Selling your business? – Understanding the mysteries of Goodwill
Goodwill is commonly misunderstood because it is hard to find a value everyone agrees on. In this post we try to give you a basic understanding of goodwill, so you can try to include a reasonable figure in your valuation when you are trying to sell your business.
What is goodwill?
As a basic definition, goodwill is the part of your business value over and above the value of identifiable assets. It is, therefore, an intangible asset and represents the portion of the business value that cannot be attributed to anything specific. To put differently, goodwill reflects the synergy among assets used to produce income. When a sale takes place, the sale price is generally greater than the sum of the parts. This is generally goodwill.
What creates business goodwill?
This is a very hard question to answer, and it’s debated thoroughly. To simplify it down, companies calculate goodwill as an asset for three main reasons.
- Going concern value – Going concern value designates the presence of business assets ready for use in producing business income vs. concept.
- Excess business income – Earnings over the fair return on all business assets is generally classed as goodwill. If two companies purchase the exact same piece of machinery, will the net income be the same? Generally no, and this is classed as business goodwill.
- The expectation of future economic benefits – Industry knowledge is a huge asset, and it takes years to gain the experience needed to give you a competitive advantage. Most companies believe they have additional value, over their assets, because they have the ability to create new products and/or services, attract new customers, and acquire or merge with other businesses.
Types of business goodwill
When it comes to SME (small to medium enterprise) valuation, there are two major types of business goodwill.
- Institutional goodwill – associated with the business, its position in the marketplace and its ability to effectively serve its customers.
- Professional practice goodwill – associated with professional practices such as lawyers, CPAs, architects, doctors, and engineers etc.
Accounting vs. Economic view of business goodwill
There are two ways you can look at goodwill; through the eyes of the accountants or those of the economists.
- Accounting view – Accounting practices are, in general, quite black and white. Business goodwill is therefore generally recorded only if it is acquired as part of a business. The typical way accountants handle business goodwill is subtracting the fair market value of the business’s tangible assets from the total business value.
- Economic view – Economists look more into the theoretical land, and a quantitative view of business goodwill is adopted. The technique here is that it equals the capitalized value of the business earnings in excess of the fair return on all the other business assets. This can be done with both tangible and intangible assets.
How business goodwill is determined
Intangible assets have three main valuation methods. As discussed, goodwill is an intangible asset and can be therefore calculated under the Cost, Market or Income approaches.
- Cost approach – The focus here is to estimate the cost, in present-day terms, required to recreate the business goodwill.
- Market approach – Uses an actual business sale. The trick here is to subtract the total value of all identified assets from the business purchase price.
- Income approach – this is the most common approach and the main techniques are the residual method and capitalized excess earnings method.
Situations that may require valuation of business goodwill
In most business valuation situations the value of the entire business is determined. There are some situations, however, when you may find the knowledge of business goodwill useful:
- Business purchase price allocation – Asset-based business valuation methods require that the value of individual assets be estimated.
- Goodwill financial reporting – Under the Financial Accounting Standards Board (FASB) Statement 142 (Goodwill and Other Intangible Assets), acquired business goodwill is not amortized.
- Damage analysis – In cases of contract breach, intellectual property infringement, or similar actions, the business may suffer.
- Business merger or spin-off – If two businesses merge, equity ownership in the new entity needs to be allocated among the business owners.
- Business reorganization – business goodwill may need to be measured to determine if the business is worth more as a going concern or should be liquidated.
- Financial solvency verification – The value of business assets in this situation includes business goodwill.
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