Calculating the Value of Goodwill in a Business Sale

Calculating the Value of Goodwill in a Business Sale

With Robert Hurst, Principal, Hurst Partners

Goodwill is one of the most important elements in any business sale, and also one of the hardest to put a price on. Put very simply, goodwill is the dollar amount you put on the business’s name, reputation, location and history.

There are several ways to calculate this figure but in short, it’s the difference between your identifiable assets and what a buyer is willing to pay for your organisation. For example, your business is for sale at $500,000 of which $250,000 of the asking price is made up of tangible assets such as fixtures and fittings, plant, equipment, trading stock etc. That means you are asking $250,000 for goodwill.

That’s a very simplified example but it gives you the idea.

Goodwill could sometimes be considered as the premium a purchaser pays over and above the value of the business assets for not having to go through the expense and risks associated with starting a business from scratch.  It also enables a purchaser to derive an immediate income rather than relying on the business to grow sufficiently enough to provide the owner with an income without jeopardising the cash flow of the business. 

There are several ways to value a business, particularly in relation to Small or Medium-sized Enterprises (SMEs) and to identify any goodwill within those businesses.   

The three most commonly used are: 

1. The Capitalisation of Earnings methodology.

2. The Asset-Based methodology.

3. Industry-based Formulas also referred to as Market-Based Methodology

The methodology adopted will depend upon the nature of the business, the industry in which the business operates, and activity in the current market for the sale of businesses, either in a specific field or in general.

Usually, a business valuer will consider two or three of the methodologies available and adopt the most suitable.

Capitalisation of Future Earnings:

This method works by calculating the worth of a business’s anticipated profits based on current earnings and expected future performance. The formula is Net Present Value (NPV) divided by Capitalisation rate.

Asset-Based Methodology: 

This is used when the value of the tangible assets (plant and equipment, fixtures and fittings, vehicles, machinery, stock etc) exceed an amount arrived at by the capitalisation of earnings.  In this instance, there would be no goodwill present.

Industry-based Formulas: 

Or Market Based Methodologies are often used where there are sufficient sales (market evidence) of businesses within a particular industry or profession to analyse and identify the basis on which these businesses are being sold. 

Businesses such as real estate agencies, accounting practices and legal practices are often valued on the basis of a multiple of the gross income; the nature of the business and the type of client base will determine the multiple.  Businesses valued on this basis may have a very large component of goodwill as the value of the tangible assets would mainly relate to office fit-out and equipment.

For businesses with a large investment in stock, inventory, plant or machinery, such as hardware, timber and manufacturing businesses, a percentage of turnover (gross income) plus the value of stock or plant and equipment could decide the goodwill component.  This is not dissimilar to the asset-based methodology with the exception that purchasers are prepared to accept that a component of goodwill does exist due to the established nature or ‘going concern value’ of the business.  

Prospective buyers will want to see previous financials of the business to back up your valuation, so you need to be well prepared. Whilst it is easy to prove turnover and hard assets, it’s harder to show the value of brand recognition, customer loyalty and Intellectual Property.

Very often, the goodwill revolves around the current business owner. This is sometimes referred to as ‘personal goodwill’, as opposed to local goodwill (location). Personal goodwill refers to the skills of the owner, reputation and customer base. Without goodwill, the business is merely premises, equipment and furniture.

If you are planning to sell your business, it is very important to maintain and protect the goodwill to achieve the best price. Once a contract has been placed on the business, be sure to maintain that goodwill until completion.

With over 40 years’ experience in the industry, Robert Hurst has extensive experience in engineering, manufacturing, hardware/timber retail and agency/distribution businesses. A Fellow of the Real Estate Institute of Australia and the Australian Institute of Business Brokers, Robert is a Certified Practising Business Broker & Registered Business Valuer (AIBB), an Accredited Business Broker (REIV) and a Licensed Real Estate Agent and Business Broker in Victoria and New South Wales.

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