When it comes to understanding what your business is worth, it is important for business owners to understand the huge impact goodwill has on business value as well as after tax proceeds from a business sale. 

So, what is goodwill and how can you place a value on it? Though challenging to define, and treated differently by lawyers and accountants, goodwill can generally be considered the key intangible asset which affords a business value over and above other tangible assets.

Why is the valuation of goodwill important? 

When valuing your business for sale, succession planning or in estate planning matters, the presence of goodwill will help determine the value of your business. 

There are also tax implications. If you or a trust is selling a business, then you or the trust will typically be entitled to a 50% discount of the capital gain of that business attributable to goodwill by virtue of the provisions of Division 115 of the Income Tax Assessment Act 1997.

Goodwill and its valuation are also important for the purchaser of shares in a private company where the company is potentially "land rich". The value of goodwill will have a critical impact on whether stamp duty is payable on the purchase of the shares in such circumstances.

What are the sources of goodwill?

The sources of goodwill for legal purposes are those which generate real value (or earnings) to the business and include the use of tangible and intangible assets and other facets of the business. This may include:

• Site goodwill – very important for the local grocer or newsagency;
• An enforceable restrictive covenant which retains customers or which reduces competition; 
• Statutory monopolies in respect of the business products such as trademarks or patents; 
• Personality of the business owner or key employees; 
• Service delivery – we all love attentive waiters and waitresses  at a restaurant; 
• Price - an obvious matter;
• Habit  - “I have been using Colgate toothpaste since I was 12 years old”;
• Expenditures on advertising and promotion; 
• Funds expended on wages, customer services and labour (HR) relations; 
• Matters that are external to the business or its locality, such as imperfect competition or extensive market penetration;
• A reputation for reliability or service and leveraging employees’ skills;
• Employees with a proven capacity to develop and expand the business;
• A technically competent workforce; 
• Innovative business techniques which give the business efficiencies and economies of scale;
• Special systems including strategic business plans.

The sources of goodwill can change and goodwill can be acquired over time. 

Let’s look at an example

Consider a local museum which gains a competitive edge from:

• its expenditure on advertising & promotion;
• the sourcing of interesting and exclusive items for its exhibits; 
• its locality being near a CBD and close to a number of high schools; 
• its external structural appearance. 

The museum attracts many school children on excursions but its trustees are disappointed that it does not attract more of the potential CBD patronage and so in 2005 the museum began to market on social media, focussing on the 18 – 35  age group demographic. 

Now, the goodwill is no longer sourced from the first list of factors. Revenue has begun to rise to a level higher than it was prior to the commencement of the social media marketing campaign, and the sources of goodwill will now extend to the fact that the museum is now adopting social media and attracting custom (bringing in more customers) from a new demographic. 

How is goodwill valued? 

Once a business is operating, the business may develop certain advantages: the business might attract a regular clientele, it might enjoy a reputation for reliability or service, or it might employ highly skilled employees able to generate above average earnings. These advantages will constitute goodwill because they will generate above average earnings. 

If the business is selling goods and services which are virtually indistinguishable from others sold in that same market, above average earnings will be difficult to achieve. But if above average earnings are achieved, it suggests the existence of goodwill. 

The measure of value of that goodwill is how much the earnings exceed the norm. That is, the additional value that the business is achieving beyond its competitors.

In a profitable business, the value of goodwill for legal and accounting purposes will often, perhaps usually, be identical. 

However, where a business is trading at a loss or with less than industry average profitability, there may be a marked difference between the value of goodwill for legal purposes and its value for accounting or commercial purposes. As a result, even when trading as a loss or just with low profitability, a business may have valuable goodwill in the eyes of the law although an accountant would conclude that the business either has no goodwill or that, if it has, it is of nominal value only.

Where a business is trading at a loss, there will be no gap between the value of predicted earnings and the fair value of the net assets. But the absence of a gap does not necessarily mean that there is no goodwill. For example, there may be goodwill derived from advertising in an unprofitable business.

Goodwill for legal purposes is different from and is not to be confused with the "going value" or the “going concern value” of the business. The going concern value of the business reflects the ability of that business to generate income without interruption even where there has been a change in ownership. It is different from the concept of goodwill. 

There are a couple ways goodwill is valued. 

The Bottom-up approach

Goodwill has historically (up to 2018) been determined by deducting from the present value of the predicted earnings of the business, the fair value of its identifiable net assets. This is called the bottom-up approach. 

The Top-down approach

This varies from case to case. But in every case, goodwill is valued in the same fashion as every other asset of the business. If the value of land is required for stamp duty purposes for example, then arriving at the land value will involve starting with the going concern (i.e. total) value of all the property of the entity in question and deducting the value of the non-land assets (including the goodwill) to get a residual value for the land. 

Valuing goodwill is rarely straightforward and will require a thorough investigation into the business in question. 

What do business owners need to consider? 

Legal goodwill might be harder to establish for a business that is selling goods and services that are virtually indistinguishable from others sold in the same market. Where such a business achieves earnings above the industry average, this could support the existence of valuable legal goodwill, but it will be necessary to establish that the increased earnings arise from goodwill rather than some other aspect of operations.

Unless the alleged source of goodwill can attract custom to the business (any activity which brings in more customers), it will not contribute to the generation of legal goodwill. However, it may contribute to the going concern value of the business. For example, merely having economies of scale will contribute to the profitability of the business and therefore its going concern value but it does not, without further, contribute to goodwill. 
When valuing goodwill in your business, work with your valuation expert to ensure they understand the relevant statutory context. This could mean that multiple valuation reports are required depending on the purpose for which they are to be used.