When another company or investor purchases your business, they are not just paying you for your tangible assets, contracts, inventory, etc. The purchase price also includes your loyal customer base, competitive advantage, reputation, and other intangible assets challenging to value and which can be grouped under the term goodwill.
So, as an owner of a small or medium-sized business ready to sell your company, you must understand goodwill.
What Is Goodwill?
Goodwill is the premium that you receive over the fair market value of your net assets (total assets minus total liabilities) when you sell your business. It is a different asset beyond money that adds value to a company.
In accounting, goodwill is an asset that differs from other intangible assets like patents, copyrights, licenses, etc., which can be sold separately. Goodwill arises when you sell your company.
While people often refer to goodwill as two different terms: accounting goodwill and economic/business goodwill. They are the same.
Warren Buffett explained the value of goodwill in the 1983 Berkshire Hathaway shareholder letter: “Businesses logically are worth far more than net tangible assets when they can produce earnings on such assets considerably above the market rates of return. The capitalized value of this excess return is economic goodwill.”
He further explained with the example of California-based See’s Candies Shops, which had net tangible assets of around $8 million and after-tax earnings of approximately $2 million in 1972, when Blue Chip Stamps (a subsidiary of Berkshire Hathaway) acquired it. Consistent annual after-tax earnings of over 25 percent of its net tangible assets were attributed to the company’s favorable reputation with consumers, based upon their countless pleasant experiences with both product and personnel. Few businesses could match that performance at the time.
Blue Chip Stamps was justified in paying $25 million, $17 million more than the value of See’s Candies Shops’ tangible assets, to acquire the company. The purchasing company accounted for that $17 million as goodwill on its books of accounts.
So, the amount over the value of your company’s tangible assets paid by the buyer represents the value of goodwill. Although you cannot quantify these intangible assets precisely, they are your company’s valuable assets.
What Constitutes Goodwill?
Goodwill includes a good reputation, brand name recognition, loyal customer base, supplier lists, trade secrets, educational or certification courses, skilled employees, specialized know-how, customized advertising materials, websites, domain names, and more.
Suppose a commercial landscaping company generates recurring revenue for several years. From the buyer’s perspective, the company’s customer list is valuable. The buyer finds the business less risky due to its realistically predictable revenues built upon the client list and its reputation (a goodwill component). Even though you cannot touch or measure reputation, it is a revenue-generating, intangible asset.
Similarly, how likely is a buyer to continue generating the same revenue in the future if the sales agreement of a successful restaurant business does not include its business name or secret recipe(s)? For example, the brand name of McDonald’s brings customers to its newly opened outlet (franchise), not the tangible assets such as the grill and deep fryer.
How Is Goodwill Determined?
When you sell your business, the difference between the fair market value of your net assets and the final selling price is called goodwill. You can calculate the fair market value of your net assets by subtracting the fair market value of your liabilities from the fair market value of your tangible assets.
The capital surplus earnings method offers another way to determine goodwill. It calculates the excess earnings, which is considered goodwill. With the help of the fair market value of business assets, this method determines the fair rate of return on those assets. Then it deducts this return from the total earnings of the business. The difference is the excess earnings (goodwill).
Another way to calculate goodwill is to use the seller’s discretionary earnings (SDE) as the base number. Seller’s discretionary earnings (also called adjusted cash flow, recast earnings, total owner’s Benefit, etc.) is the total annual financial benefit a business owner derives from the company.
The different methods to determine goodwill all involve subjective components, which are difficult to value accurately.
The buyer and seller usually find it tough to allocate a purchase price to various assets and goodwill. You, as a seller, will want to maximize the purchase price allocation to goodwill as its value is classified as capital gain and taxed at a lower rate. On the other hand, the buyer prefers to maximize the purchase price allocation to tangible assets, as those can depreciate over five to seven years against goodwill value that needs to amortize over 15 years (in the case of private companies).
Solicit professional advice to reduce tax implications on your sales proceeds.
The Impact of Goodwill on Business Value
Business value is the combined value of tangible and intangible assets, including goodwill, that increase profitability. The ability of a company to generate cash flows and the risks associated with sustaining and scaling the cash flows determine its business value.
Goodwill reduces the risk that the company’s profitability declining after the change of ownership. Goodwill means that a company’s value is more than its hard assets.
Goodwill has a powerful revenue-generating capacity and increases the value of your company. When buyers see that a target company has a good reputation, name recognition, accreditations, etc., they pay a premium price.
Identify where your goodwill lies and enhance it to get your desired selling price. Your exit planning advisors/value creation experts will help you.
How Can Quantive Help?
Goodwill adds immense value to your company’s overall business value. Identify what makes your company stand out from its competitors, your unique selling proposition, what gets recurring orders, and how you make a difference to your industry and customers. The answers to these questions will help you work towards building your company’s goodwill.
By improving goodwill for your company, you can increase its business value. Take guidance from your exit planning advisory team to identify the goodwill in your unique business and get customized solutions for your particular situation and needs.
Get in touch today to see how Quantive can help.