How Goodwill Works in Business Transactions

Many business owners don’t know what goodwill is or how to determine it properly. Goodwill is when a buyer is willing to pay a price above the company’s net tangible asset value. Goodwill is also often referred to as “blue sky”. Every  business can benefit from learning how to build goodwill and putting those ideas into practice.

What does Goodwill mean?

Goodwill refers to the intangible value of a business above it’s fair market value of tangible assets.

Goodwill can be as simple as your company having an exceptional reputation in the market place which would usually be accompanied by experienced employees, loyal base of customers, established vendor network etc. Goodwill can sometimes come in the form of technology, systems or processes that have been implemented.  Goodwill can also come in the form of intellectual property(trademarks, registrations and/or patents filed with the USPTO) or domain names that people want to use. But, as you might expect, it’s can be difficult to put a price on these kinds of assets.

Goodwill can be subjective in buyer’s and seller’s eyes, but there is a mathematical approach to properly determining goodwill and as you might expect it’s for tax reasons.

Goodwill is almost always what’s “left over” on the allocation table. An allocation table is a disclosure in the definitive purchase agreement where the buyer and seller mutually agree as to how the purchase price will be allocated to the assets being transferred for tax purposes. There are seven classes of assets for tax purposes. Here’s what a typical purchase price allocation looks like:

  • Furniture, Fixtures and Equipment : $167,500
  • Non-Compete Agreement                 : $10,000
  • Inventory                                              : $232,500
  • Real-Estate                                           : $900,000
  • Goodwill                                               : ???

 

Without the purchase price there is no solution, but we always know the purchase price so this is not a problem.

In the above example to solve for goodwill value you simply take the purchase price (let’s assume $2,000,000) and subtract the sum value of the other asset allocation classes. $2,000,000-$10,000-$232,500-$900000=$690.000.

Thus, in this example there is $690,000 of goodwill – what’s leftover after taking the purchase price minus all other allocated assets value.

Some transactions (usually stock) may include cash/cash equivalents, working capital, accounts receivable and accounts payable.  In the above example any of these would reduce the amount of goodwill dollar for dollar.

How Personal Goodwill Comes Into Play

Sometimes, a company’s goodwill comes from a person individually. Most of the time, this is because the professional has built a good relationship with the customer or client. Most of the time, this is a relationship that has grown over time. In these situations, the goodwill might not be able to be transferred. The business is linked to a person, who is usually the company’s founder. Think of vendor client relationships that are intensely personal such as  doctor’s offices and law offices.

So, how does personal goodwill affect the business sale? Personal goodwill would be subtracted from the goodwill. Why would you bother? you might ask. Well, because if a valid case can be made for personal goodwill it carries a more attractive tax treatment to the seller.

How do you protect personal goodwill?
The most effective method used to protect personal goodwill in a business transaction is for the seller to agree to an appropriate transaition period that allows the seller to transfer as much personal goodwill to the buyer as possible. This can make it easier for the new business owner to take over. In some cases the buyer and seller agree a “earn out.” At the end of an agreed upon time period a calculation is done that the parties previously agreed upon to determine if the company has performed as expected.  If so, the seller receives an additional payment.  If not, the buyer is not obligated to make the payment.  These type payments are called contingent payments and may take many forms.  In some situations, buyer money is put in escrow and distributed per the contingency calculation at previously negotiated times.

If you are buying or selling a business that involves personal goodwill, your situation may be different from that of most businesses. A Business Broker or M&A Advisor, in conjunction with your tax advisor and attorney can insure personal goodwill is negotiated and papered properly.

COPYRIGHT: ENLIGN Business Brokers, Inc.

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