How Buyers Value Goodwill
Defining Goodwill in a Business Acquisition
Investopedia defines Goodwill as: “an intangible asset that arises as a result of the acquisition of one company by another for a premium value… The amount the ‘buyer’ pays for the target company over the target’s book value usually accounts for the value of the target’s goodwill.”
Wikipedia defines Goodwill as “an intangible asset that arises when a buyer acquires an existing business, but pays more than the fair market value of the net assets (total assets – total liabilities). The goodwill amounts to the excess of the ‘purchase consideration’ (the money paid to purchase the asset or business) over the total value of the assets and liabilities.”
Thus, Goodwill is not a number that gets added to the book value to determine the market value of a company. It’s a plug number. It’s the mathematical result of subtracting the book value [FMV of tangible assets minus liabilities] from the market value [the cost of acquisition] of a company. A short-cut definition is: “Goodwill is the market value of the company in excess of its book value”. And the most accurately way to determine Goodwill is to do the simple math.
There are those who say one should consider the total value of all the actual intangibles assets [trade secrets, customer list, patents, trademarks, software, etc.] to determine the total actual Goodwill. But it’s far easier, and much more accurate, to determine the future cash flows to be generated by the entire business, including these intangible assets. And, unless something significant had recently changed, that future cash flow can be predicted by connecting the dots for the prior 12 to 24 months. If the seller cannot prove that one or more of his intangible assets is going to start producing lots of increased cash in the near future, than the value of those intangibles is already present in the current level of cash flow being generated by the business.
And, for businesses valued under $50 million, cash is king. Unless the buyer has some emotional attachment to the acquisition (i.e. purchasing a professional sports franchise), almost all well thought-out acquisitions are based upon the probability of a certain amount of cash being generated each year in the future – predicated upon what happened in the past.
Any additional cash to be generated in the future, through synergies, increased efforts, new initiatives, etc., [and the increased business valuation of the business] are rightfully due to the buyer. After all, what buyer would buy a business he didn’t feel he could make a more effective generator of cash? None!
In conclusion: The value of a business to the market is based upon the cash flow generated in the past – unless the seller has compelling evidence that future cash flow will be larger due to recent changes in his intangibles. And buyers, no matter how much they think they can improve the business, will not pay significantly more than the value of the business to all the other buyers.
So, don’t be deceived by those who argue that goodwill [based upon some complex valuations of intangibles] should be added to net book value to determine the value of a business. Goodwill is a component of the total value of the business to the market – based upon a market multiple of cash flow, not some arbitrary valuation of individual intangible assets.
The Summit Acquisitions Group — Business Brokers and M&A Advisors — specializes in the sale, appraisal, and financing of privately owned companies ranging in valuation from $750,000 to $25,000,000. Contact their offices in Atlanta, GA or Charlotte, NC for a free consultation.