How to Value Goodwill in Business
If you’re selling your business or buying one, there’s one fundamental step you can’t skirt around: how to value your business for sale and how to value goodwill.
If you don’t know the value of goodwill, you may needlessly pay more for a business acquisition or sell a company for less than its true value.
What Is Goodwill?
The concept of goodwill is the excess amount a buyer pays above the fair market value of the seller’s net assets when selling a business.
It’s the classic illustration of the phrase, “The whole is greater than the sum of its parts.”
The goodwill amount paid above the sales price is often attributed to customer loyalty, customer base, or brand recognition.
These are intangible business assets with value, but aren’t shown on a seller’s financial statements, primarily because generally accepted accounting principles (GAAP) don’t allow them.
Here’s How to Calculate Business Goodwill
To calculate goodwill, a buyer takes the purchase price and subtracts the fair value of the seller’s net assets.
Net assets are the value of a company’s assets less its liabilities.
Here’s the goodwill calculation as a formula:
Goodwill = P – (A – L)
In the formula above:
- “P” represents the purchase price,
- “A” is business assets, and
- “L” is company liabilities
The value of the business assets and liabilities in calculating goodwill is not book value, but fair market value or fair value.
Book value, as the name implies, is the value of a company’s assets and liabilities as they appear on its balance sheet. And since assets and liabilities are recorded at their original cost, this might not always equal the fair value.
But, fair value is the agreed-upon price between a willing buyer and a willing seller in a transaction in a free market that can include numerous subjective factors like:
- Perceived risk
- Market conditions
- Expected growth
In the end, the buyer will record purchased goodwill.
Examples of Goodwill
Let’s assume the book value of assets and liabilities on the seller’s balance sheet is $150,000 and $40,000, respectively.
Suppose also that at the time of sale, those assets could be sold for $230,000 and liabilities settled for the same balance sheet amount of $40,000.
How much will the goodwill be, assuming you’ve agreed on a purchase price of $400,000?
The goodwill will be:
$400,000 (P) – [$230,000 (A) - $40,000 (L)] = $210,000
Notice we used the fair value, not the book value.
Consequently, $210,000 will appear as goodwill in the buyer’s books until an impairment test reveals you should lower the amount.
What Is Goodwill Impairment and How and Why Are They Tested?
In accounting, impairment refers to a reduction in the fair value of an asset. Obsolescence, legal challenges, or increased competition could cause this.
Here’s how it works.
Goodwill is considered an indefinite asset. It doesn’t diminish or wear out over time like tangible assets, such as a machine or a car.
Since goodwill doesn’t wear out, it sits on the balance sheet indefinitely. So you don’t record depreciation like you would for equipment.
Each year, business owners should use their judgment, relevant current events, and data to assess if the goodwill has become impaired and lost value.
Without an annual review, goodwill may be overstated, and your company’s balance sheet may be incorrect.
How Does Goodwill Differ From Other Intangible Assets?
The fundamental difference between goodwill and other intangible assets is that goodwill cannot be sold independently, unlike intellectual property such as patents and copyrights.
To sell goodwill would require selling your entire business. But you could sell a patent to a competitor or assign a copyright to someone else.
What Are the Limitations of Goodwill?
The main limitation of goodwill is the difficulty in pricing. Determining a fair value of an asset can be problematic in the absence of an active market. Typically, business valuation experts determine the fair value of a company.
To assess the true value of a business, calculating goodwill is an essential step. Whether you’re in the market to sell or buy a business, understanding the true value of goodwill will ensure a smooth negotiation process. Consult an accountant to understand the implications of how goodwill is taxed when buying or selling a business.