Goodwill is the intangible added value of a business beyond the market value of its assets and liabilities: the amount a buyer pays extra for things like brand recognition, a loyal customer base, and well-trained staff. You calculate goodwill by subtracting the market value of the assets and liabilities from the purchase price. The opposite, badwill, actually reduces a business’s selling price.
You want to sell a business. That means dealing with the sale of inventory, assets, staff, customers, and other matters. But you’re also selling the intangible added value of your business: goodwill. But what exactly is it?
Content:
- What is goodwill on the balance sheet?
- What factors influence the value of goodwill?
- What types of goodwill are there?
- Is badwill also on the balance sheet?
- How do you calculate goodwill?
- What formulas do you use to calculate goodwill?
- When is goodwill paid?
- How does the Tax Authority view goodwill in the context of business succession within a family?
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1. What is goodwill on the balance sheet?
Goodwill is an important factor in determining the price when you sell a business. It represents the intangible added value of a business, which generates additional profit. Of course, it’s important that this also holds future profit potential; otherwise, it’s of no use to the buyer.
2. What factors influence the value of goodwill?
The indicative goodwill value is a starting point for acquisition negotiations. And while a high profit forecast also produces a high goodwill value, this does not directly say anything about the value of the business. Because there are several factors that affect goodwill, such as:
- The sector: if the sector nationwide is experiencing difficult times due to, for example, supply issues or low margins, this directly affects the goodwill value
- The owner: knowledgeable personnel provide a high goodwill indication, but in the event of a takeover it is quite possible that this knowledgeable personnel will seek refuge elsewhere. How high then is your goodwill value?
- Market developments: if you have taken over a business which has potential but requires substantial investments to maintain its position, this also has a direct impact on your goodwill value.
That’s why you should look beyond the indicative value and conduct thorough research into the business’s potential.
Examples of positive goodwill are:
- A strong brand/name recognition;
- Business image;
- Excellent trained staff;
- Business location;
- Fixed customer base;
- Patents;
- High level of knowledge;
- Large market share.
3. What types of goodwill are there?
This added value for a company can be divided into two types:
- Corporate goodwill
- Personal goodwill
1. Business Goodwill
First, there’s business goodwill. Does the company generate extra profit by offering an innovative product? Has revenue consistently increased because the staff provides exceptional service? If so, you’ll have an advantage when selling your business, because this type of goodwill is transferable.
2. Personal goodwill
Personal goodwill is based on the entrepreneur themselves. The additional profit belongs entirely to the entrepreneur. For example, the entrepreneur may have an exceptional talent or a special personal connection with every customer. This is tricky. Because even though the business may be doing exceptionally well right now, if the entrepreneur sells a business and leaves, the goodwill goes with them.
4. Is badwill also on the balance sheet?
Unlike goodwill, badwill can actually take a bite out of the proceeds from the sale of your business. The buyer pays less for your company because, for example, there is reputational damage. This negative goodwill isn’t yet on the balance sheet, but it is relevant for the future. Examples of badwill include:
- Image damage;
- Fraudulent trading;
- Claims;
- A bad business location;
- Obsolescence of technological equipment.
5. How do you calculate goodwill?
Goodwill is the difference between the amount ultimately paid (the purchase price) and the market value of the assets and liabilities, but why can this make a world of difference? How do you calculate goodwill, if it’s mainly a matter of subjective judgment? There are several formulas for this.
It depends on the interests of buyer and seller which business valuation formula is applied. However, the first step is the same in almost all cases:
Step 1: Determine the market value based on the fair value of the assets and liabilities. This also includes inventory and machinery, so that an accurate picture of the available equity is formed.
Then you move on to the second step, but it comes in different forms.
Step 2: Determine a goodwill formula and calculate the surplus value attributable to goodwill:
Goodwill = purchase price − market value of assets and liabilities
6. What formulas do you use to calculate goodwill?
So there are different formulas to calculate the value of goodwill. We will discuss three of them in this article.
1. Discounted cash flow method (DCF method).
This method focuses on the future. What are the financial projections for the coming years? What is the expected cash flow? In other words, it doesn’t just look at what the business has generated, but rather at what it can earn in the future. The DCF method is generally considered a straightforward formula; you can read an in-depth article about it here.
2. Profit formula calculation
This calculation focuses primarily on excess profit. You determine this by multiplying the profits from the past three years by a factor of 3 to 5. The profit is adjusted by subtracting extraordinary income and expenses, as well as the entrepreneur’s salary. The industry, location, and reputation are also taken into account.
3. EBITDA multiple formula
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. The EBITDA figure is a simple number, which you can read more about in this article. For an SME, you multiply this number by up to 10, but for a large business, this can go as high as 20. The company valuation is based on the annual financial results from the past 3 to 5 years.
7. When is goodwill paid?
Much of the goodwill is paid immediately upon the transfer of the business. It is mandatory to capitalize goodwill, i.e. put it on the balance sheet. The amount paid is legally an investment, which must be amortized within five to 10 years. A percentage of minimum 10% and maximum 20% can be amortized per year.
8. How does the Tax Authority view goodwill in the context of business succession within a family?
If a family member is taking over your business, be aware that the tax authorities are paying extra attention to how goodwill is valued. Within family relationships, there’s a greater tendency to set this value a bit lower so that your son or daughter doesn’t pay top dollar for the takeover. In such cases, the tax authorities are not so accommodating. During their audits, they determine the goodwill value themselves by multiplying the excess profit by a factor of 2.5 to 3. You will then still have to pay tax on this amount, regardless of whether the goodwill value was actually paid.
Frequently Asked Questions About Goodwill
What is goodwill in a business sale?
Goodwill is the intangible added value of a business: the amount a buyer pays above the market value of the assets and liabilities for factors such as brand recognition, a loyal customer base, a prime business location, or a well-trained workforce. Goodwill is only worth something if it also generates future profits for the buyer.
What is the difference between business goodwill and personal goodwill?
Business goodwill is inherent in the business itself (such as an innovative product or exceptional service) and is transferable to the buyer. Personal goodwill is based on the entrepreneur themselves—such as exceptional talent or personal customer relationships—and often disappears as soon as the entrepreneur leaves.
What is badwill?
Badwill is negative goodwill: the buyer actually pays less for a business, for example, due to damage to its reputation, fraudulent conduct, damage claims, a poor business location, or outdated technology.
How do you calculate goodwill?
First, you determine the market value of the assets and liabilities (the fair value, including inventory and machinery). Next, you use a goodwill formula (such as the DCF method, the excess profit formula, or the EBITDA multiple) to calculate the excess value above that market value. Goodwill is then the difference between the final purchase price and the market value of the assets and liabilities.
When is goodwill paid and amortized?
Goodwill is typically paid in large part immediately upon the transfer and must be capitalized on the balance sheet by law. The buyer then amortizes this amount over five to ten years, at an annual rate of between 10% and 20%.
How does the Tax Authority view goodwill in the context of business succession within a family?
When transferring a business to a family member, the Tax Authority is particularly vigilant, as the goodwill is sometimes deliberately undervalued. During an audit, the tax authorities determine the goodwill value themselves by multiplying the excess profit by a factor of 2.5 to 3, and you’ll still have to pay tax on that amount, regardless of whether the goodwill was actually paid out.
