How to Value Goodwill in a Small Business Sale
Whenever a small business changes hands, the purchase price rarely comes down to just the value of its tangible assets. Equipment, inventory and accounts receivable all have objective values, but there’s almost always a gap between those figures and the price a buyer is actually willing to pay.
That gap is called “goodwill,” and it often represents a substantial share of the deal’s overall value.
However, goodwill is also the component most likely to raise questions from buyers, lenders and even the IRS. So it’s important to understand this term and how to apply it when you’re selling (or buying) a small business yourself.
What Goodwill Actually Represents
Goodwill is the premium a buyer pays above the fair market value of a business’s identifiable net assets. It captures everything that makes the business worth more than as a collection of parts, such as:
- An established customer base
- A recognizable brand
- Trained employees
- Specialized knowledge
- Supplier relationships
- Proprietary processes
- A high-traffic location
It can even include the simple fact that the business already generates reliable cash flow rather than requiring a buyer to build it from scratch.
Goodwill should be distinguished from other intangible assets. Trademarks, customer lists and non-compete agreements are intangible assets, but they can be identified and valued separately.
In other words: Goodwill is what’s left over after all of those and other specific intangibles have been accounted for. Think of it as the residual value you can’t attribute to any single asset.
How Goodwill Gets Calculated
The basic calculation for goodwill is:
Purchase price – (Fair market value of assets – fair market value of liabilities) = Goodwill
So, for instance, let’s say Hypothetical Inc. paid $40 million for What If Enterprises. The fair market value of What If’s assets was $35 million, and it had $10 million in liabilities. The calculation would be …
$40 million – $25 million ($35 million – $10 million) = $15 million
Thus, goodwill would be $15 million.
Why the Allocation Matters So Much
When you buy a company and assign values to its various assets, that’s called “purchase price allocation.” Assigning a value to good will is “goodwill allocation.”
These aren’t just accounting exercises. They have real tax consequences for both parties, and their interests often don’t align.
- Buyers generally prefer to allocate as much of the price as possible to assets that can be depreciated or amortized quickly, such as equipment and inventory, as it creates near-term tax deductions. But goodwill must be amortized on a straight-line basis over 15 years (or, in the case of a public company, it must be impairment-tested every year).
- Sellers, meanwhile, typically prefer that goodwill attributable to the business itself (as opposed to personal goodwill tied to the owner) be taxed at favorable long-term capital gains rates rather than the ordinary income rates assigned to gains on assets like accounts receivable and inventory.
Because buyer and seller incentives are often at odds with one another, the IRS requires both parties to report their purchase price allocation on Form 8594 if goodwill is involved. And the figures reported by each side need to match. A mismatch is a common audit trigger, which is one more reason the allocation should be documented and agreed upon in the purchase agreement itself, not informally worked out after the fact.
Personal vs. Enterprise Goodwill
One distinction worth understanding (particularly for owner-operated businesses) is the difference between enterprise goodwill and personal goodwill.
- Enterprise goodwill is value tied to the business itself.
- Personal goodwill is value tied to the specific owner’s reputation, relationships or expertise.
This distinction can meaningfully affect tax treatment and is worth discussing with an advisor early in the sale process, as it can shift based on how involved the owner has historically been in the business’s day-to-day success.
Get Business Valuation Right From the Start
Goodwill is rarely simple to pin down, and getting the number wrong (or failing to document how it was reached) can create problems long after the deal closes. Those problems can range from IRS scrutiny to disputes with the other party over the original allocation.
McManamon & Co. is an accounting, tax, fraud, forensic and consulting firm that serves small and midsize businesses. If you’re considering a merger or acquisition, our experienced team can work with you on business valuations, including helping you value goodwill accurately, structure a purchase price allocation that holds up to scrutiny and navigate the tax implications of your sale from either side of the table.
Call us at 440.892.8900 or contact us online to learn how we can help you get your next transaction right.
Tags: McManamon, McManamon & Co., mergers and acquisitions, small business, small business accounting | Posted in business valuation, McManamon & Co., mergers & acquisitions, small business