Components of Goodwill
By: William C. Herber and Scot A Torkelson
In evaluating the market value of any business, the estimate can be broadly divided into two categories: tangible assets and intangible assets. Tangible assets include cash, receivables, inventory and fixed assets. Intangible assets, by definition less immediately recognizable, must also be considered when determining the value of a business. Collectively they are often referred to as "goodwill," and they, too, can be examined in component parts. The primary question to address before examining these components is whether goodwill exists at all in the business being valued.
What Determines Goodwill?
The Internal Revenue Service provides this concise description of goodwill, and the means to determining its existence in a business.
(F) In the final analysis, goodwill is based upon earning capacity. The presence of goodwill and its value, therefore, rests upon the excess of net earnings over and above a fair return on the net tangible assets. While the element of goodwill may be based primarily on earnings, such factors as the prestige and renown of the business, the ownership of a trade or brand name, and a record of successful operation over a prolonged period in a particular locality, may also furnish support for the inclusion of intangible value.
-Revenue Ruling 59-60 Section 4.02
In the IRS definition, there are two primary criteria for determining the existence of goodwill in a business. The first criterion relates to the presence of excess earnings, or a level of earnings that provides for a fair return over and above what is necessary to cover the tangible assets of the business. In other words, a company that has earnings of $10,000, with $1,000 of those earnings providing a fair return on the tangible assets (assuming a 10% return on $10,000 worth of tangible assets), would realize excess earnings in the amount of $9,000 indicating, by definition, the presence of goodwill in the business.
The second criterion relates to situations wherein a company may possess some transferable goodwill component of the business (for example, a brand name, customer list, license, franchise agreement, etc.) that may have value whether or not a business has earnings. These separate, identifiable, goodwill components could be sold to other businesses that would find these elements of value to their own operations. Thus, even in businesses without any indication of excess earnings, there may be intangible assets that could be transferred.
Another working definition of "goodwill value" provided by Valuation of Intellectual Property and Intangible Assets, 1993, defines goodwill...
...as all the elements of a business enterprise that exist after monetary and tangible assets are identified. They are the elements, after working capital and fixed assets, that make the business work and contribute to the earning power of the enterprise. Their existence is dependent upon the presence, or expectation, of earnings. They appear last in the development of a business and disappear first in its demise.
Further in the same publication, the four specific components of intangible assets are identified. Once it is established that a given business possesses earnings in excess of those needed to provide a fair return to the tangible assets, these identified components of goodwill, in differing combinations, will be found. The components are:
- Rights
- Relationships
- Grouped Intangibles
- Intellectual Property
How do each of these components relate to goodwill? The following descriptions offer some explanation. For specific examples of goodwill, please refer to the insert on
page 5.
1) Rights
This category describes any retained or acquired right of a business through contracts, agreements, licenses and permits, leases, etc. These "rights" can be instituted with other businesses, individuals or government bodies. At minimum, every business holds the established right to carry on operations by obtaining licenses and/or permits of operation with governmental bodies at the federal, state and/or local level. These rights can be considered goodwill to the extent they enable the business to pro-duce excess earnings.
For businesses not requiring difficult or lengthy processes to establish themselves in business, the licensing and permit rights carry a lesser value. For businesses passing through a more extensive process, the resulting rights take on an added value. As an example, obtaining a permit to serve alcohol in some communities can be very difficult, and the resulting permits, once in place, take on considerable value to the owners. In some instances, if the license or permit rights are transferable, they may have goodwill value even though the business may not be generating earnings.
2) Relationships
A business depends upon many established relationships for its continued existence. Most, if not all, of these arrangements are not directly contractual (which is true for most employee/employer relations), but they are, nonetheless, established and would cost money to recreate. The most obvious relationship of intangible value for businesses is with a company's employees; it can be quite costly to identify, locate, hire and train a work-force. This is most notably evidenced by the high fees paid to placement companies, as well as those costs related to the training of an existing work-force to reduce turnover. Generally, the more specialized a given workforce, the higher their intangible value would be to the business.
Other key relationships include customer relationships. More exclusive customer/business relationships have the greatest value. Conversely, those customer relationships in which many existing substitute operations can provide similar services carry a lesser intangible value. Additionally, businesses that do not need to rely upon advertising to generate customers demonstrate goodwill value related to relationships. This contributes to a higher level of earnings through reduced costs in advertising.
3) Grouped Intangibles
This refers primarily to the grouping of all the assets of a given business in one place and operating in a coordinated manner, such that future earnings can be realized.
Businesses, such as manufacturing and processing companies, with unique, unusual or highly complicated groupings of assets have a significant intangible value within this component. The value of typical groupings of assets (e.g., retail) would generally be less. In these cases, the value is more closely related to the cost of hiring persons to assemble the assets (including any computer hardware or software related to operations), as well as setting up inventory or supplies related to operations. These estimates could be specified through discussions with various suppliers, vendors, professional business movers, freight companies, and computer service consultants.
The end result of the organized grouping of assets is the ability to generate earnings which exceed the value of the individual assets by themselves. This greater level of earnings (over and above the unassembled tangible asset values) determines the goodwill within this component.
4) Intellectual Property-Trademark, Patents, Customer Lists, Database, Name
Intellectual property is unique because the owner of the property is protected by law from its unauthorized use by others. It specifically refers to patents, trademarks, copyrights, customer lists and trade secrets or know-how. Businesses with these intangible assets can utilize their benefits or can transfer these interests to other businesses capable of exploiting such types of intellectual property.
In Conclusion
Simply, goodwill can be defined as: the broad factors described as rights, relationships, grouped intangibles and intellectual property that produce excess earnings over and above a fair return on the net tangible assets of a business.
The presence of goodwill value relates to the above described parts of a business that contribute to its earnings in such a manner that the capitalization of those earnings exceeds the earning power of the underlying, unassembled tangible assets. It is important to note, however, that these excess earnings are produced specifically through the synergies created among the contributing components of goodwill.
For example, a manufacturing company's goodwill value might be heavily related to its intellectual assets (patents, recipes, know-how and processes) and grouped intangibles (assembly line in place, inventory, etc.), while utilizing lower-skilled employees and having few contracts. A bank's intangible value, on the other hand, would tend to be heavily related to rights (customer accounts, mortgage and loan contracts) and would, to a greater extent, rely upon a workforce in place which would include a variety of professionals. Fach individual business can be analyzed for the specific combination (and synergy) of goodwill components that contribute to its intangible value.
Although a very difficult and time-consuming task, to estimate an accurate value for a business, one must take into consideration goodwill and its various measurable components. 
RIGHTS
- Local government permits or licenses for a given business operation
- Licenses or governmental certifications
- Leases that are at below market rates
- Advantageous distribution agreements
- Employment contracts
- Vendor agreements
- Contractual rights of a franchise
- Franchises which establish a terntory or product line for the business
- Any other contracts or agreements in place which favorably affect the business
RELATIONSHIPS
- Assembled workforce in place
- Established customer relationships
- Presence of repeat customers
- Distributor relationships
- Customer~ vendor, and/or distributor lists
- Nondependence on trademarks
- Little need for advertising
- Long-term locational presence
GROUPED INTANGIBLES
- Machinery and equipment set up and operating
- Oftice furniture and supplies set up and in place
- Computers with software and peripheral equipment installed and operating
- Development of operating systems
- Carpeting, wall treatments, decorations, lighting and all leasehold improvements installed
- Deliveries and inventory stocked and/or in process of arriving
- Telephone, electricity, heating, water, etc. connected and functioning
- Advertising in process
- Signage in place
INTELLECTUAL PROPERTY
- Patents
- Trademarks
- Slogans, jingles, or logos
- Copyrights
- Trade secrets
- Formulas, recipes, methods, techniques in place
- Marketing strategies
- Research and experimental journals
- Libraries, databases, proprietary software, and other knowledge materials
- Confidential database of proprietary information
- Consumer testing or market research results
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