How to Value Goodwill When Selling a Business

When a business changes hands, the sale price often exceeds the value of its physical assets. This additional amount represents goodwill, an intangible asset that captures the non-physical value of the business. Understanding and accurately valuing this component is a crucial step for both buyers and sellers in any transaction. Goodwill can form a substantial part of a business’s overall worth, making its proper assessment a central element of the sale process.

Understanding Business Goodwill

Goodwill stands apart from tangible assets like real estate, machinery, or inventory. Instead, it reflects established positive attributes that enable a business to generate earnings beyond what its identifiable assets would typically produce. These contributing factors include:
The strength of a company’s brand reputation
Established customer relationships and loyalty
The efficiency of its operational systems and processes
A skilled and stable workforce
A favorable location
A strong market position
These factors contribute to this intangible value.

It is important to distinguish between enterprise goodwill and personal goodwill. Enterprise goodwill is the value inherent in the business itself, such as its brand, customer base, and market position, which can be transferred to a new owner. This type of goodwill exists independently of any individual’s efforts and will persist even if the owner or key personnel depart. Conversely, personal goodwill is tied directly to the individual reputation, skills, or relationships of a specific person, often the owner, and may not be fully transferable in a sale. Recognizing these distinctions is fundamental before undertaking any valuation efforts.

Information Needed for Goodwill Valuation

Accurately assessing goodwill requires comprehensive financial and operational data from the business. Historical financial statements—including income statements, balance sheets, and cash flow statements—are essential, typically spanning several years to identify trends and normalize earnings. Tax returns provide verifiable financial information, supporting the data presented in the financial statements.

Beyond core financial documents, specific operational details are necessary to support the intangible aspects of goodwill. This includes:
Detailed customer lists and data on customer retention rates
Insights from marketing and sales efforts
Information regarding employee rosters, particularly for key personnel
Details of existing contracts with suppliers or customers
Intellectual property documentation, such as trademarks and patents
Industry benchmarks and comparable market data
These offer context and support for the valuation process.

Common Goodwill Valuation Approaches

Quantifying goodwill involves several methodologies, each approaching the intangible value from a different perspective. These approaches leverage the gathered financial and operational information to arrive at an estimated value.

The Excess Earnings Method

The Excess Earnings Method isolates the earnings attributable to goodwill. This method begins by estimating the fair market value of the company’s net tangible assets. A fair rate of return is applied to these tangible assets to determine the portion of earnings generated by them. After subtracting these earnings from the business’s total normalized earnings, the remaining amount represents the “excess earnings,” which are capitalized to arrive at the goodwill value.

The Capitalization of Earnings or Cash Flow Method

The Capitalization of Earnings or Cash Flow Method is often applied as a residual approach. This method determines the total fair market value of the entire business by capitalizing its normalized earnings or cash flow. Once the total business value is established, the fair market value of all identifiable tangible and intangible assets, excluding goodwill, is subtracted. The remaining residual value is attributed to goodwill.

The Market Approach

The Market Approach determines goodwill by comparing the business to similar recently sold companies. This method relies on actual transaction data from comparable businesses to estimate the overall business value. Goodwill can be inferred as a component of the total transaction value in these comparable sales, or as a residual after accounting for the tangible assets of the acquired businesses. Less formal methods or “rules of thumb” generally lack the precision and defensibility required for a robust goodwill valuation.

Applying Goodwill Valuation in a Sale

Once the goodwill value has been determined, its application in a business sale becomes the next step. The calculated goodwill value is integrated into the overall purchase price, forming a significant part of the total consideration. For both buyers and sellers, the allocation of the total sale price among various assets, including goodwill, is mandated for accounting and tax purposes. This process, known as purchase price allocation, requires both parties to file IRS Form 8594.

Goodwill is classified as an intangible asset under Internal Revenue Code Section 197. For the buyer, allocated goodwill can be amortized on a straight-line basis over a 15-year period for tax deduction purposes. This amortization provides an annual tax benefit by reducing taxable income. For the seller, goodwill held for more than one year is treated as a capital asset, subject to long-term capital gains tax rates, which are lower than ordinary income tax rates.

Proper documentation and professional appraisals formalize the goodwill value within the sale agreement. An independent valuation analyst can assess goodwill and provide an objective assessment. This ensures the allocation is defensible to tax authorities and supports the tax treatment claimed by both the buyer and the seller.