By Maurie Cashman
Goodwill is probably one of the most misunderstood and mishandled financial components of ownership transactions. Many business owners have been convinced by aggressive buyers and their advisors that â€œblue skyâ€ has no value and that they wonâ€™t pay for it. It is a real component of business value that needs to be evaluated and properly managed in a business transaction. Goodwill is not â€œblue skyâ€ as so many in the transaction like to call it – one of my personal pet peeves.
Letâ€™s start with a definition of goodwill. Divestopedia defines goodwill as the value of the intangible assets acquired in a business acquisition. The amount of goodwill is calculated by first determining the enterprise value of the business, and then deducting the tangible net assets.
Goodwill that is tied to the owner and not the business is called personal goodwill, which is not transferable and has little or no commercial value. Goodwill that can be transferred to a buyer has commercial value, and therefore is usually paid up for by buyers.
I am currently working with a service business that is quite successful. We are working to transition ownership from father to son over a five year period in a stock transaction. We first established what the business might be worth on the market and then adjusted the transaction to fit the transaction to meet the needs of the family.
There are very few â€œtangibleâ€ assets involved in this transaction. However, there is tremendous value that has been built up over twenty years of relationships, expertise, reputation, honesty and integrity of this company. This goodwill resided primarily with the father but the apple doesnâ€™t fall far from the tree and we believe that this goodwill can be transferred to the son with time. The son also brings additional experience from his work with another company in a related field that the firm does not currently possess.
The goodwill is heavily tied to the owner in this case but also attaches to the business to some extent. It is also transferrable to the business if the father will remain with the business for a period of time sufficient to transfer relationships with key customers to the son. Therefore, in this case nearly all of the value of the business is personal goodwill, has tremendous value to certain buyers in particular and is very transferrable.
The advantage of establishing personal goodwill accrues primarily to the seller, who is able to recognize this goodwill over five years after sale of the stock as long term capital gains. There is a disadvantage to the buyer in that the goodwill will have to be amortized over fifteen years.
In many transactions, particularly those involving sales to third parties, the buyer does not want to recognize personal goodwill since it has a long write-off period. This personal goodwill is often disguised as an earn-out, which is contingent and can be expensed as paid. There is nothing wrong with this, but it is a method of asset allocation that many sellers are completely unaware of and the tax ramifications can be significant for both parties.
To be sure, tangible goodwill is separate from personal goodwill. Tangible goodwill stems from things like long-term contracts that can be valued based on probability of fulfillment and managed differently for tax purposes.
In order to establish Personal Goodwill, the executive should have unique qualifications such as a license to practice law, medicine, accounting, or other profession, related professional licenses, industry awards recognizing the executiveâ€™s unique abilities, and/or a history of outstanding sales, management, or leadership ability. Among the additional qualifications:
- the individual makes essentially all significant management decisions regarding the business entity,
- the operations of the company or practice are not functionally or economically separate from the individual, and
- the success of the business entity is directly related to the activities of the individual.
If Personal Goodwill exists it can be the difference between consummating a transaction and not. The owner of the Personal Goodwill, generally the business owner, can recognize this as capital gains over five years. This is a significant advantage over taking this payment as ordinary income. The offset to this is that the buyer must amortize Personal Goodwill over 15 years, a disadvantage to a buyer who wishes to write off expenses more rapidly. This is why it is often overlooked.
When valuing your company for a transition it is important to work with qualified advisors including an experienced valuation professional, a qualified tax expert and transaction attorney so that you donâ€™t pay Uncle Sam more than he deserves.