You cannot physically touch goodwill, but it is a significantly valuable asset for many businesses. Although it is most commonly associated with professional service firms, goodwill can also exist among manufacturers, retailers, contractors, and other types of businesses. When it comes time to obtain a business valuation, it is important to understand intangible assets, including goodwill, and how they are evaluated.
What Is Goodwill?
The International Valuation Glossary — Business Valuation defines goodwill as:
“That intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified. From an accounting perspective, goodwill represents the excess of the purchase price of an acquired company over the value of the net identifiable tangible assets and intangible assets acquired.”
Different Types of Goodwill
Business (or entity) goodwill. This belongs strictly to the entity itself. Business goodwill may arise from many sources, including the company’s name, phone number, location, and special attributes, such as special menu items or recipes at a restaurant.
Personal (or professional) goodwill. This type of goodwill is directly attributable to an individual’s characteristics or attributes. It includes not only the owner’s skills, knowledge, and reputation, but also his or her contacts and relationships.
Personal goodwill can be further bifurcated into pure personal goodwill and transferable goodwill. Pure personal goodwill cannot be transferred to the entity or anyone else under any circ*mstance. These are often true in personal relationships:
“We want Jane to testify in this case because we know what type of a witness she is. No one else will do.”
“John has developed the cultural relationship and ties necessary to gain the trust of a particular customer. Therefore, only John is able to buy and sell the product to him.”
If a business is sold, the buyer will not pay for pure personal goodwill, because it is something that will literally walk out the door with the seller.
Transferable goodwill is goodwill that is personal in nature, but might be transferred to the entity or another individual with proper planning and adequate time. These could be personal relationships or specialized knowledge that could be transferred through training or development of other people. It could also include contact lists that have been developed over a period of time or customer (or vendor) relationships that can be transferred given effort and time.
Splitting Up Goodwill
So, how personal is your goodwill? Dividing goodwill among its three components – business, pure personal, and transferable personal goodwill – requires professional judgment and careful consideration of the facts at hand. Valuators may perform different analyses to divvy up goodwill that include:
Evaluate comparable transactions. Search for similar business sales in proprietary transaction databases. Theoretically, these deals should not include any pure personal goodwill, because no rational buyer would pay for an asset that walks out the door with the seller. But beware, a comparable business could rely more (or less) on pure personal goodwill than the subject company.
For example, an accounting firm in an urban market with 10 partners and 100 employees would be more likely to possess business or transferable personal goodwill than a three-partner firm that operates in a rural market and employs just a receptionist and one bookkeeper. Clients of the smaller firm may be attracted solely to an individual practitioner and his or her reputation. Clients of a mid-sized urban firm might be attracted to the firm’s location, name recognition, and diversified staff of professionals, however.
Consider conditions of sale. Some databases list the details of employment, consulting, or noncompete agreements between the buyer and seller as a condition of sale. The value similar businesses assign to these agreements can be used as a basis to estimate transferable personal goodwill. But beware, these agreements might be based on gut instinct or driven by tax strategies, rather than market value.
Estimate the cost of an orderly transition. Some personal goodwill can be transferred to new owners through an orderly transition. The selling owner can remain for some period of time with the business to maintain a presence, introduce the new owner, and facilitate a rapport-building program with the employees, customers, and suppliers. The estimated costs of the selling owner’s compensation plus other direct expenses during the transition can be used to estimate the value of personal goodwill.
Even in an orderly transition, some customers may be lost, so it is also important to consider the expected loss of revenue. Some customers simply cannot be transitioned over to the new owner, no matter how hard the buyer and seller try. Beware however, that some customer loss may be due to operational changes made by the new owner, so it can be argued that the revenue lost from these changes is not related to personal goodwill.
Bottom Line
Knowing how to differentiate and value the components of goodwill is important if you are buying or selling a business – or if you face litigation that involves the value of a business interest, such as a marital dissolution or shareholder dispute. Splitting goodwill may seem like splitting hairs, but it should be done in a logical way by a valuation expert who understands all of the interconnections and implications.
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