The part of business value over and above the total value of all identifiable business assets.
What It Means
Business goodwill is a key intangible asset that represents the portion of the business value that cannot be assigned to other business assets.
In other words, business goodwill reveals the synergy among all the assets the business uses to produce income: in a well-run company the whole is greater than the sum of the parts.
What creates business goodwill
Here are the key factors that give rise to business goodwill:
- Going concern value
- Excess business income
- Expectation of future economic benefits
Going concern value means there are 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 that the company's earnings run above a fair return on all the other business assets. This additional or excess income points to the presence of 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 business valuation, you may consider 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 found in professional practices such as doctors, lawyers, CPAs, architects, engineers and other professional services. Professional practice goodwill has two distinct components:
- Practitioner goodwill
- Practice goodwill
Practitioner goodwill relates to the skill and reputation of professionals as individual contributors.
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 is able to produce superior income.
Accountant's view of business goodwill
From the accounting perspective, business goodwill is generally recorded on the company's books only if it is acquired as part of a business or professional practice purchase. The typical way accountants handle business goodwill in these cases is by subtracting the fair market value of the purchased business's tangible assets from the total business value. Note that this definition of business goodwill lumps all the intangible business assets together, including goodwill.
Economic view of business goodwill
The economist's view of business goodwill 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. To figure this out, you need 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 help you determine the value of individual assets. This facilitates the business purchase price allocation among the various assets acquired as part of a business purchase. Well conducted 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, you are encouraged to use a two step goodwill impairment test, repeated at least annually. The first step determines if the current total business value is below the values of recorded assets and goodwill. If so, business goodwill impairment is present. The amount of goodwill impairment is recorded as a loss.
Damage analysis. In cases of contract breach, intellectual property infringement, or similar legal disputes, the business may suffer harm. One way to measure the degree of long-term damage is to determine the reduction in business goodwill due to the wrongful acts.
Business merger or spin-off. If two businesses merge, ownership interest in the new entity needs to be divided among the business owners. One way to do this is in relative proportion to the assets the owners have 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. You may need to measure goodwill in order to determine if the business is worth more as a going concern or should be shut down. You may consider keeping the company open if you find positive business goodwill meaning that the value of the operation exceeds the value of its individual assets.
Financial solvency verification. Lenders often have this question: do the financing arrangements ensure that the company’s asset values are higher than 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, you need 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. Assume further that your existing business will have generated $300,000 yearly income in this period. Then the present value of this income is the measure of your business goodwill.
Market approach to valuing business goodwill
The usual way to estimate business goodwill in a 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 portion of the purchase price, such as the buyer’s downpayment.
You can also use data on comparable businesses sold recently 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 widely used approach to estimate the value of business goodwill. The typical methods here are:
- Total business value residual method
- Capitalized excess earnings method
To apply the total business value residual method, you use the Discounted Cash Flow method to determine the total business value. Next, you estimate business goodwill 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.