Understanding Goodwill

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.