Business goodwill equals the portion of business value over and above the total value of all other 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
Three key factors give rise to goodwill:
- Going concern value
- Excess business income
- Expectation of future economic benefits
Going concern value means a business has assets ready for use in producing income. The value arises 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. And this additional or excess income points to the presence of business goodwill.
For example, the 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 goodwill:
- Professional practice
Institutional goodwill belongs to the business, its position in the marketplace and its ability to effectively serve its customers.
On the other hand, you find professional practice goodwill in professional practices such as doctors, lawyers, CPAs, architects, engineers and other professional services. Importantly, professional practice goodwill has two distinct components:
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 can produce superior income.
Accountant's view of goodwill
From the accounting perspective, goodwill appears on the company's books only if it is acquired as part of a business or professional practice purchase. To handle goodwill, accountants usually subtract the fair market value of the purchased business's tangible assets from the total business value. Note that this definition lumps all the intangible business assets together, including goodwill.
In the economist's view, goodwill 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 goodwill.
Situations that may require valuation of 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 goodwill useful:
Business purchase price allocation
Asset-based business valuation methods help you determine the value of individual assets. This helps with the business purchase price allocation among the various assets acquired as part of a business purchase. Moreover, you may find a well conducted purchase price allocation useful from both the legal and tax perspectives.
Under the Financial Accounting Standards Board (FASB) Statement 142 (Goodwill and Other Intangible Assets), acquired goodwill is not amortized.
Instead, you should use a two step goodwill impairment test, repeated at least annually. The first step determines if the current total business value falls below the values of recorded assets and goodwill. If so, you have evidence of business goodwill impairment. As a result, you record the amount of this impairment as a loss.
In cases of contract breach, intellectual property infringement, or similar legal disputes, the business may suffer harm. And you can estimate the degree of long-term damage by measuring the reduction in 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. You can do this based on the relative proportion of the assets the owners have contributed, including goodwill. A similar situation occurs when owners split up a single business or professional practice or spin off a new company.
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 should consider keeping the company open if you find positive 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 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 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 measures your goodwill.
Market approach to valuing goodwill
In a business sale you would estimate goodwill by subtracting the total value of all identified assets from the cash-basis business purchase price. If the sale involves deferred payments such as a seller’s note or earnout you should discount them to their present value and then add it 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 goodwill as a percentage of the business sale price.
This is the most widely used approach to estimate the value of business goodwill. The typical methods here include:
- 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 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 goodwill. Here you must make the correct choice of the capitalization rate.