Goodwill and its Valuation

Monday 6 September 2021

What is goodwill?

The “goodwill” of a business is “the benefit and advantage of the good name, reputation and connection of business; it is the attractive force which brings in custom”.

Goodwill includes every advantage acquired by a proprietor in carrying on the business, “whether connected with the premises in which the business is carried on, or with the name of the firm, or with any other matter carrying with it the benefit of the business”

• Items included in goodwill are proprietary or intellectual property and brand recognition. Where the vendor is a company, it is important to consider who should be involved in transferring the benefit of the goodwill to the purchaser, and how. Shareholders and directors should also be parties to the Agreement for sale, so they are bound to restraints of trade and be required to provide assistance before or after settlement. There is a fine line between the reputation of the business and the business owner, so it is important to have vendor’s assistance or handover to make sure the client relationships transfer over to the purchaser.
• If there is no vendor assistance or handover, purchasers may want to consider negotiating a lower price (or refrain from purchase) particularly if the goodwill of the business is more strongly linked to the vendor owner’s personal reputation as opposed to the company itself.
• Restraints of trade needs to be considered carefully: who should be bound, for how long and how far.

How do you quantify goodwill?

Goodwill is calculated by taking the purchase price of a company and subtracting the difference between the fair market value of the assets and liabilities. Under generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS), companies are required to evaluate the value of goodwill on their financial statements at least once a year and record any impairments. Goodwill is considered an intangible (or non-current) asset because it is not a physical asset like buildings or equipment.

Established approaches to the valuation of goodwill include:

1. the fair market value approach: value of goodwill is determined by estimating what the interest would fetch on the open market;
2. the capitalisation of profits approach: maintainable earnings are capitalised, and the net book value of assets is then deducted to derive a measure of goodwill, which is the residual;
3. the super profits multiple approach: allowance is made for an adequate salary for effort put in.  Excess profit is then determined, and an appropriate multiple – there may be an industry norm– is then applied to arrive at the goodwill figure. (As an alternative within this method, some predetermined rate of return on net tangible assets is deducted from average net income to determine “super profits”. Again some multiplier has to be applied.); and
4. the valuation by agreement approach, in which a formula for the precise determination of goodwill is set out in a partnership agreement or some other document.

While goodwill is an asset of a business, it is recorded in the books of the vendor as an intangible asset. It is deemed to have a prescribed value that is included in the overall total asset position of the vendor in relation to the business. The New Zealand Institute of Chartered Accountants prescribes certain accounting standards for goodwill.

What should you look out for? Due diligence

• Intangible asset in company’s balance sheet – brand recognition, IP and reputation = goodwill. When analysing a company’s balance sheet, investors will therefore scrutinize what is behind its stated goodwill in order to determine whether that goodwill may need to be written off in the future.
• how the business operates and its modes of contact – e.g., email accounts and phone numbers
• Who are the important contacts – client demography
• Talk to the vendor about existing client relationships the good and the bad
• Intellectual properties e.g., trade names, trademarks, service marks, registered designs, patents, copyright, computer software, licenses, and other similar items.
• Could also include benefit of the lease. Dahya v Dahya [1991] 2 NZLR 150 (although the partnership did not have a lease, the valuation of goodwill was based on the practical security of tenure because of the husband’s interest in the property company).

Consider carefully how the above aspects of the goodwill will be transferred from the Vendor or its shareholders/directors to the purchaser.

This article is for general use only. Advice should be sought for specific circumstances. Please consult Teresa Chan at Teresa Chan Law Limited, Level 3, Westpac Building, 106 George Street, Dunedin 9016, ph. 477 1069, or email teresa@tchanlaw.co.nz