Goodwill – What is it and should you pay for it

If you are selling a business you will want to be paid for the goodwill that you have built up in the business. If there is profit in the business you will usually sell your business for an amount that is in excess of the tangible asset value. Look at these equations:

Business Value = Intangible Assets(Assets you can’t feel) + Tangible Assets (Assets you can feel)

Tangible Assets = Plant and Equipment and Assets you can feel

Intangible Assets = Goodwill + other assets you can’t feel

Business price = Assets you can feel + Goodwill

As such goodwill is not valued on its own in the last equation, it is what is left after we have given a value to the assets.

You could see this equation another way:

Goodwill = Business Price – Assets you can feel

The way goodwill is viewed will often depend on whether you are buying or selling and for good reason.

If you are buying you want to ensure you get ALL of the goodwill you are paying for.

If you are selling you want to ensure you gt paid for all the goodwill you have built up.

The most misunderstood word in the context of business valuation is “goodwill”. You will often hear the cry “Don’t pay for goodwill”. If you follow this exhortation you will probably never buy a decent business, and if you are an adviser you are going to disappoint the party on whose behalf you have been hired to add value to a transaction.

In the information and services age, goodwill is often all that is for sale.

The components of goodwill to be considered are usually identified as follows:

  • Location, geography, growth, condition and legality of premises, income, lifestyle, tradition, ethnic mix, saturation, development, competitor activity, etc.
  • Patronage, historical trading performance, projected trading performance, fee scales accepted by market, industry comparisons, etc.
  • Dependability of contracts, current staffing and availability of staff, security of tenure (i.e. leasehold or freehold), lease conditions, history, supply line, research and development, etc.
  • Skill – special skills, specific qualifications, technical competence, technical support, technical facilities and back up, administrative and management capabilities, legal qualifications, etc.
  • Quality of services and products, advice and materials used and offered, etc.
  • Further, in assessing the goodwill associated with a business, the business valuer should consider the importance of
    • Local goodwill (i.e. goodwill attached to the prominence of the position of the business), and
    • Personal goodwill (i.e. goodwill dependent on the personal skills of the Proprietor), as well as the dependability of contractual arrangements and other features of the business, in order to determine the period over which the current trading performance can be maintained.

The thing you want to remember is that, on a transaction, goodwill only has value if it is transferable to the buyer of the business.

If there is a heavy component of personal goodwill, the only way that it can be realised on a sale is if the owner remains for a while in the business to ensure that the benefit of this goodwill is transferred to the new owner.  So you see value can be determined by the terms of the transaction between buyer and seller.

 No Profit – No Goodwill?

It is often said that a business can only be said to have goodwill if it has an expectation of future maintainable profits sufficient to justify it. Likewise, a share or unit in a business enterprise can only have a value above its asset backing if it is likely to continue to attract earnings for its owner sufficient to justify that higher value.

Although goodwill is commonly valued by capitalising expected future net profits or by estimating the worth of purchasing several years of the past profits of a business, it may exist even though the business has not made any profits and is unlikely to do so for some time.

In the case of a new business, money expended on research, advertising and distribution networks for example, may have created sources of goodwill which will ultimately generate future profits even though the business has not made any profit.”

Take the case of a service business or professional practice. It may have been built up over a period of years, and be just about to come into profit. Surely it must be worth more than the one that is just a start-up. You would think this was so in all cases. However you would be surprised at how often this is just not the case. There is “romance” in a start-up. Blue sky is the limit. It’s all up to you. There is plenty of ego involved. A traded “Just break even business” appears jaded and past its use by date. “Maybe it’s a dog”

A key is whether the business will in fact come into profit. The shrewd investor picks winners. Young (inexperienced) players often lose their house

Another key is when and to what extent the existing proprietor influences the future emergence of profits.

In our program we show you how to maximise the value of assets you can’t feel as well as looking at how to structure assets you can feel

In our ebook we look at other ways to maximise the value of your business.

If you take up our offer of a free appraisal, you will quickly learn how well you are prepared for sale in these important areas.

On our associated site you will see many examples of different valuation methods and of how to value particular businesses.