What is goodwill and does my business have any? Studies report that more than 50% of the purchase price of a business is typically attributed to goodwill. Since the largest portion of the value of your business could be comprised of something that you can’t even touch, it is important to understand what goodwill is and why it is so valuable. We asked our own David Laycraft for his thoughts on this:
“I find that goodwill is a term that is frequently used but is rarely fully understood or appreciated. And this shouldn’t really be surprising – goodwill is not physical in nature but is “intangible” and, if created by the business, does not even appear on its balance sheet.
Goodwill is colloquially referred to as the sum of all intangible assets that provides a competitive advantage to the business, such as reputation, customer contracts, trademarks or proprietary software, and it is this “economic” goodwill (as compared to “accounting” goodwill) that I am referring to here.
Specifically, goodwill is identified when a purchaser is willing to pay a price premium over the market value of the company’s net tangible assets. Warren Buffett articulated this concept as follows: “Businesses logically are worth more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic goodwill.”
So, if the true value of a business is not based solely on its combined “tangible” assets – such as inventory, equipment or real estate – but may also include the proven ability of the business to generate cash flow, how do we identify it?
Goodwill often manifests itself in the following forms:
- One common form is repeat patronage. While all businesses exist to satisfy their customers, monitoring sales alone doesn’t give a complete picture of the value of your customer base. Other indicators include client retention rates, gross profit per customer and whether or not you are the customer’s preferred vendor. If a new competitor entered the market, how easily could they convince your customer to buy from them?
- When trained properly, a company’s workforce can also be a competitive advantage over its competitors. Companies that consistently invest in their employees, reward them appropriately and have a history of strong retention adds to the overall value of the business.
- Proprietary technology – whether in the form of patents or trade secrets – are competitive advantages that often lead to increased sales and profitability.
- Documented systems and processes, brand development or a culture of innovation are all intangibles that add to profitability and goodwill.
Not all companies have goodwill – primary commodity producers, very small businesses or if the goodwill is determined to be of a “personal” nature are all examples where it is unlikely that transferable goodwill exists. But even when it exists, purchasers are generally hesitant to pay too much for the goodwill of a privately-held company, not only because of the higher risk associated with its intangibility, but also because banks have historically been averse to lending for its purchase or using it as security.
Being able to identify and quantify goodwill is important, and a business valuation is often the first step in this process. From there, business owners are better equipped to either preserve or grow the goodwill component of their company.”
David Laycraft P.Ag., MBA, CMC, CBV, CF, CDFA
David has over twenty years of diversified experience working with privately-held businesses, and regularly assists clients in identifying, measuring, growing and realizing business value.
David can be contacted at (403) 750-7685 or firstname.lastname@example.org