Sale of Goodwill Agreement: Asking Price vs. Fair Market Value

When selling your business, knowing how to determine the value of your goodwill is critical. Goodwill can be challenging to quantify, but it’s often one of the most valuable parts of a business.

Before you sign a sale of goodwill agreement, take some time to understand the concept of goodwill and how to calculate goodwill using the two main valuation methods. 

What Is Goodwill in a Business Sale?

The goodwill legal definition describes an intangible asset that increases a business’s value beyond its calculated book value. It includes essential factors like reputation and other core aspects of a business’s profit engine, such as proprietary technology and employee relations.

Goodwill comes from two sources: internally generated goodwill and purchased goodwill. Internally generated goodwill is created when a business provides excellent customer service, builds a strong reputation or brand, and develops customer loyalty. This type of goodwill is often challenging to quantify but can be precious.

On the other hand, purchased goodwill is created when a business buys another business or assets that include goodwill. This type of goodwill is often easier to quantify, but it can be challenging to maintain over time.

Common Examples of Goodwill Assets

Some goodwill assets examples include a strong reputation, a large and loyal customer base, and a unique location. It can also be a well-trained workforce, valuable intellectual property, and favorable lease terms. All of these can increase the value of a business and should be considered when valuing goodwill.

Strong Reputation

A strong reputation can be challenging to quantify, but it is nonetheless one of the most valuable assets a business can have. A company with a strong reputation has a lot of goodwill. Customers are more likely to patronize a business that they perceive to be reputable, and employees are more likely to enjoy working for a reputable company. 

A large and loyal customer base

A business with a large and loyal customer base has a lot of goodwill. Loyal customers will likely continue doing business with the company, even if cheaper alternatives are available. Loyalty provides a degree of stability and predictability that is advantageous to companies.

Unique location

A unique location can be challenging to replicate and create goodwill in real estate. An attractive site can give a company a competitive advantage, as customers may be more willing to patronize the business because of the convenience or vibe of the location.

A well-trained workforce

Highly skilled and well-trained employees are often more productive and efficient. They can provide a higher level of customer service, leading to repeat business and referrals, further increasing the company’s value.

Valuable intellectual property

Patents, trademarks, and copyrights are all intellectual property (IP). But IP can also include things like trade secrets and other proprietary information. Valuable intellectual property gives a business advantage, making it worth more to potential buyers, an essential aspect of creating goodwill.

Favorable lease terms

Favorable lease terms can make a business more attractive to potential buyers. They include below-market rent, long-term leases, and options to renew at reasonable conditions.

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How to Evaluate Goodwill in Business

The two main methods for valuing goodwill of a business are the residuum approach and the excess profits approach.

The residuum approach is simply the difference between the agreed-upon sale price of the business and the fair market value of the company’s assets. Although the formula is relatively simple and this method can be quick and easy, in some cases, the residuum approach may not always give you an accurate picture of the goodwill’s true financial value. It relies heavily on the subjective nature of the agreed transaction price, which can be inflated or deflated depending on the target company’s attractivity.    

The excess profits approach, on the other hand, relies on the value of all projected excess future earnings for the acquired business vs. the standard profits for a similar company. Determining the value of goodwill with this method can be time-consuming and difficult. Furthermore, this method can also be imprecise because future earnings tend to be unpredictable.

Each method has advantages and disadvantages for valuing the goodwill of a business. The best one for you will depend on the unique circumstances surrounding your transaction.

Factors That Influence Goodwill Value 

Many internal and external factors can influence the value of goodwill. These include the size and reputation of the business, competition and the industry the company operates in, and customer base. External factors can also influence goodwill, such as the economy and changes in technology.

The business’s size and reputation

The size and reputation of a business can have a significant impact on its goodwill value. Size and reputation can be highly correlated, and small businesses typically have less goodwill than larger businesses. Smaller companies may rely more heavily on the owner’s skills and charisma to drive sales. Someone purchasing the business might struggle to maintain momentum from the outset.

Industry and competition

A business’s competition and industry can also influence its goodwill value. A company in a stable or growing industry with limited competition might enjoy more goodwill than one in decline or full of cut-throat competitors. Further, specific industries, such as technology or healthcare, tend to have higher goodwill values than businesses in other industries like retail or manufacturing.

Economy

The state of the economy can also influence the value of a business’s goodwill. Understandably, companies tend to have higher goodwill values during periods of economic growth and lower goodwill values during periods of economic decline.

Changes in technology

Early adopters of the right new technologies may have higher goodwill values than late adopters. A company ahead of the curve can gain an early-mover advantage and capitalize on market shifts, leading to higher valuations and an increase in goodwill.

These factors impact a company’s value and must be considered when drafting a goodwill purchase agreement. 

Key Aspects of a Goodwill Purchase Agreement

A goodwill agreement is a contract between two parties as part of a business sale in which one party agrees to buy the other business’ goodwill. 

When purchasing goodwill, the agreement typically includes the following:

• The sale price of the goodwill and the date of the sale
• A description of the business, its assets, and the goodwill
• The names and contact information of the parties involved
• Any other relevant details about the sale

Why Would You Need a Goodwill Agreement?

Quantifying your business’ goodwill can be challenging, mainly because its value can significantly affect a business’s sale price. Many factors can impact this essential aspect of any business. Deciding which of the two main ways to use to value your company’s goodwill can become especially critical when selling your business or performing a valuation.

A goodwill purchase agreement is often separate from the rest of the transaction for the sale of a business. Specifying and valuing the goodwill of a business sets it apart from other assets. Further, it ensures that both parties know the sale details and that the sale price is fair. 

However, understanding the factors that influence goodwill value is an excellent first step in determining which approach you should take to define the value of your business’s goodwill.