You put a lot into your business, and much of that effort is focused towards creating a strong relationship with your customers and a solid reputation to the public. This goodwill an essential part of the selling process, but it’s also notoriously difficult to measure.
Below we explore the concept of goodwill in more detail, discussing what it is, how to value it, what it means for partnerships, and how it’s influenced by location, clients and partners.
What is Goodwill?
Goodwill is an asset unlike your others (e.g. equipment, real estate, plant). It’s essentially a representation of the people, ideas and ongoing success or profitability of the business. It may also be generated by the type of customers, intellectual property and the brand name. As such, it’s an intangible value that’s more closely attributed to public perception of success than cold data.
Profit is also an indicator of goodwill. If a business generates greater profits than salaries for the equity principles, it can be assumed that goodwill exists. In contrast, low-profit businesses which have returns lower than salaries are unlikely to have goodwill, as the public is not prepared to pay for the job.
How to Value Goodwill
Goodwill can be valued using a general formula. It’s essentially the sum of consideration transferred, the amount of controlling interests, the fair value of previous equity interests, minus the net assets recognised.
Let’s break this down further in an example.
“Melon Inc.” acquires “Guava B Inc.”, and to obtain 90 percent of interest, Melon agrees to pay $150 million. The fair value of non-controlling interest is $16 million. Considering that the fair value of net identifiable assets to be acquired is $140 million and that no equity interests existed, the amount of the goodwill will be: $26 million ($150 + $16 – $140). This is also called full goodwill method.
What Does It Mean in Partnerships?
In partnerships, goodwill is divided into ‘goodwill’ and ‘no goodwill’ arrangements. In goodwill partnerships, a partner pays for the value of the business when they enter, and they receive a lump when they leave. For example, a small legal firm valued at $1.5 million may have three partners, each fronting $500,000.
However, most larger professional practices are no goodwill. This means partners can enter without buying a proportion of the equity. This is because if a large legal firm is valued at $50 million and a goodwill stake costs $1.5 million, potential partners would go elsewhere. A financial contribution is still often required, but this doesn’t represent goodwill.
Whether a business is a partnership (goodwill or no goodwill) or any other structure, goodwill still matters for an accurate valuation when selling.
The Importance of Quality Location, Clients and Partners
A lot of the selling process is about risk. The riskier the deal, the less the asking price will be. However, risk is diminished if a business can already prove it has quality clients and partners, and operates in an excellent location.
Location is a key part of goodwill. And this is closely associated with demand. For example, due to strong demand for accounting practices in CBD areas, businesses can hope to receive 90c to 93c in the dollar for a large space with quality clients. This means a practice with $500,000 in gross fees would sell for around $465,000.
For clients, size matters. If a business has a lot of low-value clients, they’ll be worth less than a business which has a few large, high-value clients. They can then expect to charge higher rates and this translates to a higher return, and as such these businesses carry a greater goodwill.
Interestingly, there is an element of inherent goodwill associated with important partners. Think of a financial services business where one of the partners is the best tax accountant in the country. Not only is this a big asset to the business in itself, she also holds the value of attracting particularly high-value clients, meaning that there is additional goodwill value the employees and management structure of the business.
Goodwill is a vital part of the selling process, but it’s difficult to calculate accurately. Talk a trusted advisor and ensure you’re getting what your business is worth.