Goodwill: what is it? & how do you calculate it?

You want to sell a business. Then you have to deal with the sale of stock, inventory, personnel, customers and other things. But you also sell the non-tangible capital gain of your business, goodwill. But what exactly is this?

Content:

1. What is goodwill on the balance sheet?
2. Goodwill factors
3. Different types of added value
4. Is badwill also on the balance sheet?
5. How to calculate goodwill?
6. Calculating goodwill: which formula to use?
7. When is goodwill paid?
8. The goodwill of the tax authorities

1. What is goodwill on the balance sheet?

Goodwill is an important factor in determining the price when you sell your company. This is because it is the non-tangible added value of a business, generating additional profit. Of course, it is important that it also carries profit potential for the future, otherwise it is of no use to the buyer.

2. Goodwill factors

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.

Therefore, look beyond the indicative value and do 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. Different types of added value

This added value for a company can be divided into two types:

1. Corporate goodwill
2. Personal goodwill

1. Company Goodwill

To begin with, you have corporate goodwill. Is the company generating extra profit because they offer an innovative product? Is there a structural increase in revenue because the staff provides exceptional service? Then you have an edge when selling your business, because this form of goodwill is transferable.

2. Personal goodwill

Personal goodwill rests with the entrepreneur himself. The extra profit is entirely in the hands of the entrepreneur himself. This one, for example, has exceptional talent or a special personal bond with each customer. This is tricky. Because the business may be doing extremely well now, but if the entrepreneur sells a business and leaves, the goodwill goes with him.

4. Is badwill also on the balance sheet?

Unlike goodwill, badwill can actually take a bite out of the proceeds of your business sale. The buyer will pay less for your company because of reputational damage, for example. This negative goodwill is not on the balance sheet yet, but it is relevant for the future. Examples of badwill are:

• Image damage;
• Fraudulent trading;
• Claims;
• A bad business location;
• Obsolescence of technological equipment.

5. How to calculate goodwill?

Goodwill is difference between the market value and the final amount paid, but why can it make a world of difference? How do you calculate goodwill, when it is mostly 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 by taking the fair value of the assets and liabilities. This includes inventory and machinery to get a good idea of the equity present.

Then you move on to the second step, but it comes in different forms.

Step 2: Determine a goodwill formula and calculate what the excess value due to goodwill is.

6. Calculating goodwill: which formula to use?

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 is focused on the future. What are the financial expectations for the coming years; what is the expected cash flow? So it does not just look at what the business has brought in, but rather what can be earned in the future. The DCF method is generally considered an obvious formula, about which you can read an extensive article here.

2. Profit formula calculation

In this calculation one mainly looks at the surplus profit. You map this out by multiplying the past three years by a factor of 3 to 5. The profit is corrected by deducting extraordinary income and expenses, as well as the entrepreneur's salary. Industry, location and reputation are also taken into account.

3. EBITDA multiple formula

EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. EBITDA is a simple number, which you can read more about in this article. You multiply this number by up to 10 for an SME, but for a large business it can be as high as 20. The business valuation is based on annual figures for 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. The goodwill of the tax authorities

If your business is succeeded by a family member, be aware that the tax authorities are extra alert to the goodwill valuation. Within family relationships you tend to set this value lower, so that your son or daughter does not pay the highest price for the acquisition. The tax authorities are not so of good will in that case. In their audits, they determine the goodwill value themselves by multiplying the excess profit by a factor of 2.5 to 3. You then still pay tax on this amount, regardless of whether the goodwill value was paid.