The term goodwill gets bandied about a lot in the business world, but I find it is often misunderstood. There are a few definitions, but generally only two of them apply in a business sense:

1. the favour or advantage that a business has acquired especially through its brands and its good reputation
2. the excess of the purchase price of a company over its book value which represents the value of goodwill as an intangible asset for accounting purposes
   Source: https://www.merriam-webster.com/dictionary/goodwill accessed 24 November 2022

Strangely enough, they are both correct... However, whilst goodwill does relate to the advantage enjoyed by a business due to its good reputation and brands (amongst other things), it does not have any value unless it satisfies the test set out in the second definition! If there is no excess in price (or valuation) over book value, there is no goodwill detected. So, one definition describes the nature of the beast and the other provides the accounting-based determination of how to recognise its presence.

There seems to be a school of thought that a business must possess goodwill simply because it might own a pretty website, or maybe an Instagram following of 1000 people, has 5-star Google Reviews, owns a patent, or that its people possess some specialist knowledge or edgy haircuts. However, a business does not possess goodwill just because one or more of those (and many other) things are present. It doesn’t exist just because you think it ought to! Simply put, goodwill is the difference between the sales price of the business and the fair market value of its assets used in earning business income. Goodwill is a mathematical formula. The formula is simply telling you what a prospective purchaser would pay over and above the value of your assets to own the business… the difference is a measure of just how badly they want it!

Unfortunately, many business owners get the wrong end of the stick when they try to work out what their business might be worth. For instance, I have seen many valuations where businesses are being valued by attempting to determine the value of goodwill and then adding that amount to the value of the assets of the business. This is in fact the direct opposite of how goodwill is calculated. Goodwill is intangible. You can't touch it, see it, smell it… so how can you work out what it's worth? The answer is surprisingly easy: you work out what someone would pay for the business, you work out what the value of all of the tangible assets are, and you take them away from that purchase price. What’s left is that murky, intangible thing that we call goodwill. You can’t even look at it for fear it will slink away… it is simply that mysterious. If the purchase price changes by even one dollar, so does the goodwill. If the value of the other assets forming a part of the sale changes, so does the goodwill… They are each intrinsically linked, and goodwill cannot exist independently of the other two.

OK, so I have probably got a little too passionate about the definition of goodwill there. Anyway, moving on…

I've lost count of the number of small business owners who have come to me asking to have their business valued and are surprised when I tell them that their business either does not possess any goodwill or that it is minimal. I'm not going to get into the nitty-gritty of how a business is valued or the various methodologies that can be adopted in valuing different businesses. This is neither the time nor the place. Instead, here are a few (general) home truths for why your business might not have any goodwill:

1. If the business is mature and has a history of being unprofitable or highly volatile, it likely does not possess goodwill. Nobody wants to buy a business that they then have to put extra money into each year.
2. If you are the business owner and do not draw a commercial salary for the work you do in the business, I will remove a commercial salary from the profit of the business. If there is now no profit, refer to Tip 1. No one should have to pay a multiple of their own salary to purchase a job. And no one wants to buy a business that does not make a profit.
3. Telling me that the business could be profitable if the purchaser was to invest in marketing, change the business, or some other way of creating profit, you are likely telling me this because the business doesn’t make a profit. Refer to Tip 1. You are selling your business as it is right now, not some fantasy version of what the business could be under certain circumstances.
4. If your business owns a patent, trademark, or other intellectual property but does not make a profit, refer to Tip 1. Sure, you might be able to sell the patent or trademark if it has some value to a third party, but the business doesn't seem to be benefiting from it, and thus it does not possess goodwill.
5. Just because there is a line item called goodwill on your balance sheet, does not necessarily mean that your business still possesses goodwill. The real question is does the business make a profit? If no, refer to Tip 1.
6. Just because your business has allowed you to live a comfortable lifestyle does not mean that the business possesses goodwill. Often business owners have been pulling out way more from their businesses than they ought to, creating large shareholder loan accounts. Once again, does the business make a profit? If no, refer to Tip 1
7. You can't expect to use your business as a vehicle for personal expenditure and tax minimisation and expect a valuer or prospective purchaser to ignore the financial results you have communicated to the tax office. Refer to tip 1.

Obviously, there are exceptions to these ‘Tips’. For instance, start-up businesses are often valued on the basis of cash flow forecasts rather than historical earnings, so they may show goodwill despite not even earning a dollar of revenue yet. But if you don’t have forecasts, we have nothing to hang our hat on when performing the valuation…

Essentially, a business valuer is there to independently assess the business to work out what it might be sold for in a fair market transaction. We rely upon evidence, such as your published financial statements, management reporting, and the business owner’s assertions to come to a balanced assessment based on market research, experience, and expertise. These valuations are often relied upon by a purchaser to decide on whether or not to buy, so valuers tend to be pretty risk-averse and won’t make a statement unless we can back it up with evidence.

The point of this (as it feels like more of a rant than an article at this stage), is that if you want to sell your business, you need the evidence to tell your valuer and the potential purchaser a compelling story about why it is a sound investment and that it is worth more than the total value of its net tangible assets. Why? Because it is profitable. It is consistent. It is relatively low risk… and did I mention profitable?

It’s much more likely that a valuer or purchaser will identify valuable goodwill if you are prepared for the transaction in advance. It is impossible to make your prior years look better than they were, but it is possible to make changes now that will make the business desirable in the future. Start preparing for your exit now. It’s never too late (unless of course, it is now too late).