Every aspiring entrepreneur who is interested in entering into a new business venture or wants to place a value on the brand they have built would benefit from considering the concept of goodwill. Business owners can position themselves to financially benefit from the goodwill of their existing business when it comes to selling. Further, purchasers can position themselves to better understand how goodwill is determined. This article will explore the meaning of goodwill and outline the most common approach to attributing value to it.

What is Goodwill?

Goodwill is an intangible business asset, which means that it does not have a fixed value. The two most common types of intangible assets which are important for business owners to understand are:

  • intellectual property; and
  • goodwill.

Intellectual property has quite an arbitrary value and an owner must subjectively determine its value. Goodwill operates in a similar way.

For example, the it may be comprised of a the following aspects: 

  • reputation with consumers and clients: these are positive or negative associations with the brand or business; 
  • profitability: the size or ‘calibre’ of client lists can demonstrate the ability for a business to have a steady flow of work from returning clients; 
  • reputation within the industry: having a widely recognised brand that is positively associated with quality products or services; and
  • potential for the business to grow or expand based on current success.

The digital economy now means that it is not just the standing of the business within the local community which contributes to goodwill. It can also comprise the recognition and reviews about the products or services on social media. Most businesses have an online presence simply by being listed on the google business directory. Therefore, businesses can easily amass a bank of reviews from customers, whether positive or negative.

When Is It Not Appropriate to Consider Goodwill?

There are a few situations where it would not be appropriate to attribute value to goodwill. One arises when a purchaser is only acquiring stock or equipment required in carrying out a business, without also acquiring the registered business name. This means the business is not being sold ‘as a going concern.’

Before you decide not to sell your business as a ‘going concern,’ you should consider whether you are more likely to have a higher valuation from selling the business in its entirety. This can help ensure you do not undersell yourself by parting with only a component of your business. Commercialising the element of ‘goodwill’ to your business name can be profitable.

Who Determines its Value?

Goodwill has no financial value until the business owner (or a business valuation professional) attributes one to it. The business owner who is best placed to weigh up the factors that contribute to the business’ goodwill. You may also rely on your accountant or financial advisor to help you determine a reasonable and appropriate value.

You may want to speak with a professional valuer who can provide a valuation after they have inspected your business records to assess the profitability of the business against the levels of risk associated with the business. However, it is worth noting that valuations may vary between service providers, as there are several methods to value a business.

When Does Goodwill Matter Most?

There are two points in the lifetime of a business where goodwill matters most, and the reason it matters will vary depending on your relationship with the business:

  1. the time a business is listed for sale; and
  2. on settlement.

Why Does Goodwill Matter for the Business Owner?

From the perspective of the business owner, goodwill matters because you want to ensure you are not undervaluing any aspects of your business. If you are selling your business in its entirety, you should consider the market value for each component of the business, including: 

  • fixtures and fittings;
  • stock or inventory;
  • equipment; and
  • goodwill.

When a business owner lists the business for sale, it is commonplace to consider the value of tangible and intangible assets as a guide for a suitable listing price. 

Why Does Goodwill Matter When Purchasing a Business?

From the perspective of a prospective purchaser, the value of goodwill or its absence in valuation is noteworthy. If a business valuation does not include goodwill, you should ask for a clear breakdown of the value attributed to each asset. This will help you to assess whether the: 

  • sale price was undervalued;
  • business is not profitable; or
  • other assets of the business have been inflated.

Conversely, if you are only buying tangible assets, the concept of goodwill is irrelevant regardless of how reputable the business may be, or how the above factors are weighted.

What Is the Most Common Way to Determine Goodwill?

Although the value of goodwill is arbitrary and subjective, the Australian Tax Office suggests business owners should use the ‘residual value’ method. After identifying all business assets which will be included in the sale, you should group the assets by category in the following order:

  1. cash and cash equivalents;
  2. actively traded assets;
  3. stock or inventories;
  4. all other tangible assets (such as equipment); and
  5. identifiable intangible assets other than goodwill (such as intellectual property)

Key Takeaways

Business owners stand to benefit greatly from spending time to determine a reasonable value for the goodwill they have generated for the business brand or name. Before it comes time to negotiate a price with a purchaser, you should consider using the ‘residual value’ method as it is one of the most systematic ways to attribute value to goodwill. Alternatively, if you are buying a business, you should seek legal advice before you sign the sale of business agreement and commit to the purchase price. Contact LegalVision’s sale of business lawyers on 1300 544 755 or fill out the form on this page.

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