Goodwill refers to the value of intangible assets in a business. In this video, John Carvalho, president of Stone Oak Capital and co-founder of Divestopedia.com, discusses goodwill, how to calculate it and how it impacts the calculation of a business's value. Check it out, and note the transcript below.
Hey everybody, John Carvalho here from Stone Oak Capital.
Today we're going to talk about a concept that's going to help you determine a realistic valuation for your business. That concept is goodwill.
What is Goodwill?
What exactly is goodwill? Goodwill is just the value of your business less the tangible assets within your business—tangible assets are items like working capital, property, plant, and equipment, so anything over and above the hard assets in your business is going to be considered goodwill. (Read also: How do you value intangible assets in a business sale?)
If we were doing a real simple calculation, we would take a purchase price, somebody comes around and offers you a purchase price of $10 million for your business. You’re assessing your tangible assets within your business—again that's the working capital, property, plant, and equipment—and you value that at $7 million dollars, the remaining amount or that $3 million (10 million less the 7 million) is going to be considered the goodwill within your business. The value that's attributable to items that you can't really put your finger on, or you can't wrap your arms around—the intangible assets within the business.
If we were putting a little bit more substance around what exactly is goodwill, it would be things like your brand, your trade name, it would be things like customer relationships.
You know how long you've had customers, and what's the turnover of some of those customers. It might be things like supplier agreements, it would also be your assembled workforce. So all of the procedures, policies, everything that makes your company tick.
There also might be items such as patents and technologies within your business that's going to add to the value of goodwill. It brings a little bit more substance to this very nebulous concept, this nebulous idea of an intangible asset within your business.
Determining Realistic Value and Goodwill
I believe the concept of goodwill is really important in determining a realistic value because in my experience most buyers will put a ceiling on the amount of goodwill that they're willing to pay for a mid-market business.
So try this exercise: think about the value that you would find acceptable when you're selling your business, deduct all of the tangible assets that would be included in that value—so again that’s going to be the working capital, the property, plant, and equipment, which we’ve already discussed—the residual value is goodwill.
If that goodwill makes up 50% or more of the total valuation that you have kind of put in your mind, or putting your head, as being realistic then you have a little bit of work to do in really justifying what makes up that amount. (Read also: How Goodwill Impacts Business Value.)
Is that amount related to the relationship with your customers, is that amount related to some sort of proprietary process that you have in your business, is that amount related to growth that you're seeing in your business year-over-year? Again, take some time and think about what that value is attributable to, and be sure that you're able to communicate that to a prospective buyer.
I really encourage all business owners to try that real simple exercise of taking your expected Value, less your tangible assets, to figure out where your goodwill is.
Thanks everybody for watching, I hope that this simple exercise will help you understand and look at a realistic value for your business, if you have any questions please leave comments below and I'll be sure to get back to you. If you'd like to hear more about selling mid-market businesses or valuations around market businesses please subscribe to our YouTube channel.