How Goodwill Affects the Value of Small Business

By Jerry Barney Friday, May 29, 2009

The term “goodwill value” is a term of art that is applied to the incremental increase in value of an enterprise over and above the simple replacement value of the fixed assets. Unless it is added to a balance sheet reflecting an actual purchase of goodwill in an acquisition, it almost never is seen on a balance sheet based upon Book Value. It is the primary reason for business appraisals, and a necessary element to determine the actual Fair Market Value of a business enterprise.

Two Basic Potential Components of Goodwill

  1. The basic form of goodwill is called “Enterprise Goodwill.” It applies to the business as a whole and exists regardless of the increment of value resulting from a key person’s personal knowledge, reputation, customer relationships or any other attribute which resides in his/her persona. It generally reflects a value which would exist without the participation or contributions of one or more key officers or employees.
  2. Personal and Professional Goodwill are very similar and they attach to the individual that contributes them. Personal Goodwill is associated with individuals. It is the part of increased earning capacity that results from the reputation, knowledge and skills of individual people, and is non transferable and unmarketable. An example would be the CEO of a small business that has long-term personal relationships with the customer base, which could (or likely would) be lost if the person were no longer involved in the business.

Similar to Personal Goodwill, Professional Goodwill is often characterized as "conceptually distinct from that associated with a trade or business," and attached to the individual. It is usually associated with reputation and experience. In most professional practices, Professional Goodwill is largely dependent upon the skills and attributes of the individual practitioners.

There are two basic reasons for valuing Personal/Professional Goodwill, Marital Dissolutions and Sales of Businesses.

The most common reason for an actual appraisal of Personal/Professional Goodwill value is marital dissolutions. This is because it varies widely from state to state, as determined by case law. The two issues are whether Enterprise Goodwill and/or Personal/Professional Goodwill are included in the marital estate. Our research shows the following:

  • In six states, neither Personal/Professional Goodwill nor Enterprise Goodwill is included in the marital estate.
  • In four states, the issues are undecided.
  • In 40 states, Enterprise Goodwill is included, but in 24 of these, Personal/Professional Goodwill is not.

Typically, a business appraisal obtained by a seller will not consider Personal Goodwill as separate from Enterprise Goodwill unless the entity is a C-Corporation. This is because normally, any Personal Goodwill is mitigated in the purchase and sale agreement to provide a means whereby the buyer will inherit the Personal Goodwill of the seller. This can be achieved with such tools as:

  • Non-Compete Agreements
  • Retaining the seller as a key employee for a defined period of time
  • Partial buy-in, with a buy-out later.

The objective of all the above tools is to create time and exposure to the buyer by the client or customer base to allow them to become inured to the purchaser.

The principal reason a seller will want to know what percentage of the total Goodwill Value is Personal/Professional is that these can often be mitigated prior to the sale by effectively transferring the Personal/Professional goodwill to key employees. This typically results in the buyer's willingness to pay a higher price for the business.

If Personal/Professional Goodwill is mitigated, it also opens the field to investor-buyers as opposed to operator-buyers. For more valuable businesses, the investor-buyer is likely the most efficacious way to sell.

The biggest problem for owners of C-corporations is the double taxation of capital gains upon a sale. First, it is taxable to the corporation, then when distributed to the shareholders, it is taxed again at the personal tax level. This is not the case with proprietorships, partnerships, LLCs or S-Corps.

However, when Personal Goodwill is part of the sale, it can be structured as two separate transactions. One is a sale of the C-corporation’s interest (either stock sale or asset sale) and the other is a personal sale of Personal/Professional Goodwill, which will then be taxed only at the personal rate.

*Disclaimer*: Harvard Business Services, Inc. is neither a law firm nor an accounting firm and, even in cases where the author is an attorney, or a tax professional, nothing in this article constitutes legal or tax advice. This article provides general commentary on, and analysis of, the subject addressed. We strongly advise that you consult an attorney or tax professional to receive legal or tax guidance tailored to your specific circumstances. Any action taken or not taken based on this article is at your own risk. If an article cites or provides a link to third-party sources or websites, Harvard Business Services, Inc. is not responsible for and makes no representations regarding such source’s content or accuracy. Opinions expressed in this article do not necessarily reflect those of Harvard Business Services, Inc.

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