November 11, 2020
You can’t touch goodwill, but it’s one of the most valuable assets for many businesses. Commonly associated with professional service firms, goodwill can also exist among manufacturers, retailers, contractors and other types of businesses. Valuing intangible assets, including goodwill, requires the use of a business valuation professional to get it done right.
Different Types of Goodwill
If you talk with business owners or professional practitioners, many will tell you that their companies could not survive without them. That may be a bit of an exaggeration, but they do have a point. Traditionally, goodwill has been broken down into two components:
Business (or entity) goodwill. This belongs strictly to the entity itself. Business goodwill may arise from many sources, including the company’s name, phone number, location, and special attributes, such as special menu items or recipes at a restaurant.
Personal (or professional) goodwill. This type of goodwill is directly attributable to an individual’s characteristics or attributes. It includes not only the owner’s skills, knowledge and reputation but also his or her contacts and relationships.
Personal goodwill can be further bifurcated into pure personal goodwill and transferable goodwill. Pure personal goodwill cannot be transferred to the entity or anyone else under any circumstance. These are often true personal relationships:
- “We want John to testify in this case because we know what type of a witness he is. No one else will do.”
- “Wayne has developed the cultural relationship and ties necessary to gain the trust of a particular customer. Therefore, only Wayne is able to buy and sell the product to him.”
If a business is sold, the buyer won’t pay for pure personal goodwill, because it’s something that will literally walk out the door with the seller.
Transferable goodwill is goodwill that is personal in nature, but might be transferred to the entity or to another individual with proper planning and adequate time. These could be personal relationships or specialized knowledge that could be transferred through training or development of other people. It could also include contact lists that have been developed over a period of time or customer (or vendor) relationships that can be transferred given effort and time.
Splitting Up Goodwill
So, how personal is your goodwill? Dividing goodwill among its three components — business, pure personal and transferable personal goodwill — requires professional judgment and careful consideration of the facts at hand. Valuators may perform different analyses to divvy up goodwill that include:
Evaluate comparable transactions. Search for similar business sales in proprietary transaction databases. Theoretically, these deals should not include any pure personal goodwill, because no rational buyer would pay for an asset that walks out the door with the seller. But beware, a comparable business could rely more (or less) on pure personal goodwill than the subject company.
For example, an accounting firm in an urban market with 10 partners and 100 employees would be more likely to possess business or transferable personal goodwill than a three-partner firm that operates in a small, rural market and employs just a receptionist and one bookkeeper. Clients of the smaller firm may be attracted solely to an individual practitioner and his or her reputation. Clients of a mid-sized urban firm might be attracted to the firm’s location, name recognition and diversified staff of professionals, however.
Consider conditions of sale. Some databases also list the details of employment, consulting or noncompete agreements between the buyer and seller as a condition of sale. The value similar businesses assign to these agreements can be used as a basis to estimate transferable personal goodwill. But, beware, these agreements might be based on gut instinct or driven by tax strategies, rather than market value.
Estimate the cost of an orderly transition. Some personal goodwill can be transferred to new owners through an orderly transition. The selling owner can remain for some period of time with the business to maintain a presence, introduce the new owner, and facilitate a rapport-building program with the employees, customers, and suppliers. The estimated costs of the selling owner’s compensation plus other direct expenses during the transition can be used as an estimated value of personal goodwill.
Even in an orderly transition, some customers may be lost, so it’s also important to consider the expected loss of revenue. Some customers simply can’t be transitioned over to the new owner, no matter how hard the buyer and seller try. Beware however, that some customer loss may be due to operational changes made by the new owner, so it can be argued that the revenue lost from these changes is not related to personal goodwill.
Knowing how to differentiate and value the components of goodwill is important if you’re buying or selling a business — or if you face litigation that involves the value of a business interest, such as a marital dissolution or shareholder dispute. Splitting goodwill may seem like splitting hairs, but it should be done in logical way by a valuation expert who understands all of the interconnections and implications.