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Goodwill - what is it?

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During negotiations for the purchase of an established business, it is inevitable that the aspect of goodwill will play a factor in the final price paid. Needless to say, its value will be assessed differently from a buyer’s and sellers’s perspective.

From an accounting point of view, goodwill represents the difference between the purchase price and the fair market value of the assets. For example: if you pay R 3m for a business and the plant / machinery, fixtures and fittings are valued at R 2m, you would have paid R 1m for the goodwill of the company.

In essence, this means that you would have paid R 1m for the fact that:

1.  The company has been in business for some time

2.  That the assets purchased have an ability to generate future income.

So you can understand why it can become an emotional issue during negotiations. The seller expects to receive compensation for the many years in business while the buyer views goodwill as a business’s inflated value of self worth.

It's clear that determining goodwill is anything but an exact science and can become a moving target during buyer/seller negotiations. There are however, certain factors that need to be taken into account and these can be unique to certain businesses. These can include the following:

  • What is the state of the industry within which the business operates; is it mature or is there still growth potential?
  • How consistent has past profitability been?
  • What could be considered as a realistic future income stream – say over the next 2-3 years?
  • How diverse is the client base? Do they rely on certain clients and the industries within which they operate?
  • How many serious competitors are there and how high is the cost of entry into the market for a new player?
  • Will the seller remain in the business post sale? In owner managed businesses, this is an extremely important consideration – if past and future business has and will be dependent on his input / presence / skills, sustainability is vital
  • Negotiating a win / win contract with the seller to remain in the business for the next 2-3 years will pay dividends in the long run. It would of course be essential that this term is used to transfer as much knowledge and as many skills as possible

It has been said that goodwill is very much a ‘nebulous’ figure & will be determined quite differently by a buyer and seller. Try not to over-analyse and get ‘bogged down’ in agreeing on a figure – at the end of the day, once negotiations are finalised, goodwill will equal the purchase price less the fair market value of the assets acquired.

Barry Wiseman is a director of the IQUAD Finance Solutions (Pty) Ltd who provide business development services, assist business owners raise funding & secure equity capital. See www.iquad.co.za and www.bwifs.blogspot.com

Copyright (c) 2016, the credited author
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