That part of business value over and above the value of identifiable business assets.
What It Means
Business goodwill is a key intangible asset that represents the portion of the business value that cannot be attributed to other business assets.
Put differently, business goodwill reflects the synergy among the various assets used by the business to produce income: in a well-run business the whole is greater than the sum of the parts.
What creates business goodwill
Here are the key factors that contribute to the creation of business goodwill:
- Going concern value
- Excess business income
- Expectation of future economic benefits
Going concern value indicates the existence of business assets ready for use in producing business income. The value is created because a business can effectively apply its capital (financial resources and equipment), labor (employees), and coordination (management) to produce economic benefits for its owners.
Excess business income implies the existence of earnings above a fair return on all the other business assets. The idea is that this excess income is due to business goodwill.
Owners may believe that the business has additional value because they see it as being able to create new products and services, attract new customers, and acquire or merge with other businesses.
Types of business goodwill
For the purposes of small business valuation, you may be interested in these types of business goodwill:
- Institutional goodwill
- Professional practice goodwill
Institutional goodwill is associated with the business, its position in the marketplace and its ability to effectively serve its customers.
Professional practice goodwill, as the name implies, is associated with professional practices such as doctors, lawyers, CPAs, architects, engineers and other professional services. Unlike business goodwill, the professional practice goodwill has two components:
- Practitioner goodwill
- Practice goodwill
Practitioner goodwill relates to the skill and reputation of the individual professional practitioner.
Practice goodwill, much like the business goodwill, arises from the professional practice itself, its institutional reputation, location, track record and operating procedures that make it an effective service provider that can produce superior income.
Accounting view of business goodwill
From the accounting perspective, business goodwill is generally recorded only if it is acquired as part of a business or professional practice purchase. The typical way the accountants handle business goodwill then is by subtracting the fair market value of the business tangible assets from the total business value. Note that this definition of business goodwill captures all intangible business assets, not just the goodwill.
Economic view of business goodwill
A quantitative view of business goodwill adopted by the economist is that it equals the capitalized value of the business earnings in excess of the fair return on all the other business assets, both tangible and intangible. This view seeks to establish the value of all identified business assets by allocating a portion of the business income to them. The remaining or excess earnings are then considered to be due to business goodwill.
Situations that may require valuation of business goodwill
In most business valuation situations the value of the entire business is determined. There are some situations, however, when you may find the knowledge of business goodwill useful:
Business purchase price allocation. Asset-based business valuation methods require that the value of individual assets be estimated. This facilitates the business purchase price allocation among the various assets acquired as part of a business purchase. Accurate purchase price allocation may be useful from both the legal and tax perspectives.
Goodwill financial reporting. Under the Financial Accounting Standards Board (FASB) Statement 142 (Goodwill and Other Intangible Assets), acquired business goodwill is not amortized.
Instead, a two step goodwill impairment test is used, repeated at least annually. The first step determines if business goodwill impairment is present. If so, the value of business goodwill is estimated in order to measure the amount of goodwill impairment which is recorded as a loss.
Damage analysis. In cases of contract breach, intellectual property infringement, or similar actions, the business may suffer. One way to measure the degree of damage is to determine the reduction in the business goodwill due to the action.
Business merger or spin-off. If two businesses merge, equity ownership in the new entity needs to be allocated among the business owners. One way to do this is in relative proportion to the assets being contributed. Business goodwill is one of these assets. A similar situation occurs when a single business or professional practice is split up or spins off a new company.
Business reorganization. Business goodwill may need to be measured to determine if the business is worth more as a going concern or should be liquidated. Positive business goodwill indicates that the business value exceeds the value of its asset base.
Financial solvency verification. From the lender’s perspective, the question often arises: Do the financing arrangements result in the company’s assets exceeding its liabilities? The value of business assets in this situation includes business goodwill.
How business goodwill is determined
Cost approach to valuing business goodwill
Here, the focus is to estimate the cost, in today’s dollars, required to recreate the business goodwill. Under the component build-up method, you estimate the opportunity cost of lost income were the business to be rebuilt from scratch.
Let’s say it will take 3 years to build another business that will match the current business income. Let’s further assume that your business will generate $300,000 each year in income. Then the present value of this income is the measure of your business goodwill.
Market approach to valuing business goodwill
A common way to estimate business goodwill in an actual business sale is to subtract the total value of all identified assets from the cash-basis business purchase price. Note that deferred payments such as a seller’s note or earnout should be discounted to their present value and then added to the cash components of the purchase price, such as the buyer’s downpayment.
You can also use comparative business sale data of businesses sold in your industry to estimate your business goodwill as a percentage of the business sale price.
Income approach to valuing business goodwill
This is the most commonly used approach to estimating the value of business goodwill. The most useful methods here are:
- Total business value residual method
- Capitalized excess earnings method
Under the total business value residual method, the Discounted Cash Flow business valuation method is the preferred choice to determine the total business value. Business goodwill is then estimated as the difference between the total business value and the fair market value of all identified business assets.
The Capitalized Excess Earnings method works as follows:
- Estimate the fair market value of all identified business assets.
- Determine a fair rate of return on these assets.
- Subtract the return from the total business earnings. The difference is the excess earnings.
- Capitalize the excess earnings to determine business goodwill. Correct choice of the capitalization rate is key.