How does goodwill impact my small business?
When we consider what a business is worth, whether to buy or sell, there are many factors that determine value. This is why two businesses that perform the same services and have the same net income can be sold for drastically different prices. The fact is that the tangible assets of a business and even the cash in the bank are only partial indicators of a business’s worth. It is the often the many intangible assets of a business that buyers find attractive. The name given to these intangible assets is goodwill.
Goodwill is the value of all of the intangible assets of a firm. The only time you ever see a number in your financials related to goodwill is when you buy a company. Then goodwill is included on the updated balance sheet of the purchasing firm to represent the premium paid for the intangible assets of the target company. The chart of several types of assets (at right) gives a sample of the sort of things that make up goodwill.
How is Goodwill calculated?
The formal calculation of goodwill in large scale M&A work is a complex process that requires identifying each intangible asset from an acquired business and assigning a value to them. The value of each asset is totaled and that becomes the value of Goodwill. This is typically done prior to selling the business so the owner can go into negotiations knowing the fair value of their business, because goodwill cannot be internally generated and put onto a balance sheet, only acquired. In the small business world, the calculation of goodwill is often more of a gut feeling the owner has that the business is worth a certain amount, and that gut check is often borne out by other measures, such as comparable business sales and the overall owner benefit of the company. Goodwill is the way to rectify the true value of the business (as agreed upon by the buyer and seller) and basic book value, which is usually much lower.
A few examples will bears this out.
A real estate purchase is something that most people understand, so it provides a good example of the power of intangible assets. The price of materials, labor and land that it takes to build a house are only one of many factors that set the price of a home. Intangible assets like the low crime rate in the area or the great school district, proximity to the city or the country, depending upon your preference, and a host of other considerations are taken into account.
To apply this to a small business, let’s say a buyer and seller agreed to a business transaction at a price of $650,000. But the book value of the business is only $300,000, as shown below. The difference between the assets and liabilities on the balance sheet are subtracted from the purchase price of the target business. The remainder is that business’s goodwill.
Goodwill = Purchase Price – (Assets-Liabilities)
The difference between those will be the amount recorded on the acquiring business’s balance sheet as goodwill.
Once goodwill is recorded on a business’s balance sheet, it must be updated, per GAAP standards, at least once per year. GAAP standards do not apply to most small businesses, but they are worth understanding.
To update goodwill, an impairment test must be done. This, like the original calculation of goodwill, impairment is a complex calculation that involves assessing each individual intangible asset’s current value. If the impairment test shows no change or a positive change, the amount of goodwill on the balance sheet remains the same. If it shows a negative change, then that will be marked down on the balance sheet and be shown as a credit on the year’s earnings to show the loss in value. Goodwill as a line on your balance sheet can marked down, but never goes up.
For most small businesses who do not have to follow GAAP, goodwill may appear on their balance sheet following the purchase of another company, but it rarely, if ever, is adjusted.
Even though goodwill cannot be recorded on a balance sheet merely from the ever increasing value of your internal operations, it is still an important part of valuing your business. Things like
- Your brand,
- The loyalty of your employees,
- Customer and vendor relationships,
- Systems,
- Training and
- Intellectual property
are all important elements of running a business that will increase the value of your business.
