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Financial Advisory Services Insights
Goodwill Valuation Approaches, Methods,
and Procedures
Robert F. Reilly, CPA
Financial advisers are often asked to value goodwill within a corporate transaction
environment. These goodwill valuations may be performed in the due diligence phase of
the corporate transaction for transaction pricing and structuring purposes. These goodwill
valuations may be performed in the consummation phase of the corporate transaction—as
part of the preparation of a transaction fairness opinion or solvency opinion. And, these
goodwill valuations may be performed within the controversy phase of the corporate
transaction—to defend against dissenting shareholder appraisal rights claims or claims that
the transaction resulted in a fraudulent transfer. For some transaction-related purposes,
financial advisers may value goodwill as a residual amount (i.e., the residual of a total
business or professional practice value minus the value of all identifiable tangible assets
and intangible assets). For other transaction-related purposes, financial advisers may value
goodwill as an individual, income-producing intangible asset. This discussion summarizes
the generally accepted goodwill valuation approaches, methods, and procedures. And, this
discussion presents an illustrative example of a goodwill valuation analysis.
introduction defend against dissenting shareholder appraisal
rights claims or claims that the corporate transac-
There are different types of goodwill, including (1) tion involved a fraudulent transfer
business or institutional goodwill and (2) personal This discussion summarizes the generally accept-
or professional goodwill. Financial advisers are often ed approaches and methods related to the valuation
asked to value these different types of goodwill for of goodwill. This discussion focuses on business
transaction, taxation, financial accounting, litiga- enterprise (or institutional) goodwill. However, this
tion, and other purposes. This discussion describes discussion also considers personal (or individual)
the various components of goodwill and the various goodwill.
reasons why independent financial advisers may be
asked to value goodwill. This discussion starts with a definition of good-
Financial advisers are often asked to value good- will. Since there is no single definition of goodwill
will within a corporate transaction environment. that is applicable to all purposes, this discussion
These goodwill valuations may be performed in the considers alternative definitions. This discussion
due diligence phase of the corporate transaction describes the types and attributes of goodwill. And,
for transaction pricing and structuring purposes. this discussion considers the many reasons why
These goodwill valuations may be performed in financial advisers are asked to value goodwill.
the consummation phase of the corporate transac- Finally, this discussion mentions many of the
tion—as part of the preparation of a transaction common internal and external data sources related
fairness opinion or solvency opinion. And, these to the goodwill valuation. These data sources pri-
goodwill valuations may be performed within the marily include sources of transactional data regard-
controversy phase of the corporate transaction—to ing the sale of goodwill within the context of a busi-
ness acquisition.
10 INSIGHTS • SPRING 2015 www .willamette .com
Some financial advisers believe that only income concern) premise of value—rather than on a value
approach methods are applicable to value goodwill. in exchange (or piecemeal disposition) premise of
However, this discussion describes cost approach, value.
market approach, and income approach valuation Some going-concern value may attach to the
methods. This discussion concludes with an illustra- business entity’s specifically identified identifiable
tive goodwill valuation example. intangible assets. For example, an entity’s patent,
copyright, or trademark value is typically greater
when that intangible asset is appraised on a value in
Goodwill components continued use (or going-concern) premise of value
There are many interpretations of goodwill. These rather than on a value in exchange (or piecemeal
interpretations are generally grouped into two cat- disposition) premise of value.
egories: residual interpretations and income inter- The second goodwill component is the exis-
pretations. While income interpretations may be tence of excess income (however measured). This
more common, financial advisers should be familiar component is described later in this discussion.
with both categories of interpretations. Both inter- For a business entity, excess income is income
pretations agree on the components of (or the fac- generated by the entity that is greater than the
tors that create) goodwill and the types of goodwill amount needed to provide a fair rate of return on
(or situations in which goodwill arises). all of the entity’s tangible assets and identifiable
There are three principal components of good- intangible assets.
will. Financial advisers consider these three compo- This excess income component relates to the
nents as either (1) the factors that create goodwill concept of goodwill as that portion of business
or (2) the reasons why goodwill exists in certain enterprise value that cannot be specifically assigned
circumstances. The first and third components pri- to the entity’s tangible assets or identifiable intan-
marily relate to business goodwill. And, the second gible assets. For an individual (e.g., professional
component relates to both business goodwill and practitioner, athlete, celebrity), excess income is
personal goodwill. the income generated by the individual that is
The first goodwill component is the existence of greater than the amount that would be expected to
operating business assets that are in place and ready be accrued by a comparably skilled individual work-
to use. This component is sometimes referred to as ing in comparable circumstances.
the going-concern element of goodwill. The fact that The third goodwill component is the expectation
all of the elements of a business enterprise are phys- of future events that are not directly related to the
ically and functionally assembled creates intangible entity’s current operations. Goodwill may be created
value. These business enterprise elements include by the expectations of future capital expenditures,
capital (e.g., equipment), labor (e.g., employees), future mergers and acquisitions, future to-be-devel-
and coordination (e.g., management). oped products or services, and future customers or
Some financial advisers identify and measure clients. This future expectations component relates
this going-concern value as a separate intangible to the concept of goodwill as the current value of
asset of a business. This separate identification future assets (both tangible and intangible) that do
may be appropriate for certain taxation or forensic not yet exist on the analysis date.
analysis purposes. Investors assign a goodwill value to a business
Other financial advisers measure going-concern entity if they expect that the net present value of
value as one component of the entity’s business the income associated with future events is positive.
goodwill. This aggregate identification is appropri- The positive net present value of the expected future
ate for purposes of Financial Accounting Standards income associated with assets that are already in
Board (FASB) Accounting Standards Codification existence (for example, capital assets, product lines,
(ASC) Topic 805, Business Combinations, fair value and customers) is appropriately assigned to those
accounting for business combinations. respective tangible assets and intangible assets.
Either identification procedure may be appropri-
ate depending on the purpose and objective of the the residual interpretation oF
goodwill analysis.
This going-concern value may enhance the value Goodwill
of the business entity’s individual operating assets. Under generally accepted accounting principles, the
For example, a business entity’s equipment value is goodwill that an entity develops in the normal course
typically greater when the equipment is appraised of business is rarely recorded on the entity’s financial
based on a value in continued use (or going- statements. And, the accounting recognition for
www .willamette .com INSIGHTS • SPRING 2015 11
internally created goodwill is different than the intangible assets. This allocation of the entity’s
accounting recognition for purchased goodwill. income is typically based on a fair rate of return
Internally created goodwill is rarely recorded on on the asset category multiplied by the value of the
the entity’s balance sheet. In contrast, purchased asset category.
goodwill is recorded on the acquiror’s balance sheet Third, the financial adviser typically quantifies
as soon as the purchase transaction is completed. the portion of the entity’s income that cannot be
Under FASB ASC topic 805 acquisition accounting, associated with any other tangible or intangible
the fair value (calculated as a residual from total asset. That residual income is often called excess
purchase consideration) of purchased goodwill is income (or excess earnings). This excess income is
recorded as an intangible asset on the acquiror’s then assigned to goodwill.
balance sheet. Fourth, goodwill value is typically quantified
Accountants often use a fairly broad definition as this amount of excess income capitalized as an
of goodwill. This broad interpretation of goodwill is annuity in perpetuity. The excess income is capital-
the residual value that is calculated by subtracting ized by a risk-adjusted and growth-adjusted direct
the fair value of all the acquired tangible and iden- capitalization rate. The result of this direct capital-
tifiable intangible assets from the acquired entity’s ization procedure indicates the goodwill value.
total purchase price.
Sometimes this goodwill definition collectively
quantifies all of the intangible value of the acquired Goodwill types
company. This is the case when all of the identifi- There are three general goodwill types. These three
able intangible assets are not adequately identified goodwill types may affect the identification and
and valued. ownership of the goodwill. But, the distinction of
This collective goodwill valuation may occur these three types of goodwill should not affect the
when the fair values of the individual identifiable valuation results.
intangible assets are immaterial compared to the The first goodwill type is institutional goodwill.
total business purchase price. In this circumstance, This is the goodwill that relates to an industrial
this residual definition of goodwill may capture or commercial business enterprise. This goodwill
the total intangible value of the acquired business type typically results from the collective operations
entity, with little consideration of the identifiable of—and the collective assemblage of—the entity’s
intangible assets. assets. Institutional goodwill is typically owned by
the industrial or commercial business.
the income interpretation oF However, in the case of a professional services
business (for example, a manufacturers representa-
Goodwill tive company or other professional sales organiza-
The income interpretation of goodwill may be more tion), some or all of the institutional goodwill can be
conceptually robust than the residual interpretation created by the individual employee/owners.
of goodwill. As a result, the income interpretation of The second goodwill type is professional practice
goodwill may be more useful to the financial adviser goodwill. This type of goodwill relates to a medi-
who is interested in the valuation of the entity’s dis- cal, dental, legal, accounting, engineering, or other
crete goodwill—as opposed to the valuation of the type of professional practice. This goodwill type is
entity’s total intangible value. distinguished from the other goodwill types because
First, the financial adviser typically quantifies it has two distinct components: the practitioner (or
all of the income of the entity. For purposes of this personal) component and the business (or practice)
excess income analysis, income can be measured component.
many different ways. The only requirement is that The practitioner component relates to the good-
the measure of income is calculated on a basis con- will created by the reputation and skills of the indi-
sistent with the measure of the fair rate of return on vidual professional practitioners (the actual physi-
the entity’s operating assets. cians, dentists, lawyers, CPAs, engineers, and other
Second, the financial adviser typically allocates professionals). The business component relates to
(or assigns) some portion of this total income to the goodwill created by the location, reputation,
each tangible and intangible asset category that longevity, assembled assets, and operating proce-
contribute to the income production. These asset dures of the institutional professional practice.
categories typically include working capital, tan- One issue that often arises with regard to this
gible personal property, real estate, and identifiable goodwill type is who owns each of the two compo-
nents. This ownership question can be controversial
12 INSIGHTS • SPRING 2015 www .willamette .com
in marital dissolutions, shareholder disputes, or in 2. the operations of the company or practice
other types of litigation. are not functionally or economically sepa-
Ultimately, the ownership of the goodwill com- rate from the individual, and
ponents is a legal question with a legal answer. 3. the success of the business entity is directly
However, the financial adviser may be tasked with related to the activities of the individual.
the identification and the valuation of these two
components of professional practice goodwill. In the early stages of an entity’s operations, most
The third goodwill type is celebrity goodwill. internally created goodwill is typically personal
This is the goodwill associated with being a famous goodwill. As the entity matures (as it increases in
individual. Typically, there are three categories of size and complexity), goodwill usually shifts from
celebrities who enjoy such goodwill: sports celebri- the personal category to the institutional category.
ties, entertainment celebrities, and achievement
celebrities.
These various categories of celebrity goodwill reasons to value Goodwill
are distinguished by the factors that created the There are many reasons why a financial adviser may
goodwill. For example, the sports celebrity goodwill be asked to value goodwill. Some of these reasons
is created by the individual’s physical prowess. That follow:
prowess (and the associated goodwill) may wane n Economic damage analyses. When a busi-
with the age of the athlete. ness has suffered a breach of contract or
Entertainment goodwill relates to singers, musi- a tort (such as an infringement, breach of
cians, actors, television talk show hosts, and so on. a fiduciary duty, or interference with busi-
This type of goodwill also relates to the individual’s ness opportunity), one measure of the dam-
skill and ability. But for many entertainers, pro- ages suffered is the reduction in the value
fessional skill and ability may increase (and not of the entity’s goodwill due to the wrongful
decrease) with age. action.
The category of achievement celebrities includes This analysis may encompass the com-
prominent corporate executives, politicians, cler- parative valuation of the entity’s goodwill
gy, or organizational leaders. The goodwill of an before and after the breach of contract or
achievement celebrity often relates to the career tort. This before and after method is also
or other professional accomplishments of that indi- useful for quantifying the economic effects
vidual. Unlike the other types of goodwill, it may be of a prolonged labor strike, a natural disas-
difficult to transfer celebrity goodwill. ter, or a similar phenomenon.
It is often important for the financial adviser to n Business or professional practice merger.
separately identify and individually value the three When two businesses merge, the equity of
types of goodwill. There may be different legal, eco- the merged entity typically is to be allo-
nomic, and taxation consequences for each goodwill cated to the merger partners. One common
type. way to allocate equity in the merged entity
The following factors affect which type of good- is in proportion to the relative value of the
will exists: assets contributed, including the contrib-
uted goodwill.
1. The type of services or products offered by n Business or professional practice separa-
the business entity tion. When a business separates, the assets
2. The individual’s personal relationships with of the consolidated business typically have
customers or clients to be allocated to the individual business
3. The individual’s direct impact on the man- owners.
agement and direction of the business entity One common way to allocate the assets
to the separating business partners is in
Most goodwill is likely to be personal goodwill proportion to the relative value of the assets
(that is, goodwill owned by the business owner/ controlled by or developed by each partner,
operator, individual practitioner, or celebrity) if: including the goodwill of each business
1. the individual makes essentially all signifi- partner.
cant management decisions regarding the n Solvency test. The solvency of a business
business entity, entity is an issue with regard to lender’s
fraudulent conveyance concerns during a
www .willamette .com INSIGHTS • SPRING 2015 13
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