What’s Goodwill

Q: I’m negotiating to buy a truck accessories store but the owner is asking a lot more than I estimate the equipment and furnishings are worth. He keeps talking about the goodwill he’s established. What exactly is goodwill and how is it calculated?

A: Goodwill is an intangible asset, and can’t be valued directly using a formula. Intangible assets have no physical existence. Tangible assets can be touched and seen and so have fair market values. Some intangible assets can be assigned accounting values, e.g., the cost of securing a patent on a new product.

The value of goodwill is derived after valuing the entire business and subtracting the value of the tangible assets. Financial assets, equipment, facilities, inventory and other tangible assets represent the owner’s equity. Goodwill is defined as the value of the business in excess of its owner's equity.

Goodwill value is justified only when the business profits exceed the required return on tangible assets. This enables a business to continue to earn a profit in excess of the normal or basic rate of profit earned by other businesses of similar value.

Goodwill often attaches to the owner - so, if the owner stays, the goodwill stays. If a business is being sold, often it’s important for the owner to stay on as a manager or a minority owner so he/she can transmit their unique knowledge and feel for the business or so the new owner can develop the same customer/vendor relationships as the old owner.

Some intangible assets are more distinct than others. A strong brand and a loyal customer base can be distinct assets owned by a business or simply part of a business's goodwill. Other examples of distinct intangible assets include copyrights, trademarks, intellectual property, trade secrets, pricing formulas, customer lists, long term contracts, business plans, or recipes that let a business sell its products for a higher price or in greater quantity than its competition. Every pizza shop has an oven, but not every pizza shop has the secret family recipe for the sauce that has been handed down for generations.

Intangible assets are only recorded on your balance sheet if paid for and are ignored if internally generated. The fees to secure the patent mentioned earlier could be recorded; the research and development costs could not. You should seek the advice of a CPA to properly record the value of an intangible asset.

Intangible assets like goodwill are typically the foundation upon which a company is built in a business world full of copycat competitors. Their value is often worth more than the value of tangible assets. So, the creation and management of intangible assets is often essential to long-term success.

April 29, 2007