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How Goodwill Affects Business Valuation

It's imperative to not forget about these intangible assets when putting up your business for valuation.
how does goodwill affect business value?

As a business owner, you ought to know there’s more to your company’s worth than just bricks, machines, and tools. 

We’re talking about goodwill. This is an important but frequently ignored factor. It’s all about the intangibles that give your business an extra edge over the competition.

So, when sizing up your company, don’t forget to factor in goodwill—it’s key to figuring out your business’s real potential for long-haul wins.

Let’s take a closer look at what goodwill really is:

What is Goodwill?

Goodwill is an essential intangible asset that represents the portion of a business’s value beyond its tangible assets. It’s those special elements that fuel your business’s expansion, help it stand tall among rivals, and ensure it’s a money generator in the long run. 

When the moment comes to value your business, make sure you account for goodwill. 

It’s key to fully understanding not just what your company is worth today, but its potential last into the future.

Think about your:

  • Customers’ loyalty
  • Intellectual Property
  • Top-notch team members
  • Suppliers’ and distributors’ relationships
  • Long-term contracts
  • Future purchase orders
We’ll break these components down and have them explained one by one.

7 Components of Goodwill

1. Brand Name Reputation

components of goodwill brand reputation

Don’t underestimate the might of your brand’s reputation and recognition; they’re key parts of goodwill. They shape how the public sees you, and they can sway the trust and confidence of customers and investors.

A brand that’s strong and respected? It’s like a magnet pulling in new customers while keeping the old ones close, boosting your earnings and piece of the market pie.

On top of that, having good customer relations will increase the likelihood of your business becoming the talk of the town.

2. The Loyalty Factor

Then there’s customer loyalty. When customers stick around, they’re most likely turning into your company’s advocates. Even if competitors try to lure them away with similar offerings, they stay put. 

This loyalty spells more sales, greater value from each customer over their lifetime, and a solid edge over your competitors.

3. Intellectual Property

Intellectual property (IP), another jewel in the goodwill crown, is an intangible asset. Examples are patents, copyrights, trademarks, and trade secrets.

This is like a protective shield for your products and services, keeping copycats at bay.

4. A Skilled Team

components of goodwill a skilled team of employees and workers

Remember the value a skilled and knowledgeable team brings to your company and goodwill. 

Your talented workforce is like the engine driving innovation, streamlining operations, and delivering top-notch customer service, all adding to your company’s worth.

In other words, have good employee relations.

If you want to know how to find them, there are plenty of easy strategies to get top talent that you can easily get ideas from.

5. Supply and Distribution Networks

components of goodwill supply and distribution networks

Your established supplier and distribution networks are important pieces of the goodwill puzzle. 

They ensure a smooth flow of raw materials and efficient product delivery to customers.

Companies that have strong networks often have better bargaining power with suppliers—ensuring you get the best deals.

6. Long-term Contracts

components of goodwill long-term contracts

Stability and predictability—are two terms that would ring a bell to investors. 

Having long-term contracts with key clients and partners instill confidence and improves long-term relationships with stakeholders.

Think about investing in a company that has a solid foundation of networks and partnerships. If they trust the business, you’re more likely to do the same.

Consequently, this attracts more investors—further adding to your goodwill value.

7. Future Purchase Orders

components of goodwill future purchase orders

Future purchase orders can potentially bring steady streams of demand for your products and services. And this ensures a consistent flow of revenue as well.

What does this mean? Investors would line up at the door because your sales pipeline indicates stable growth and profitability. Nothing is more attractive to investors than a future-proofed company. 

 

However, considering that you have all these components in play, what can you get from them?

Let’s dive in and see how goodwill influences your business’s value.

How Goodwill Affects Business Value

1. Boosts Revenue

Goodwill has a direct line to your business’s revenue-generating capacity. 

 

With a solid reputation, a devoted customer base, and priceless IP on your side, you can expect a rise in sales, and charge a premium for your offerings. 

 

2. It Holds the Competitive Edge

Goodwill can arm your business with a competitive advantage, creating hurdles for others trying to break into your market space. 

 

Your business can make it tough for competitors to match (let alone outdo) your offerings. This solidifies your competitive edge.

 

3. Establishes Future Growth

A business brimming with goodwill is all set for future expansion. 

 

You can leverage your sterling reputation, the loyalty of your customers, and your investors’ trust to break into new markets or roll out new products or services—setting the stage for enduring value creation. 

 

Needless to say, it can bolster your business’s profitability and predictability in the long haul.

 

This leads to a hike in your profit margins that’s not just a one-off but is here to stay.

 

4. Secures Your Market Spot

Goodwill can strengthen your grip on your market position and put up barriers to keep competitors at bay. 

 

A strong reputation, valuable IP, and well-established networks can ward off newbies trying to muscle into your market, safeguarding your slice of the market and revenue.

 

But what does it take to get the ideal goodwill for your business? 

 

More importantly, how are we going to know if your goodwill is on the right track?

How to Calculate Goodwill

To calculate goodwill, you need to use a basic formula.

Simply subtract the net fair market value of the company’s net assets and liabilities from the purchase price. In other words, your company’s purchase price minus assets minus liabilities.

Here’s a better illustration:

how to calculate goodwill formula

Goodwill = P – (A – L)

  • P = Purchase price of the target company
  • A = Fair value of assets
  • L = Fair value of liabilities

Simply put, it’s the difference between the amount transferred from the buyer to the seller and its net identifiable assets.

However, when including uncertain elements like future cash flows and other factors during acquisitions, the process can become quite tricky.

It’s also imperative for business owners to annually review their company’s balance sheet in order to assess the business’s goodwill.

While this isn’t a major issue in general, it complicates comparisons of reported assets or net income across different companies. 

And things can get even trickier when negative goodwill enters the picture.

What is Negative Goodwill?

Negative goodwill happens when a company is bought for less than its fair market value, often because the target company can’t or won’t agree on a reasonable price for the acquisition.

Negative goodwill typically pops up in distressed sales and is logged as income on the acquirer’s income statement.

But that’s not all. There’s also the looming risk of a previously successful company facing insolvency. When this unfortunate situation occurs, investors subtract goodwill from their calculations of residual equity.

Why? When a company reaches the point of insolvency, the goodwill it once had doesn’t hold any value in terms of being sold off.

Sounds like a puzzle, especially with the potential complications of negative goodwill and the impact of insolvency on its value.

Fortunately, we can’t just stick around with one formula.

There are also several methods to determine the value of your business’s goodwill.

Other Approaches to Value Goodwill

Cost Approach

The cost method is like a blueprint for building a twin of your intangible assets from square one. It pegs the value of goodwill to what it would cost to craft a brand reputation like yours—accounting for all your business’s qualities.

For instance, if it would cost $500,000 to build a brand as recognized as yours, that’s part of the value of your goodwill.

Market Approach

The market method is like shopping around for a business identical to yours. It assigns a value to goodwill based on what businesses similar to yours are fetching in the market minus the value of the tangible assets.

You’re looking at other players in your industry that are in the same ballpark in terms of size and operations. In other words, you’re also looking at their revenue and comparing them to yours side by side. In this case, you might want a simple approach such as the Times Revenue Method.

So, if businesses akin to yours are selling for a million dollars, this sets the bar for the value of your goodwill.

Income Approach

Goodwill Varies Across Industries

The worth of goodwill can swing wildly from one industry to another. 

Industries that lean heavily on intangible assets (tech or pharma) usually have more goodwill than those that are anchored to tangible assets.

Here’s why:

Let’s see this in action with two examples: Zapier, a well-known tech company specializing in automation software, and your local steel manufacturer. 

Zapier’s value mainly comes from intangible assets such as intellectual property (their product design, which is automation software) and brand reputation across the web. Consequently, this leads to a higher level of goodwill. 

On the other hand, your local steel manufacturer’s operations are based on tangible assets like manufacturing plants and equipment, resulting in potentially less goodwill.

That is because most steel manufacturers invest more in tangible assets.

So, it’s clear that the nature of the industry has the potential to significantly impact the amount of goodwill it possesses.

Final Thoughts

This teaches us that the success of a business may not be entirely linked to the can-be-seen assets, but also it stretches beyond the imagination.

Therefore, getting to grips with the nuts and bolts of your unique goodwill—its influence and how to value it—is a must for sizing up the value of any business.

However, it doesn’t just stop there. As a business owner, you should know by now the characteristics unique to your business and how those qualities influence the value of your goodwill.

With all that’s said, if you’re looking to get a ballpark estimate of your business’s value, try our Business Valuation tool for free.

We, at Tsetserra Growth Partners, are eager to know more about your business.

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