A recent post by Tony Arena on valueabusiness.com.au, this article has some great points to consider when buying a business.
§ Identifying what exactly Goodwill is and its worth.
§ Explaining different contexts of goodwill
§ Defining what Goodwill you should pay for, and what Goodwill you shouldn't pay for.
In classical business valuation terms, goodwill is what is left in the value of the business after deducting assets.
The equation is Business Value – Assets = Goodwill. Some businesses have no goodwill and hence the value equals their assets. Further, in classical business valuation terms, goodwill can be described as “that intangible asset arising as a result of elements such as name, reputation, customer loyalty, location, products, and related factors not separately identified and quantified”. The first thing to say is that goodwill is one of the intangible assets that a business may have. Others might be trademarks, patents and designs and similar intellectual property, customer lists, software – in fact any intangible asset that is not strictly goodwill.
In classical business valuation context, goodwill has value. However, goodwill is used in another context, especially in relation to the buying and selling of the business. In this context, in layman’s terms goodwill may have value and it may have no value. You will often hear an accountant or other professional adviser say “Don’t Pay for Goodwill”.What they are saying there is, be careful when you are investing in intangible assets to ensure that the goodwill you are paying for will be there once you own the business. This is very sensible advice. However in the modern day business selling, you can’t get away with saying “Don’t Pay for Goodwill”. The amount of the business value that can be apportioned to goodwill has grown over the last 25 years.
Let’s break Goodwill down into two categories: Goodwill you should pay for and Goodwill that you shouldn’t pay for.
In the category of goodwill that you can pay for, I include databases of clients, software to which the purchaser has the right of assignment, training manuals, practice and procedure manuals, relationships with suppliers and customers that will survive the purchase transaction.
In the category of goodwill that you shouldn't pay for, they include customer reputation that will be lost when the owner departs the business, other intangible items that are solely the property of the current owner and will be lost in the transaction, goodwill that relates to a location where that location is not secured for the long-term (at least five years). This problem can always be solved by asking yourself the question: "Will What I Am Paying for Be Transferred To Me?”