May 4, 2015 | Valuations
Goodwill is one of the most valued assets for many small businesses. It exists among many different types of companies, from professional service firms to retailers to manufacturers. To place a value on this important piece of a business’ puzzle requires a valuation professional.
Typically, goodwill has been broken down into two parts:
Business (or entity) goodwill. This belongs to the company itself. It can come from many sources, including the company’s name, phone number, location, and also things like 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.
Furthermore, personal goodwill can be divided into pure personal goodwill and transferable goodwill. Pure personal goodwill is often about true personal relationships, and can’t be transferred to anyone else under any circumstance.
If a business is sold, the buyer won’t pay for pure personal goodwill, because it’s something that will literally walk out the door with the seller.
Transferable goodwill is goodwill that is personal in nature, but could be transferred to the entity with proper time and planning. 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
Dividing goodwill among its three components — business, pure personal and transferable personal goodwill — requires professional judgment and careful consideration of the facts at hand. There are a couple of different ways valuators may try to divvy up goodwill:
Evaluate comparable transactions. Valuators will look for similar business sales in proprietary transaction databases. Theoretically, these deals should not include any pure personal goodwill, though business owners should remember that some companies rely more on personal goodwill than others.
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 small, rural market and employs just a receptionist and one bookkeeper.
Consider conditions of sale. Some databases also 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 as an estimated value of personal goodwill.
Even in an orderly transition, some customers may be lost, so it’s also important to consider the expected loss of revenue. Some customers simply can’t 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.
Knowing how to differentiate and value the components of goodwill is key, whether buying or selling a business, or if facing litigation that involves the value of a business interest, such as a marital dissolution or shareholder dispute. Splitting goodwill should be done in logical way by a valuation expert who understands all of the interconnections and implications.
For more about valuations, and the importance of having a professional complete the process, contact Filler & Associates.