may be entitled to compensation for loss of goodwill where the taking renders it even more unprofitable.

Presidio Performing Arts Foundation (“Foundation”), operated a non-profit dance theatre in a leased building located in the Presidio of San Francisco.  The California Department of Transportation (“CalTrans”) moved to acquire, under threat of eminent domain, the building occupied by the Foundation for construction of the Doyle Drive Replacement Project.  The Foundation was forced to relocate to a smaller, more expensive building in a less desirable location.

While CalTrans agreed to pay $107,000 for tenant improvements, that payment did not include anything for goodwill.  Instead, CalTrans filed an action for declaratory relief, requesting a declaration that the Foundation could not establish entitlement to a claim for loss of goodwill.  The Foundation responded by filing a cross-complaint seeking compensation for the taking of its goodwill.  The trial court found that, although the Foundation demonstrated it had goodwill before the taking, it failed to prove a quantitative loss by calculating its pre-taking goodwill value and then subtracting from that amount its post-taking business goodwill value.  The Court of Appeal reversed, opening the way for a jury trial on the amount of compensation due for lost goodwill.

The right to compensation for goodwill does not arise under the just compensation clause of the state or federal constitutions, but rather is created by statute.  In enacting Code of Civil Procedure, section 1263.510, the Legislature defined “goodwill” as “the benefits that accrue to a business as a result of its location, reputation for dependability, skill or quality, in any other circumstances resulting in probable retention of old or acquisition of new patrons.  (§1263.510(b)).  As with any other element of just compensation, a business owner has the right to a jury determination on the amount of goodwill lost.  (Redevelopment Agency of San Diego v. Attisha (2005) 128 Cal.App.4th 357, 367)  However, this right attaches only if the owner first establishes, in a court trial, certain qualifying conditions for compensation.  Those conditions, which are to be determined by the court, include proof of pre-existing business goodwill and a loss caused by the taking.  (Section 1263.510(a); People ex rel. Dept. of Transportation v. Dry Canyon Enterprises, LLC (2012) 211 Cal.App.4th 486, 491).

The question confronted by the Presidio Performing Arts Foundation court was whether a business owner must quantify the lost goodwill in the entitlement phase.  In answering this question, the Court first addressed the more ethereal question of:  What is goodwill?

Goodwill has previously been defined as “the amount a willing buyer would pay for an ongoing concern above the book value of the assets.”  Redevelopment Agency of San Diego v. Attisha (2005) 128 Cal.App.4th 357, 367.  Put another way, “it is the present value of anticipated profits”  (People ex rel. Dept. of Transportation v. Muller (1984) 36 Cal.3d 263, 271)  Thus, for purposes of establishing the existence of goodwill, a business owner typically demonstrates that, before the taking, the business generated profits beyond what its other assets would indicate.

Here, the Foundation generated no profits.  Indeed, it had a negative annual cash flow of approximately $14,000.00.  After its relocation, the amount of its shortfall increased to approximately $62,513.00.  The Foundation’s appraiser attributed this increased shortfall entirely to loss of goodwill.  He made no effort to value goodwill in the before-condition.  Instead, he observed that the business enjoyed a favorable location, with below market rent, and a good reputation for the services it provided.  These facts were, in his opinion, “indicators” of the existence of business goodwill.  Since there was no change to the Foundation’s tangible assets at the relocation site, the increased annual shortfall must be attributable to lost goodwill.  He then measured the loss by capitalizing the $62,513.00 and reducing that sum to present value to arrive at a total goodwill loss of $781,000.00.  (Presidio Performing Arts Foundation, supra, at p. 3)

In approving of this methodology, the Court rejected CalTrans’ argument that loss of goodwill must be measured by comparing the value of goodwill before condemnation with its value after the taking. However, the Court went one step further. It uncoupled the link between goodwill and profits.

In Dry Canyon Enterprises, the Second Appellate District concluded that goodwill almost always translates into a business’ profitability.  “Goodwill is the amount by which a business’ overall value exceeds the value of its constituent assets…”  (Dry Canyon, supra, 211 Cal.App.4th at 493-494).  By contrast, the Presidio Performing Arts Foundation Court held that “nowhere in the statutory language is there a pre-condition that this compensation is available only to businesses that, before the taking, had a total business value in excess of its tangible assets, or profits in excess of a fair rate of return on its total assets.” (Id. at p. 12)  Therefore, by extension, a “business operating at a loss before a taking may not be able to demonstrate pre-taking goodwill value, but that does not mean that the benefits it enjoyed from its location reputation have not been adversely effected by the taking.  Nothing in the statute suggests compensation should be given to a business that was profitable but became less profitable, but deny compensation to a business that was unprofitable and became even more unprofitable.  To do so would preclude recovery to those least likely to afford the loss of goodwill benefits due to a taking.”  (Id.)

It is tempting to conclude that the capitalization of negative cash flow approach will be applied only to nonprofits which, by necessity, dedicate any excess cash flows to their nonprofit purposes. However, the broad language of Presidio Performing Arts Foundation suggests that the court did not intend for its holding to be so limited.