Establishing the value of a business’s established goodwill and reputation is a key element of the purchase or sale of that business. For buyers, being able to properly assess the value of intangible assets ensures they are paying a fair purchase price. For sellers, knowing how their business’s intangible assets are likely to be assessed by buyers allows them to plan accordingly and maximize the value of the business when it is time to sell.
This blog post will explain the two main types of business goodwill, how they can impact the overall valuation of a business, and how business owners can plan for the future by maximizing goodwill that holds value for buyers.
What is “Goodwill”?
Goodwill may be a familiar term to many people, but it is hard to define. Goodwill is valuable but intangible. In everyday speech, it tends to refer to a positive feeling of being inclined to assist or help or otherwise give someone the benefit of the doubt.
In the business world, it has come to represent the intangible value that encompasses the hard work put into it by its owners and employees. In effect, goodwill represents the “gap” between the value of a business on paper – often physical assets – and its ultimate sale price.
Goodwill can reasonably be assumed to be present if three characteristics of a prospective asset are identified:
- An asset must be intangible;
- There must be an expectation of future earnings over the returns expected in a comparable business absent the asset; and
- The asset must be inseparable from the business to which it belongs.
Although these principles help to provide some guidance, goodwill is hard to define because many things that can be considered goodwill are intangible. Things that could be considered goodwill include:
- Having a well-established brand and reputation
- Strong relationships with suppliers, customers, or the community at large
- Having a particularly valuable physical business location
- Specialized or long-tenured staff
- Patents, copyrights, or trademarks
There are two general types of goodwill that have different implications for buyers and sellers.
Personal Goodwill
Personal goodwill can be attributed to specific individuals connected to a business. This is usually the owner(s), but in some cases may also include key employees. A high-profile owner or employee who has strong links in the community, has run their business for many years and has built longstanding, personal relationships with suppliers, and a loyal customer base will possess a lot of personal goodwill. This is especially true in cases where a business is named after an owner, is family-run, or if the owner features prominently in business advertising and is central to the business’ brand.
Personal goodwill can be particularly prominent in professional services, such as medical professionals, accountants, lawyers, and realtors. Personal goodwill is usually valued higher in smaller to medium-sized businesses.
Commercial Goodwill
By contrast, commercial goodwill flows from an organization rather than a specific individual. The most obvious example is a strong brand name or reputation that exists independently of the business owner. Many of the famous global brands we are familiar with, from McDonald’s to Coca-Cola, hold valuable commercial goodwill based on their business names or logos alone. This value is independent of the ownership or management of the business. Commercial goodwill is generally higher with larger businesses.
The Most Important Difference Between Personal and Commercial Goodwill
The critical difference between personal and commercial goodwill – aside from establishing to what degree goodwill in any business exists as one or the other – is that commercial goodwill is more easily transferable, whereas personal goodwill may not be. If a business’s goodwill is almost entirely personal as opposed to commercial, this may lower the value of a business if it is likely to lead to the business not being as successful in the absence of those specific individuals.
In contrast, if most goodwill held in a business can be characterized as commercial goodwill, it will increase the prospective value of a business when it is being sold since this form of goodwill is more easily transferable. Absent a situation where a business owner intends to keep the holders of personal goodwill employed as an integral part of the business (and maybe not even then, as there is no guarantee that an individual with personal goodwill won’t quit or otherwise perform as well when their role changes), a buyer of a business generally expects to only pay for commercial goodwill.
Generally speaking, personal goodwill is less valuable to prospective buyers than commercial goodwill because commercial goodwill is seen as more portable and durable.
Converting Personal Goodwill Into Commercial Goodwill
From the perspective of a business owner who may be thinking about selling their business in the future, it is helpful to remember that commercial goodwill is more attractive to potential buyers than personal goodwill.
Training employees well, ensuring key elements of business operation are standardized, and generally working to ensure that important relationships (such as with suppliers) can survive a change in ownership intact will all help shore up commercial goodwill.
Contact Tierney Stauffer LLP for Advice on Enhancing and Valuing Business Goodwill
Whether you are considering buying or selling a business, seeking professional guidance can help give you peace of mind that you are not over or undervaluing a business and provides a better understanding of the nature of the goodwill attached to it.
At Tierney Stauffer LLP, our business lawyers provide proactive and reliable advice, no matter the size of your operation. We have extensive business law experience, from real estate and commercial leasing to business succession. Contact us online or at 1-888-799-8057 to arrange a consultation.