We use the term “goodwill” to identify the intangible but valuable asset of a business arising from its reputation and customer relationships.

By Jeff Compton
June 28, 2016
Originally published in Texas Lawyer.

We use the term “goodwill” to identify the intangible but valuable asset of a business arising from its reputation and customer relationships. The words “reputation” and “relationships” can reference something personal and individual in nature as well as something belonging to a corporation or other separate legal enterprise. In the most general sense, is the customer choosing to do business with the person or the separate legal entity or both? Answering this question tells where and to what extent we should allocate the value of the reputation and relationships among the individual versus the enterprise.

Goodwill is often allocated between personal versus enterprise for marital property valuation.

Understanding the methods of allocation assists in understanding valuations performed for other purposes. Goodwill must be transferable to be included as part of the fair market value of a business, as a hypothetical buyer would be unwilling to pay for goodwill from which it cannot benefit. Accordingly, all valuation estimates must consider whether it is transferable.

As Shannon Pratt explains in BVR’s Guide to Personal Versus Enterprise Goodwill, he has stayed with his lawyer although his lawyer has been with three separate law firms—that lawyer has personal goodwill with regard to Dr. Pratt, the law firms apparently do not have corporate goodwill with regard to that client.

Smaller businesses and professional practices are more likely to have personal goodwill because of the importance of the owner to the business. Nonetheless, other types of businesses, especially among smaller enterprises in the service industries may have personal goodwill as an asset.

To arrive at the value of goodwill, specifically identifiable tangible and intangible assets are valued and deducted from the total value of the enterprise; the remaining value is goodwill which cannot be further segregated from other tangible and intangible assets. This means technically the net working capital, property, plant, equipment, software, trade names, non-compete agreements, customer relationships and assembled workforce are separately valued and subtracted from the value of the entire enterprise to arrive at the residual value equal to goodwill. When there has been accounting for a purchase under generally accepted accounting principle, the other, specific elements just described have already been identified and valued, helping to isolate goodwill precisely.

In many valuations, for practical reasons not all these elements are separately valued but may sometimes be included to varying degrees in goodwill which is determined using a variation upon capitalized earnings or market indications of the business value from which various deductions are made to arrive at goodwill which can then be allocated between personal and enterprise. In the graphic below “Goodwill” incorporates both personal and enterprise goodwill versus other tangible and intangible assets.

Reading the publications and cases dealing with the identification and valuation of personal versus enterprise goodwill, many methodologies have been used. James Hitchner opines in his book Financial Valuation “there are no generally ‘accepted’ methodologies to divide goodwill into its personal and entity components.”

Personal goodwill is more likely when the entity is providing the services of an individual and moreover when the entity’s services are exclusively the provision of that individual’s services. Ideally the valuation professional attempting to estimate the allocation of goodwill between the person and the enterprise would ask the major customers whether they choose to do business with the individual or the enterprise or both and the probability each customer would move with the individual to another enterprise. This option is rarely available.

Instead, a variety of factors have been identified which tend to indicate either the goodwill is attributable to the person or the business employing the person. The chart below provides a summary of commonly used attributes:

 

Under one common allocation method, the Multiattribute Utility Model or “MUM,” each attribute from the table above is assigned a weight for first its existence and how much it adds to the enterprise earnings. A second and separate weight is assigned to the extent the attribute is important to allocating between personal and enterprise goodwill. For example, systems and intellectual property may, depending upon the facts, have a high weight in terms of its effect on earnings and a high weight or importance in allocating between personal and enterprise goodwill such that everything else being equal, enterprise goodwill comprises more of total goodwill.

Another common method known as “With and Without” calculates the incremental value added to the enterprise by the individual possessing the potential personal goodwill.

Testing the amount of personal goodwill determined by one method using another method represents good practice. By way of anecdote, in a valuation of a small industrial service company two independent appraisals reached very similar conclusions as to personal goodwill although one primarily relied upon the MUM while the other included interviews of the majority of customers regarding the probability their business would follow the owner to another business. The values of personal goodwill estimated in each valuation were within 10 percent of each other.

Another consideration when determining personal goodwill is the existence of a key person discount which represents the diminished value to the business of losing any key person including the person whose personal goodwill is being valued. Losing the person and diminishing the value of the company should be compared with the personal goodwill value to understand the reason for any differences.

Because the transferable amount of goodwill affects the fair market value of any business and transferability is affected by the personal versus enterprise nature of goodwill, consideration of personal goodwill and the transferability of goodwill overall enhances business valuations.

Jeff Compton is a shareholder in Houston CPA firm Compton & Wendler. Compton regularly values businesses, estimates lost profits and investigates suspected fraud. He is also accredited in business valuation by the American Institute of CPAs and is a Certified Fraud Examiner.