What is goodwill? How is it measured? Why is it important? Goodwill is often misunderstood by owners of closely-held businesses.
An Intangible Asset
According to the American Institute of Certified Public Accountants’ Statement on Standards for Valuation Services, goodwill is “that intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified.”
The Internal Revenue Service defines it as “The value of a trade or business attributable to the expectancy of continued customer patronage. This expectancy may be due to the name or reputation of a trade or business or any other factor, and in the final analysis, goodwill is based upon earning capacity. The presence of goodwill and its value, therefore, rests upon the excess of net earnings over and above a fair return on the net tangible assets.”
What does this mean in English? Goodwill is the value of a business, over and above the value of its identifiable tangible assets. It is the expectancy of future earnings. As a simple example, assume a distribution business’s only asset is inventory with a value of $100, but someone is willing to purchase that business for $500. The $400 paid over and above the value of the inventory is payment for goodwill.
The Value of Goodwill
Why would someone pay more for a business than the value of the tangible assets? Because they expect to use those assets to earn a profit. In the distribution business or any business, goodwill may include customer relationships, supplier relationships, reputation, location, trade secrets, or any other factor that causes the business to earn income above and beyond a fair return on tangible assets.
How can you create or increase the value of goodwill in your business?
- By earning consistent (and hopefully increasing) net income, which is supported by good accounting records.
- By establishing consistent and well-documented procedures, which will hopefully support continued future profitability. After all, someone who buys a business is not doing so because of what happened last year, he or she is buying it with the expectation of what will happen next year.
Who Owns Goodwill?
If goodwill is based on customer relationships, is the goodwill owned by the business or the employees who maintain the relationships? This is an area of controversy because it has significant tax ramifications in the sale of some businesses, but the courts have generally held that goodwill is owned by the employee unless he or she has executed a restrictive covenant or employment agreement with the company. If no such agreement exists, and the employee is free to work for a competitor and bring the relationship there, then the company does not own the goodwill. However, if you are considering selling your business and do not have restricted covenants or employment agreements, consider very carefully whether or not they are necessary.
For more information on this subject, please see my article, Business Sales and Personal Goodwill.
For help in valuing your business, give us a call at 201-655-7411, or email [email protected]