A Deep Dive into Goodwill
A Deep Dive into Goodwill
In this blog, we discuss different sources of goodwill, expanding upon the considerations previously described in our Building Blocks of Value Series.
In a previous Davis Martindale blog, The Building Blocks of Value: Goodwill and Intangible Assets, we provided readers with a general understanding of goodwill, including various factors that may influence its value. In this blog, we will elaborate on the different sources of goodwill, introduce the concept of transferability, and discuss how goodwill may impact a business valuation.
A Quick Refresher
At its core, goodwill is a non-separable, intangible asset that is recognized when a business is purchased as a going concern. It reflects the premium that the buyer pays in addition to the value of the business’ net assets.
There are three main types of goodwill, which we discuss further below: Commercial goodwill, individual goodwill, and personal goodwill.
Categories of Goodwill
Commercial goodwill accrues to a business by virtue of its products, services offered, location, and other features that are not dependent upon particular employees or owners of the business and can be readily transferred upon the sale of a business.
Examples of commercial goodwill include the following:
- Location Goodwill – a business may generate higher sales if located in an accessible spot. This is why you may often see multiple gas stations or coffee shops located at the same intersection.
- Product or Service Goodwill – a business with favourable online reviews may generate higher sales than competitors providing similar services.
- General Business Goodwill – may include factors such as competent employees, an experienced management team, amicable relationships with suppliers, and so forth. These factors also play a role when determining a company’s specific risk premium, as discussed in our latest blog, What is WACC?
Individual goodwill accrues to a business by employing a person with certain abilities, business contacts, and reputation. If that person were to leave the business and compete with it, the profitability of the former business could be hindered. Individual goodwill has commercial value to the extent that:
- The business has the capacity to substitute other people to fill the role played by those individuals who cease to be employed by the business, such as an existing employee or an external hire; and
- Those individuals who cease to be employed by the business are precluded from competing with it because of a non-compete agreement.
Personal goodwill accrues to a business because of a business owner’s talents, skills, efforts, and reputation. Excess profits will diminish or disappear entirely upon the death or retirement of that person. Therefore, personal goodwill is non-transferable in nature and is not included in the definition of fair market value.
A classic example of personal goodwill is an owner-operated hair salon, as a majority of the existing clientele are likely attracted to the experience and skillset of the hair stylist, rather than the brand name of the business itself.
Owners that are looking to decrease the impact of personal goodwill on a potential sale should focus on enhancing management knowledge amongst their employees by increasing experience and training. This effort decreases the business’ overall reliance on the owner.
As a business owner, one of your objectives should be to increase the value of your transferable goodwill in order to receive a higher valuation when you decide to sell. Alternatively, if you are purchasing a business, you may want to consider approximately how long the business will need to operate before you will start generating a positive return on goodwill. This phase is known as the goodwill payback period. In some situations, a business sale may incorporate earn-outs or contingent consideration to mitigate the risk of the purchaser paying too much or too little for goodwill.
Whether you are purchasing or selling a business, it is important to obtain the professional judgement of a CBV to ensure that the goodwill is estimated appropriately – something we consider to be both an art and a science.
If you are looking to value your business for purposes of sale, estate planning, litigation or anywhere in between, give the professionals at Davis Martindale a call. We have experience in all forms of valuation engagements.
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