Understanding Goodwill

(excerpted from the book "Transaction Patterns" by Toby Tatum - with permission)

Business sellers and quite often business appraisers as well tend to focus their attention exclusively on the market value of the owner’s equity.  They want to know how much the owner can ‘take to the bank’ upon the sale of the company.  The effort devoted to the estimation and calculation of the seller’s equity notwithstanding, concern for this issue is virtually non-existent among business buyers.  Buyers couldn’t care less about the amount a seller will profit from the sale of his or her business.

The three things small business buyers typically want to know first about a potential acquisition are the seller’s discretionary cash flow, the total asking price for the business, and the amount by which that price exceeds the value of the business’s hard assets—i.e., the amount represented by the intangible assets.  Although the intangible assets of a going concern may be identified individually, for convenience of analysis and price negotiations among small business owners, they are usually all lumped together under the general heading of “goodwill.” 

Buyers want to know how much of the purchase price is represented by “goodwill” because they often have the very real alternative of starting a similar size business from scratch and therewith avoid paying for any ‘goodwill’ at all. This is something that many sellers don’t think about.  However, it would serve them well if they did. Sellers should always keep in mind that there is a price beyond which it will make more sense for a buyer to start a business rather than buy a business even considering the greater risk involved in doing so.  Indeed, the Small Business Administration estimates that approximately 880,000 new businesses were started in 1997. This is four times the number of going concerns that were purchased over the same time period. Moreover, assuming that both the prospective buyer and business owner can estimate the value of the company’s tangible assets included in the asking price, then even though the asking price is an all inclusive number, the only thing that is really being negotiated is the value of the company’s goodwill.  The value of everything else to be included in the price is more or less known going into price negotiations.

If you're considering buying, selling, or determining the value of a business, please take a look at some of the excellent books, reports, and software we have at Business Book Press to help you achieve success. For example:

The Business Reference and Pricing Guide is the bible of the business brokerage world. If you're a shrewd business buyer or seller, you will want this book to learn what just what the business broker knows. It will pay you big dividends throughout every aspect of the purchase and sale process. Learn more about it...

BizPricer™ Business Valuation Software is an accurate and inexpensive resource for prospective business buyers and sellers (and business brokers) who want to know the fair market value of a business. No financial expertise or specialized knowledge is needed. Save hundreds to thousands of dollars over hiring an appraiser to provide you with a similar result. Learn more about it...

Preparing A Business for Sale provides business owners with an understanding of the process they need to know to sell their business for the most money. Contains hundreds of little known tips, ideas and strategies to maximize the selling price of a business. Learn more about it...

Strategies for Successfully Buying or Selling a Business is our bestselling book. It has been recommended by Kiplingers Personal Finance Magazine, the BottomLine Personal Newsletter, and has been awarded the Best Business Book of the Year Award from the North American Bookdealers Exchange (NABE). Learn more about it...

Anatomy of a Business Purchase Offer provides you with all of the practical hands-on knowledge you need to make a successful purchase offer to buy a business. The author uses an actual Purchase Offer form to show you exactly what needs to be written and why! He details all of his recommendations in a line-by-line format for each and every aspect of the purchase offer. Learn more about it...

The Business Buyer's How-to Kit: We've assembled a specially-priced Kit with all of the key information you'll need to know to successfully buy a business.

The Business Seller's How-to Kit: We've assembled a specially-priced Kit with all of the key information you'll need to know to successfully sell a business.