Personal vs Enterprise Goodwill
Since the value of personal goodwill is generally not marital property in Maryland, it is important to understand the amount, if any, of personal goodwill included in the value of a professional practice or, in many cases, other types of businesses. I would suggest that there is an element of personal goodwill attributable to the vast majority of closely held businesses. To understand the nature of goodwill, one must understand the underlying methods used by the valuation analyst. Let’s discuss the three basic approaches considered in all valuation engagements.
Asset Approach
Under the asset approach each component of a business is valued separately, and summed up to derive the total value of the enterprise. The analyst estimates value, using this approach, by estimating the fair market value of the individual elements of the business property being appraised, item by item, asset by asset.
Often, however, the asset approach is employed in situations where a business is not profitable or is a business which would be difficult to sell as a continuing enterprise. The asset approach is also often used in cases where the subject company is an investment company such as a family limited partnership holding real estate or marketable securities. Asset holding companies such as these do not generate goodwill; therefore, the analyst would generally not consider goodwill in the value conclusion.
It is likely that, under the asset approach, there is no goodwill included in the value and further analysis of goodwill would not be required.
Market Approach
Under this approach, the analyst attempts to find guideline companies traded on a public stock exchange, in a same or similar industry as the appraisal subject, which allows a comparison to be made between the pricing multiples that the public company trades at and the multiple that is deemed appropriate for the appraisal subject. Another common variation of this approach is to locate comparable privately-held companies that have been bought or sold in the marketplace that allow the analyst to determine the multiples that resulted from the transactions.
For smaller businesses, multiples from sales of comparable privately-held companies will often be the method under the market approached utilized by the valuation analyst. Under this method, there is less likely to be a large element of personal goodwill in the value because the multiples are based on actual transactions. However, the inclusion a covenant not to complete in the purchase price would indicate an element of personal goodwill value.
Income Approach
The computations using the income approach generally determine that the value of the business is equal to the present value of the future benefit stream to the owners. This is generally accomplished by either capitalizing a single period income stream or by discounting a series of income streams based on a multi-period forecast.
The income approach is the approach that will most likely include personal goodwill in the value. Under the income approach, discount rates are applied to the earnings of the business and there is usually no attempt to adjust the earnings for income earned solely due to the professional and personal attributes of the owner. The discount rate may consider the issue somewhat by recognizing the increased risk of relying on the owner through a “key employee” adjustment to the discount rate. However, this adjustment will likely not fully address the personal vs. enterprise goodwill issue.
The issue of personal vs. enterprise goodwill may be a key factor to consider in many cases involving the value of small businesses and professional practices. If you have a situation where personal vs. enterprise goodwill may be an issue or would like to learn more, feel free to call me.
John Clay is a director at Lanigan Ryan. He has over twenty years of experience in public accounting, working with a wide variety of closely held businesses. He has spent a considerable part of his career concentrating on valuations for gift and estate tax; mergers and acquisitions; and divorce purposes. He is a licensed CPA in the state of Maryland and was designated as a Certified Valuation Analyst in 2002 by the National Association of Certified Valuation Analysts.
