Valuing the goodwill of a business involves separating personal factors from other assets. Here’s an explanation of how it’s done.
If you talk to business owners or professional practitioners, many will tell you that their businesses or practices could not survive without them. That may be a bit of an exaggeration, but they do have a point. The goodwill of a business or professional practice can be a critical factor and consists of two distinct parts:
1. The reputation of the owner. This is commonly called personal or professional goodwill.
2. The trade name or advantageous location of the company. This is often called entity goodwill.
The two parts are intertwined and hard to separate, so why should you bother? Even though it’s difficult, some situations require splitting goodwill into its components including:
Business Sale – The potential buyer of a small business will not pay for personal goodwill because it involves something that will literally walk out the door with the existing owner.
Valuing a business – Fair market value assumes a hypothetical sale of the business. As described above, no rational buyer will pay for personal goodwill.
Marital dissolution – Many jurisdictions do not consider personal or professional goodwill to be a marital asset because it cannot be separated from the individual that possesses it.
In situations like these, here are the ways that the amount of personal versus entity goodwill can be estimated:
Compare the business with other businesses that have been sold recently. Search for similar business sales in databases like BizComps or Prat’s Stats. Use a multiple such as sales price to annual sales. Apply this multiple to the business to arrive at an estimated value of the total entity. The amount that this value exceeds the value of tangible assets is entity goodwill. No personal goodwill is included because the multiple is derived from actual sales of businesses.
Estimate the cost of an orderly transition. Many of the detrimental effects of an ownership change can be offset 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 this method should be combined with the next one.
Estimate the expected loss of revenue. During an ownership change, some customers will be lost. The exact number depends on factors such as the amount of contact between the owner and customers, the visibility of the owner, the nature of the products or services offered, and the nature of the relationship between the owner and the customers.
The revenue lost over a period of time is the estimated value of personal goodwill. 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.
Compare the non-competition agreements from the sale of other companies. Many business sales include an agreement from the selling owner not to compete with the new owner. The value assigned to these agreements in similar businesses can be used as a basis to estimate personal goodwill.
However, keep in mind that the amount assigned to these agreements is often arbitrary or based on tax implications. Opening a competing business is entirely different from the seller just leaving the business. Comparing non-compete agreements has some serious limitations, so use this method sparingly.
Conclusion: Splitting goodwill can be like splitting hairs, but it should be done in logical way by a valuation expert who understands all the implications.
For more information contact Troy Lowe at [email protected].
copyright BizActions 2011