In my line of work, the topic of goodwill crops up a lot, and sparks debate as often as a simple discussion. But what is goodwill, and how do you value it?

The value of goodwill is often spoken of as though it is the value of the entire business, and in some cases it can be. But generally, it is not. It’s a balancing figure.

Goodwill, in its essence, represents the favour or advantage a business has acquired through its brands, reputation, customer relationships, systems and processes, databases, and unique offerings. Though these can contribute, it’s not simply about having a sleek website or a hefty Instagram following. Goodwill emerges as a value in a business transaction, calculated as the excess of the purchase price over the value of the assets required to run the business. It’s the premium that buyers are willing to pay for a business over the value of its underlying assets due to its reputation, market position, or more importantly – its ability to generate profits into the future.

Valuing goodwill isn’t as straightforward as adding up numbers on a balance sheet. It’s a nuanced process that requires understanding the intrinsic qualities that make a business valuable beyond its physical assets. For instance, a business renowned for exceptional customer service or possessing a coveted patent will likely carry significant goodwill compared to a business that has a bad reputation. That extra value is about risk. A business that has an advantage in the market, whether that be their trademark, their robust systems and processes, their diversity of income sources, or their loyal customer base, is less risky than a similar business that does not possess such an advantage.

The real challenge arises in quantifying this nebulous concept. The process begins by determining the fair market value of a business’s tangible assets. A detailed analysis follows to figure out what someone would realistically pay for the business as a whole. The difference between this total business value and the value of the tangible assets gives you goodwill.

But here’s where it gets tricky; goodwill is intrinsically linked to a business’s profitability and stability. The perceived goodwill can drastically diminish if a business is unprofitable or exhibits volatility. Buyers aren’t just purchasing the present; they’re investing in what they believe the business can generate in the future. If the future looks bleak, the goodwill evaporates.

For those trying to navigate the complexities of goodwill, here are a few tips to steer you right:

Profitability is Key:

Goodwill hinges on profit. Any calculated goodwill might be wishful thinking if your business isn’t turning a decent profit.

Consistency Matters:

Businesses with consistent revenue and profit streams are more likely to possess genuine goodwill.

Substantiating Claims:

Claims of potential profitability need backing with solid evidence—wishful thinking does not equate to real value. Show me the trading history, or if that doesn’t exist, show me a cashflow forecast that tells me a compelling story, but is underpinned by solid reasoning and assumptions.

Existing Intangible Assets:

You need to examine the business without considering the existing intangible assets. Exclude things like borrowing costs, blackhole expenses, trademarks, intellectual property, or purchased goodwill. Your valuation ought to provide an aggregated value for all of these intangible assets as the newly calculated goodwill.

Prepare and Plan:

If the business owner is considering selling, prepare the business well in advance. Proving your business’s stability and potential for future earnings will maximise goodwill.

Valuing goodwill is more science than art — it’s a blend of analysis, intuition, and experience – but the analysis is the critical part of the equation. The valuation of goodwill is about capturing the full story of a business, not just the numbers. Start by ensuring your business’s profitability and stability, substantiate your future earnings potential, and remember that thorough preparation and clear evidence are your best allies in business valuation.