You’re looking at purchasing a business that has been around for a long time – it has a loyal customer base and specialized marketing, for example – so when it comes time to settle on a price you’ll need to account for the value of these intangible assets, often called goodwill. But what is goodwill in business?
These are intangible assets that can sometimes be hard to pin down. They include good customer or employee relations, excellent branding and recognition or unique processes and training systems.
You can calculate the value of goodwill by taking the fair market price of business and subtracting the net value of its assets.
Here’s a look at why goodwill is important when buying an existing business.
What is Goodwill?
When determining the value of a business, you often have to look beyond the value of its assets or net revenue.
These intangible assets are commonly known as goodwill and can include reputation, branding or customer loyalty.
By their very nature, it can be hard to nail down exactly what goodwill is and how much it is worth.
However, understanding the value of goodwill can be extremely important when buying or selling a business. According to a 2010 KPMG study, over 50% of the purchase price of a business is allotted to goodwill.
Let’s look at couple specific examples of goodwill.
Imagine that you purchased a restaurant but the sale did not include keeping the existing name or recipes.
They don’t have specific value per se but the business would be a lot more valuable if it came with these intangible assets.
Customers would be less likely to patronize the new establishment without having to try the new food to see if they like it.
Consider a scenario where you were purchase two identical restaurants but one was in an up and coming neighborhood that was in the process of gentrifying and the other was in a more run-down area of town.
Even if they had the same net revenue, you would probably value the former business because it has a much higher expectation of future growth.
Why is Goodwill important when buying a business?
Although it may be intangible, that doesn’t mean that considering the value of goodwill is unimportant or should be ignored.
If you’re selling your business and you know that you have an extremely good reputation and a very loyal customer base, you’re going to want to make sure that you get the value of that goodwill when you sell.
Your business is worth more than a similar sized one in the same industry that doesn’t have as much goodwill.
You also don’t want to pay more for goodwill when you are looking to buy a business.
Goodwill is usually built slowly over time as a business acquires and retains a loyal customer base, for example. Or by creating an enjoyable workplace so the owner and employees have a very positive relationship.
This is usually the result of the hard work and effort of the business owner who will usually place a higher value to the goodwill of their business.
A seller, on the other hand, would want to value the goodwill lower so they don’t end up paying too much.
How to calculate the value of goodwill?
You can calculate the value of a business by taking he combined value of the company’s tangible assets (less liabilities) and subtract that figure from the fair market value of the business.
For example, let’s say a business has an asking price of $2 million, assets of $500,000 and liabilities of $250,000.
You can calculate the value like this:
Goodwill = Fair Market Value – (Assets + Liabilities)
Goodwill = $2 million – (500,000 + 250,000)
Goodwill + $250,000
A company is supposed to list the value of its goodwill on its balance sheet when it purchases another business for a higher price than the recorded value of assets, according to generally accepted accounting principles.
Goodwill is not amortized over time.
Instead it is the responsibility of management to value goodwill every year and make adjustments as necessary.
Businesses cannot have a negative goodwill. Likewise, an increase in the fair market value of the business would not be accounted for on the balance sheet.
What factors influence the goodwill of a business?
There are numerous factors that go into influencing the goodwill of a business. You should consider carefully when assessing the value of goodwill.
Here’s a look at some factors that affect goodwill:
- Company brand and recognition
- Strong and loyal customer base
- Company website and domain name
- Exclusive customer mailing lists
- Unique or specialized advertising or marketing
- High-traffic location
- Excellent relationship between owner and employees
- Good reputation among vendors
- Proprietary technology
- Specialized equipment and tools
- Special industry knowledge
- Difficult to obtain permits and licensing
- Well-positioned for future growth
Conclusion
Although goodwill can be hard to pin down, it’s important to settle on a fair value when buying or selling a business.
You don’t want to overpay.
It can be a little tricky to land on an exact value so consider all of the factors carefully including, whether the business has a loyal customer base, whether it is in a high-traffic area or has difficult to obtain permits and licenses.
You definitely want these assets.
If you’re buying an HVAC company you’re going to want to keep its existing clients. If you’re buying a restaurant, you’re probably going to want to keep the menu and name.
All of these intangible assets are important when buying a business.
