Wednesday 29 June 2016

Business Goodwill - What's It Worth?

First, let's break down exactly what goodwill means. When business owners say “goodwill” they usually mean economic goodwill and not accounting goodwill, which is a plug number on a balance sheet.

Economic goodwill refers to the the fair market value of a business that is over and above the value of its tangible assets and its identifiable intangible assets. IMPORTANT:  NOT all businesses have goodwill. Only those businesses that can generate sufficient cash flow such that the present value of the cash flow exceeds the value of their net tangible assets and identifiable intangible assets have goodwill.

See the chart below for an illustration:

Net Tangible Assets. It is usually relatively straightforward to measure the value of a business's net tangible assets. This consists of things like net working capital, equipment, tools, machinery and so on.

Identifiable intangible assets - consist of things like patents, trademarks, franchise agreements, copyrights and so on. It is more involved to measure the value of these items compared to tangible assets but it can be done. They key here is that while these items are intangible, they are identifiable.

– consists of:
  (1) personal goodwill (which does not contribute to the fair market value of a  business); and
  (2) commercial goodwill (which does contribute to the fair market value of a business).

 1. Personal goodwill. It is non-transferable. Example – imagine that Joe operates a hot dog stand. Let's imagine that Joe's hot dogs aren't the greatest but Joe is a fantastic fellow that greets all of his customers with a smile and brightens their day. In fact, the only reason most of his customers visit the stand is because of Joe's great personality and funny jokes he tells. Joe is successful because of his personal attributes that are non-transferable to a prospective buyer. This is a simple example but the point is that personal goodwill is attached to a person, not a business and it is non-transferable. Personal goodwill is not included in the definition of fair market value. In other words, personal goodwill doesn't factor into the value equation of fair market value, shown in the chart above. As a business owner, you should strive to make your goodwill commercial in nature.

2. Commercial goodwill. It is transferable. Example – a commercial cleaning company has 100 clients. The owner trains his staff well and his clients deal with his managers and foremen (not just himself). The owner can remove himself from the business and it would carry on without him. This is a transferable form of goodwill, it is commercial in nature. Examples of commercial goodwill include efficient business practices, a well-trained staff and overall business reputation. Commercial goodwill does contribute to the fair market value of a business. It adds value to the business because it is transferable in nature.

Valuing Goodwill
Businesses that generate cash flow value that exceeds the value of their  tangible assets and identifiable intangible assets have goodwill.  If the goodwill is commercial goodwill then it would contribute to the fair market value of the business.

Really simple example: Your business generate $100,000 in normalized earnings before interest, taxes and depreciation & amortization (EBITDA). You have spoken to a chartered business valuator and he told you that your business has a capitalization rate of 25%. The CBV has valued your business at $400,000 ($100,000 / 25%).

The net working capital, equipment and machinery is valued at $150,000. There are no identifiable intangible assets (like trademarks, copyrights, patents, etc). The goodwill is commercial in nature and not personal.

To determine the value of the business's goodwill, the formula would be:

Please contact us for assistance with a business valuation issue.

Keystone Business Valuations

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