Module 13-: Business goodwill can be defined as the part of the value of a business over and above the value of the tangible assets of that business. In other words, it is key intangible asset that represents the portion of the business that cannot attributed to other business assets, such as a recognizable company or product name, strong reputation, or long-term relationships with customers and suppliers. So, when a buyer pays more than the net book value of a company, he is typically paying for goodwill.
Goodwill value should not be confused with going concern value, which is the expectation that a business will continue to operate well in line with its intended purpose as opposed to being liquidated. In other words, the going value of a business is its value for being able to remain operational and being likely to continue to thrive.
Examples of goodwill items include the following:
- Phantom assets
- Local economy
- Industry ratios
- Custom-built factory
- Loyal customer base
- Management’s expertise
- Supplier list
- Mailing lists
- Royalty agreements
- Trade secrets
- Low employee turnover
- Skilled employees
- Experienced design staff
- Recession-resistant industry
- Delivery systems
- Growing industry
- Computer databases and designs
- Advertising materials and campaigns
- Name recognition
- Systems and procedures
- Proprietary designs
- Government programs
- Training procedures
- Credit files
- Engineering drawings
- Websites and domain names
- Favorable financing
Much of the value of a business cannot be found in its hard assets, but in the intangible assets that come under goodwill. This explains why a business might sell for a whopping $5 million when its tangible assets total only $1 million.
Goodwill cannot be downplayed in any acquisition deal. But most of the time, the buyer erroneously thinks that the asking price set by the seller is an arbitrary figure. Yet, the seller knows best about the goodwill value of his business.
For example, assume you want to buy a restaurant from its owner, who is selling the business because he wants to retire and has no children or relatives interested in carrying on with it. The restaurant has been in operation for close to 20 years, and it’s still doing very fine. And the owner has set an asking price of $60,000 but the tangible assets of the restaurants have a total value of just $15,000.
In the described situation, how would you see the asking price? Would you hit the roof because you deem it ridiculous, considering that the tangible assets are worth just $15,000? Or would you accept that the $45,000 goodwill value is just fine?
Well, most of the time, such deals are open to negotiation. And whether the goodwill value is too much or not will be subject to the buyer’s explanation of what goes into the restaurant’s goodwill value. However, you must understand that a goodwill value must be paid.
Remember, this business has been in operation for close to 20 good years. Over the years, the owner has invested a lot of time, effort, and money into building its reputation and attracting customers. He has built a huge base of loyal customers. He has done so much advertising that the business would still continue to thrive even if no more advertising is done. He has established a strong relationship with certain suppliers. He has developed unique recipes that have helped the restaurant stand out from the competition. He has trained his employees and have helped them hone their skills over the years. In short, he has put in so much into the business that there’s little left to be done by you the buyer.
So, the business is really worth much more than the tangible assets. Imagine buying the restaurant without its name, reputation, customers list, unique recipes, and other intangible assets. Would the restaurant have the same value as it would with the name included? Would it have the same value without its unique recipes and customers? The answer is no! These intangible assets cannot be replaced easily.
The total value of a business is determined by available cash flow and the risks associated with obtaining it. Yes. But the intangible aspects of the business matter too. But most buyers tend to evaluate a business based on cash flow and assets only.
However, there are times when a business owner will set a goodwill price that is far more than the goodwill value of the business. The only way to avoid paying excess goodwill cost is to scrutinize each item that the seller factored in while coming up with his goodwill value. If it’s too high, then you can negotiate.