The concept of “good will” in evaluating a business is a long established and vital part of determining the appropriate price of a business or asset. The term refers to the value represented by the reputation of a name or identity of a product in the industry or to the public and is quantified in determining what is the economic value of a business as a going concern.
Since it is an amorphous concept that can alter over time, a great deal of analysis has been devoted among accountants, financial advisors and tax professions as to how to develop a fair and appropriate method to quantify this value. And in a business world in which “hard” assets such as machinery and inventory are of less relative value for more and more industries, the value of the “soft” assets such as trade name and proprietary intellectual property becomes increasingly critical. Good will is one of the intangible assets that may be the most valuable part of a business.
This article shall explore both the role of good will and some basic methods used to value same in the business context. When buying or selling a business, or, indeed, when seeking to finance a business, it is important to be able to quantify for a third party the underlying value of good will. This article explores some of those methods of analysis.
The Basic Concept and Accounting Methods for Good Will
Good will comes in many forms and is not necessarily based on the particular name of a business or product, though it may be. Indeed, the location of a retail outlet may, itself, be the real locus of good will as any restaurant owner or store owner can advise. A restaurant that loses its lease and must move to another location quite often fails and within malls the carts that abound in the center outdoor areas vie for location since movement of the cart by only fifty feet can cut sales in half. The location itself becomes the major factor in good will.
Most often, it is a combination of reputation in the industry, location and availability of distribution, and the longevity of the production or service elements that constitute the elements of good will and all those factors can alter over time or, as in the case of a location’s lease being lost, be eliminated overnight.
Image is a part of good will but seldom constitutes all of it and is often confused with the true value of good will. Thus, a “youthful” image for a brand (such as Gap used to have or Abercrombie and Fitch now has) may be part of the good will a brand name has but the image can alter over time with good will being maintained. Thus Abercrombie used to be known for rather conservative high end sportswear rather than youthful clothing and the company devoted years to changing the image but maintaining the good will.
Such names as Coca Cola or Apple are of extreme value precisely because over the years they are associated with a particular product quality or image. And once lost, good will may take decades to recover…or may never recover. No one wishes to start an automobile company using the name Studebaker or Edsel or Nash Rambler. Wachovia, as a banking name, was destroyed in its good will value in two months in 2008 and Well Fargo is imposing its own name on the locales that once boasted the prior name. In that case, the hard assets may have had value for Wells, but Wachovia’s good will was actually negative and had to be removed.
The value of “good will” has long been very important in most retail industries. Recall that the concept of good will grabbed major headlines back in 2001, when basic accounting methods accepted worldwide changed the way companies had to account for it on their books. In the "olden" days (that is, before 2001), when one company bought another, the purchaser could treat purchased good will as a wasting asset, amortizable over a period of up to 40 years. But this practice had become increasingly archaic as good will evolved to often represent the most valuable asset many entities possessed.
When a company (typically high-tech firms) is primarily good will, good will cannot really be deemed wasting; rather it must be viewed as living indefinitely, otherwise several large companies could conceivably have a value close to zero. Accordingly, the accepted accounting methods (FASB) now requires companies (originally via FAS 142 and currently via ASC Topic 350) to account annually for the value of good will and to write down, as a nondeductible loss, the value of good will that is "impaired," that is, that no longer exists or never existed in the first place. (This may be the original new math or "fuzzy math," but it makes perfect sense to those versed in the nuances of accounting.)
As another example, consider it in terms of paying $10.00 for what is otherwise a $.25 pack of gum solely because it is made by Wrigley's (as opposed to Bubble Trouble, an unknown company that sells a similar pack for $.25) and later realizing the Wrigley's brand only increased the resale value of the gum to $.50, thus rendering the price you paid too high by $9.50. Under FASB rules, instead of amortizing that amount, one now has to write it off all at once. The paper losses in such cases can result in a staggering blow to shareholder value.
The most infamous case of such loss was the AOL-Time Warner merger in January 2001. When AOL purchased Time Warner, it paid $147 billion (in stock), even though the value of Time Warner's hard assets (its book value) was only $51 billion—the excess $96 billion was deemed good will (attributable primarily to Time Warner's strong brands). Under the old accounting rules, AOL-Time Warner would have amortized that Goodwill for a long, long time. Under the new rules, the drop in AOL-Time Warner's market value after the collapse of the stock market in 2001 had to be accounted for immediately. The result? AOL-Time Warner reported that it had lost $10.01 per share in the fourth quarter of 2002, even though it had earned $.28 per share from actual operations. Chalk up most of the difference (some $45.5 billion in all) to impaired good will. In the everyday shopper's vernacular, that is how much AOL overpaid for Time Warner. And that entire overpayment was based on an invalid valuation of the good will.
Valuing Good Will
In the more mundane world of non-public companies, good will still plays a pivotal role in determining the value of the company both in terms of financing, sale of the company, and methodology for determining appropriate buy and sell agreements within a company. To ignore good will is to create a value that often has little to do with the real value of the company. At the same time, the departure or death of a key owner may drastically alter the good will of the company, thus the formula to determine its value must take that possibility into account. To purchase a restaurant known for its sauces when the sauce chef is the one selling his interest and leaving the country requires a valuation that reduces the value of good will.
The most basic formula utilized in business and by accountants in creating good will valuation for buy and sells and third party sales involves a multiple of the gross or net income averaged over the past several years. Typically, for example, a professional corporation such as a law office will have a formula of net book value (hard assets minus liabilities) plus a multiple of net or gross of the average annual income for the last three years or five years, depending on the time it has been in existence. For example, a law office only five years old would have a minimal multiplier (two or three times) while a law office with fifty years of history and with no years of net loss would have a multiplier of ten or fifteen times a year’s average gross.
The formula becomes more complex when one deducts good will that may be departing. A named partner or a person with particular expertise leaving must reduce the good will. While accountants can develop various formulas, in reality it is often hard bargaining that determines what good will shall be agreed upon to exist for purposes of any formula for buys and sells.
But all the formulas have certain basic criteria that one sees repeatedly:
- The good will is related to a particular person, product, market position or reputation that has demonstrated financial success or value over time.
- The good will has reduced from it the possibility of reduction in value over time, either due to leaving of a key element that contributed to the good will or increased likely competition.
- The good will is extrapolated into the future usually utilizing a multiplier of past success and the greater the good will, the longer the period used for the multiplier.
And, as discussed above, the tax ramifications of valuing good will must also be considered by any buyer or seller of a business.
Intellectual Property versus Good Will: Not the Same
A common mistake is to equate intellectual property or trademarks or logos that a company may have with good will. All those assets may contribute to good will and be part of good will, but good will is seldom restricted to intellectual property or a trade mark. “Kleenex” was simply facial tissues in a box which dominated the market so long that their name became synonymous with the product. In that respect, since their paper was not unique, the brand name and logo were equivalent to its good will.
But in most instances, the good will is comprised of more than a logo or brand name. If half the intellectual property owned by Microsoft was sold, the good will of the entity would be altered but not entirely eliminated. Good will includes everything that denotes reputation and unique placement in the field, not just one type of asset.
It is an oddity of the current business world that more and more of what we make, sell and buy is intangible. Services, software, and digital items have become the mainstay of our economy and our businesses and the world of hard assets such as equipment and machinery has given way to a service economy in which value is often not found on the factory floor.
In this context, an intangible asset such as good will is to a business what software is to a computer…what makes it run and useful. Anyone in business must become as comfortable dealing with that concept of this type of asset…and valuing same…as any other asset owned by the business.