The value of goodwill

Goodwill is probably one of the least understood words when it comes to valuing or acquiring a business. For example, a third-generation owner of a family retail business decided to sell after two major "box stores" became competitors. The fact that the business had lost money for the past five years also influenced the decision. An appraisal indicated that the only value that existed was in the liquidation of fixtures and inventory. The owners were stunned. "What about our goodwill?" they asked.

One of the better definitions of goodwill is that by Raymond C. Miles, founder of the Institute of Business Appraisers; "Those elements of a business that cause customers to return and that enable the business to generate profit in excess of a reasonable return on all other assets."

Goodwill is an intangible asset as distinguished from tangible assets such as furniture, fixtures, equipment, inventory, cash, accounts receivable, etc., and is related to profit. A "business" without intangible assets (sales, profit) is not really a business. If a person leases a store, equips it with trade fixtures, and stocks it with inventory, it is merely a bundle of tangible assets until such time as it generates sales and hopefully profits. When it generates profits, it can be called a business and it can be said that goodwill may exist. If it has goodwill, the question is "what is its value?"

Internal Revenue Service Revenue Ruling 59-60 says, "In the final analysis, goodwill is based on earning capacity, and its value therefore, rests upon the excess of net earnings over and above a fair return on net tangible assets." The valuation method, known as "Excess Earnings," is detailed in IRS Revenue Ruling 68-609. Important questions are:

1. What is meant by "fair return on net tangible assets"?

2. What is meant by "excess of net earnings"?

Owners of businesses, users of valuation services and even some business appraisers have difficulty understanding what is meant by "fair return on net tangible assets." Let us assume that the value of the tangible assets is $1 million (inventory, machinery and equipment, accounts receivable) and that the business owes $100,000. The net assets of $900,000 are sitting on a shelf, are in the plant, or are in paper waiting to be collected. Let us also assume that the $900,000 required to pay for those assets came from a bank loan, and that the bank is receiving 10 percent interest. If, however, that $900,000 came directly from the owner's pocket instead of from a bank, isn't that owner also entitled to receive 10 percent $90,000 on his investment?

If we assume that the business has $400,000 in net profit after owner's compensation, and if the required return on the tangible assets is $90,000, then the business itself has earned $310,000. The remaining $90,000 was earned by the assets. The owner did not need to own the business in order to earn $90,000. All he had to do was lend $900,000 to someone who wanted to borrow against similar tangible assets. The above $310,000 represents "net earnings over and above a fair return on net tangible assets" also known as excess earnings, or goodwill.

In order for the excess earnings (goodwill) to have value it must:

1. Be transferable

2. Be measurable

There are some businesses and professions where there is a limited opportunity of there being a transferability of goodwill, especially in one-person businesses or professional practices.

A case in point: A 40-year-old, one-person dental practice with old equipment, drab premises, new competition and practice is losing money. The patient base is largely of older, loyal people who will have no loyalty to a new owner. There is very little goodwill, if any, to be transferred.

Measuring the value of excess earnings (goodwill) is highly controversial. While there have been many opinions written as to what should be considered in developing a yardstick, there has not emerged a single consensus as to establishing a specific formula. IRS Revenue Ruling 68-609 says that a capitalization rate must be applied to the excess earnings. IRS Revenue Ruling 59-60 states "A determination of the proper capitalization rate presents one of the most difficult problems in valuation." A capitalization rate is a rate of return expected by investors which, when applied to earnings, equals the value of the earnings. For example, a 25 percent capitalization rate applied to earnings of $100,000 equals $400,000 (divide $100,000 by .25)

There are many risk factors to consider when developing an excess earnings capitalization rate including:

1. Profit trends: up, down, or level?

2. Sales trends: up, down, or level?

3. Expense trends: up, down, or level?

4. Quality of financial statements: audited, compiled, reviewed?

5. Income risk: pending legislation, freeway impairment, rezoning?

6. Working capital required: a little or a lot of money to enter?

7. Business type: manufacturing, retail, wholesale, service?

8. Age of industry: new, get-rich-quick, long established?

9. Experience skills required: average business skills, master's in business, a doctorate?

10. Years in operation: start-up or well established?

11. Competition: average, excessive, little?

12. Market size and share: big market, big share, little market, little share?

13. Who makes the sales: owner, manager, sales staff, reps?

14. Type of management: owner/manager, general manager, levels of management?

15. Number of employees: a lot who are difficult to manage, a few who are easy to manage?

16. Customer base: wide-spread or small base?

17. Employee turnover: high training and retraining costs?

If the capitalized value of the excess earnings (goodwill) is $1,000,000, and, if the net asset value is $900,000, then the value of the entire enterprise would be $1,900,000.

Restated, the value of the business including goodwill is $1,900,000.

Jerry F. Golanty, president of Reno-based BizVal, is Nevada's only Master Certified Business Appraiser and is governor of the Institute of Business Appraisers. Contact him at jerrygolanty@bizval.net.