How to Calculate Goodwill When Selling Your Business

When selling a business, understanding and calculating goodwill is crucial. Goodwill represents things other than your physical assets; it encompasses customer loyalty, brand reputation, and future profitability. However, determining its value can be complex.

This guide breaks down the concept of goodwill, explains how to calculate it, and highlights the factors influencing its value, providing insights for both immediate and long-term business planning.

What is Goodwill in Business?

Goodwill is a unique asset, unlike tangible items such as property or equipment. It refers to the intangible value that a business generates due to factors like its reputation, loyal customer base, intellectual property, and brand strength. Essentially, goodwill represents the portion of the business’s value that exceeds the sum of its tangible assets.

Goodwill is often linked to profitability. If your business generates consistent profits beyond the owners’ salaries, it likely has goodwill. Conversely, businesses with minimal profits may not possess significant goodwill since potential buyers won’t pay for a job or role—they want to invest in future growth.

How to Calculate Goodwill

Calculating goodwill involves a specific formula:

Goodwill = (Consideration Transferred + Controlling Interests + Fair Value of Equity Interests) – Net Assets Recognised

Let’s explore this with an example:
“Melon Inc.” acquires “Guava B Inc.” paying $150 MM to secure a 90% stake. The fair value of non-controlling interests stands at $16 MM, and the fair value of net identifiable assets totals $140 MM.

Using the formula: Goodwill = ($150 million + $16 million) – $140 million = $26 million.

This calculation is often referred to as the full goodwill method. It’s a straightforward approach, but be mindful that external factors such as market conditions and the business’s future earning potential also play a role in the final valuation.

What Does Goodwill Mean in Partnerships?

In business partnerships, goodwill is treated differently depending on the type of arrangement — there are goodwill partnerships and no goodwill partnerships.

Goodwill partnerships: When partners enter the business, they contribute to its value. And when they exit, they are compensated through a sale. For example, if a legal firm is valued at $1.5 million, each of the three partners would pay $500,000 for an equal stake.
No goodwill partnerships: In larger firms, partners often enter without buying a share of the existing goodwill. For example, in a large law firm valued at $50 million, requiring incoming partners to invest $1.5 million each in goodwill would deter potential candidates. Instead, you may still need to make a financial contribution, but it won’t reflect the goodwill value..

Regardless of the structure, understanding goodwill remains essential when valuing a business for sale.

The Impact of Location, Clients, and Partners

Several external factors, such as business location, client quality, and key partnerships, influence goodwill.

Location: Businesses situated in high-demand areas typically carry higher goodwill. For example, accounting firms in prime CBD locations may fetch around $1.20 to $1.30 to each dollar of revenue. Thus, a practice generating $500,000 in gross fees could be valued at around $600,000 when location-driven goodwill is factored in.
Clients: High-value clients contribute significantly to goodwill. A business with fewer, high-value clients is generally more attractive to buyers than one with many low-value clients. The ability to command premium rates adds to goodwill value.
Partners: Key employees or partners can enhance goodwill. For instance, if a financial firm employs the country’s top tax expert, that expertise brings additional goodwill, attracting high-value clients.

Intangible Assets

It’s important to distinguish goodwill from other intangible assets. While goodwill reflects the overall value of a business’s reputation and relationships, intangible assets can include specific items like trademarks, patents, and proprietary technology.

Trademarks: Registered logos or branding elements that represent the business.
Patents: Legal rights protecting unique inventions or technologies.
Licenses: Exclusive rights to sell or use a product or service.
Franchises: Agreements allowing third parties to operate under the brand name.

Unlike goodwill, one can individually identify and value these assets. When calculating goodwill, exclude the value of these intangible assets, as the balance sheet accounts for them separately.

Goodwill Examples

Understanding goodwill becomes clearer through practical examples. Let’s look at a few scenarios:

Small Retail Chain: A popular retail chain with strong customer loyalty and recognisable branding may have significant goodwill. Even if the business owns no physical property, its brand equity and customer base are valuable assets that drive future profitability.
Tech Startup: A startup that has developed a unique software solution and built a dedicated user base over a few years could hold substantial goodwill. The company’s market reputation and loyal customers would be integral to its valuation, even if it has limited physical assets.
Consulting Firm: A consulting firm that boasts a well-known partner with a strong personal brand may have higher goodwill. This individual’s network and reputation add additional value, as they attract new clients and retain existing ones when they are tied to the business.

In each of these examples, goodwill is an intangible yet crucial factor in determining the business’s overall value. Properly assessing and calculating goodwill ensures you receive the full value of your business when it’s time to sell.

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.