Goodwill: Your Business, Not the Charity
Understanding and calculating goodwill
Quick! What is the value of your HVAC contracting business? Is it taxable income times three? Taxable income times five? Or is it the value of the assets minus debts? It is literally your million dollar question that you need to know.
In the past 10 years, there has been a trend in the U.S. to consolidate (and sell) companies. Many clients have contacted appraisers to assist in buying or selling a business. A component in determining the value of a company is goodwill. Often in the process of determining the value, clients are surprised at what their business is really worth beyond the net value of the company’s assets. This additional value is what is known as goodwill. Just as surprising as the additional value goodwill can add to the value of a company, is how it is formulated. This article will inform the reader of what goodwill is and how it is calculated using acceptable methods.
WHAT IS GOODWILL?
To even begin a discussion of goodwill, one should try to conceptualize it with a proper definition. Goodwill, in simpler terms, is the additional value of a business over its net assets. If the additional value of the business is not in the form of assets, then where does it come from? This is a tough question to answer with any precision and is the reason why goodwill is only calculated when the business is being sold. Goodwill is not only a creation of exercising scrupulous business practices for several years, but is the product of a much broader range of factors. Eight factors are typically considered by business appraisers when calculating goodwill. These factors include one or more of the following:
1) Age of the company.
2) The value of the suppliers and the products sold.
3) Quality relations between management and employees, who can add to earnings through effective employee performance and a reduction of losses from labor turnover.
4) Market area.
5) Potential growth.
6) Inventory efficiency.
7) Company location.
8) Banking relations.
This list is not meant to be exhaustive, but to only offer a few possible factors in the development of the formula. From this list, however, a value is determined on a company’s excess earning capacity. In short, goodwill means the ability of the business to produce profits beyond what would normally be expected from similarly sized companies within the same industry.
Additionally, an important thing to remember about goodwill is that the tax law classifies it as an intangible asset. With this classification, not only does the seller of a business clearly benefit by having a higher selling price from the value of this additional asset, but the purchaser does also. The tax law will permit a purchaser a tax deduction for the additional amount paid for a business that is attributable to goodwill. A deduction for goodwill cannot be taken all at once, but instead it must be taken ratably over a 15-year period. Of course, with our tax system, there is a condition; any amounts paid for goodwill must be objectively determined.
IRS METHOD TO CALCULATE GOODWILL
Once the underlying asset method is calculated without goodwill, and the weighted average annual earnings after taxes is calculated under the earnings capacity method, it is possible to determine whether or not the company has generated any value based upon goodwill. If the result is positive, the goodwill can then be added to the underlying value of assets to determine a true value of the asset structure of the company. There has been a misconception in the past in that many appraisers were valuing goodwill alone and using the goodwill values as a total value for the company. This is incorrect due to the fact that goodwill is an asset of a company and should be added to the fair market value of the tangible assets to determine a total value for the company using the underlying asset method.
The IRS has stated, through Revenue Ruling 68-609, that when there is no appropriate basis to calculate goodwill (most of the time there is no basis), the “formula” approach may be used to calculate the fair market value of intangible assets of a business. The “formula” approach is stated as follows:
A percentage return on the average annual value of the tangible assets used in a business is determined, using a period of years (preferably not less than five) immediately prior to the valuation date. The amount of the percentage return on tangible assets, thus determined, is deducted from the average earnings of the business for such period and remainder, if any, is considered to be the amount of the average annual earnings from the intangible assets of the business for the period. This amount (considered as the average annual earnings from intangibles), capitalized at a percentage of 15 to 20 percent, is the value of the intangible assets of the business determined under the “formula” approach.
The appraiser should be aware that the past earnings applied to the formula should reasonably reflect future earnings. If there are any abnormal years, where the annual earnings for that year do not properly reflect the business’s normal earning capacity, they should be discarded or weighted less in determining an average annual earnings figure.
The percentage of return on the average annual value of the tangible assets used should be the percentage prevailing in the industry involved at the date of valuation. If an industry percentage is not available, a percentage of 8 to 10 percent may be used. This return is what a normal company in the industry would expect to receive with an investment equal to the asset base.
If the business is of small risk, is stable, and has regular earnings, an 8 percent rate of return and 15 percent rate of capitalization is applied. If the risks of the business are high, then a 10 percent rate of return and 20 percent capitalization rate should be applied. It is at the appraiser’s discretion to apply a certain return on investment and capitalization rate. The factors that influence the capitalization rate include (1) the nature of the business, (2) the risk involved, and (3) the stability of earnings.
To illustrate the “formula” approach, assume ABC Company has $1,000,000 net asset value under the underlying asset method. The next step is to apply a 9 percent return on assets. This would be equal to $90,000. Then, as determined by the earnings capacity method, the actual average annual earnings after taxes equaled to $150,000. If we subtract the $90,000 from the $150,000 we can determine if any profits were made as a result of goodwill. In the present situation, the difference is $60,000. We then take the $60,000 and apply a capitalization rate. In this situation, an 18 percent rate was determined to be applicable. Applying the rate results in goodwill equaling $333,333. In addition to the capitalization method, many appraisers will apply a second method to the excess earnings using a present value factor. The two methods would then be averaged. However, the second method is outside the scope of this article. A future article will explain the proper use of the present value concept coupled with an appropriate growth rate. Once goodwill is calculated, the result can be added to the underlying value of assets to determine the overall value of the company based upon the underlying value of assets method including goodwill. In the present situation, the net assets were valued at $1,000,000. Adding the goodwill determined under the capitalization approach of $333,333, we get the value of the ABC Company to be $1,333,333. Here is a summary of how it was computed:
Value of net assets from underlying asset method $1,000,000
Average Annual Earnings from earnings method 150,000
Apply 9 percent ROI to value of net assets ($1,000,000 x .09) 90,000
Excess Earnings (150,000 – 90,000) 60,000
Apply Capitalization Rate (60,000/.18) divide by .18
Add Goodwill to Value of Net Assets 1,000,000
Value of ABC Co. using Underlying Asset Method $1,333,333
Don’t overlook this additional method in valuing a business. Goodwill, though conceptually simple, can and often is very arbitrary. As can be seen from the above example, the most difficult part of the calculation is determining the ROI and capitalization rate. Professional guidance is necessary to maintain the objectivity of any goodwill determination, as well as to preserve the deductibility of any amounts paid for goodwill.
Publication date: 8/8/2016