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Personal Goodwill Revisited: Its Nature and Importance in Business Valuation

As tax considerations and financial reporting requirements grow in complexity, distinguishing between personal goodwill and enterprise goodwill in valuing a business can produce important outcomes for the parties

Don Wenk  
 

In valuing a business, the term "goodwill" may have different meanings, depending on who is using the term.

In many cases, goodwill is used as a catch-all for all intangible value of a business. However, from an accounting perspective, goodwill has a more specific meaning, i.e., "the excess value of an enterprise beyond the value attributable to the entity’s identifiable net assets." Because accounting rules often require the recognition of certain intangible assets, this accounting definition of goodwill may exclude specifically identified intangible assets such as trade names, patents, developed technology, etc.

In this article, we approach goodwill in the more general sense, referring to any and all value of a business that is not attributable to the business’s monetary assets (cash, accounts receivable, etc.) or its tangible assets (inventory, furniture, equipment, etc.).

Overall goodwill can be further broken down into two components: enterprise goodwill (also known as "business goodwill") and personal (or professional) goodwill.

In a 2009 article, "Personal Goodwill vs. Enterprise Goodwill," we discussed the distinctions between the two types of goodwill and noted their distinguishing characteristics:

  • Enterprise goodwill is derived from characteristics specific to a particular business, regardless of its owner or specific employees working within the business.

  • Personal goodwill is value associated with a particular individual working within the organization, rather than the characteristics of the business itself.

 Some of the indicators of enterprise and personal goodwill are as follows:

Business Category Evidence of Personal Goodwill Evidence of Enterprise Goodwill
Advertising Focus on the reputation, experience and skills of the owner/operator; business name is the name of the owner; photos of owner Focus on the entity without mentioning management or ownership; business name different from owner’s name; corporate logo
Repeat Customers Customers return due to personal relationship with owner/ operator; many other options for similar goods or services in the area Customers return due to location, convenience, price or other company specific factors; goods or services are unique to a particular area
Referrals Other professionals refer business based on skills and reputation of service provider; many similar providers in area; no formal referral contracts Other professionals refer business based on proximity or organizational affiliation; referral relationships are contractually defined and transferrable
Organizational Structure New customers arrive seeking a particular service provider; profits are allocated based upon income production New customers arrive seeking a general service from the business; profits are allocated equally among owners
Management Depth The business is either completely or mostly reliant on one owner for income generation; income associated with ownership interest being valued would disappear if that owner left The business generates income from multiple producers; income associated with the ownership interest being valued would not disappear if that owner left
Employment and Non-Compete Agreements No employment or non-compete agreements between owners and business; key employees are not secured by employment or non-compete agreements with the business Employment or non-compete agreements exist between owners and business; key employees are secured by employment or non-compete agreements with the business

From a valuation standpoint, one might ask why the distinction between personal and enterprise goodwill matters. In fact, depending on the specific purpose of the valuation analysis, in many cases goodwill (personal or enterprise) is not delineated from overall company value. The total goodwill of an entity is simply incorporated as part of its total enterprise value.

For instance, for a valuation prepared for gift or estate tax purpose, one would seek to determine the company’s total value as a going concern. The resulting value often significantly exceeds the value of the company’s tangible and monetary assets, indicating the existence of goodwill. However, the resulting goodwill is rarely further analyzed and decomposed into the enterprise and personal components.

When the Distinction Matters

In other cases, the distinction between enterprise and personal goodwill matters a great deal; two examples follow.

Business Sale. One such case would be to assist in structuring a business transaction. In an acquisition, it may be beneficial to segregate out personal goodwill, since a buyer paying proceeds directly to the seller specifically for the personal goodwill (rather than as proceeds for the value of the company) may help a seller avoid certain corporate-level taxes.

Another reason for delineating personal and enterprise goodwill pertains to the process of evaluating the total consideration to be paid in acquiring a business. A buyer will be willing to pay only for the portion of the intangible value of an enterprise that can be transferred upon consummation of the transaction. Based on the characteristics detailed above, this often results in only enterprise goodwill continuing with the acquirer. However, a transaction can be structured such that a portion of the personal goodwill, and its associated benefits, can transfer to the acquirer. This is often accomplished through the use of employment agreements.

Marital Dissolution. Over the years, there has been a great deal of debate within the business valuation and legal professions with respect to the treatment of personal goodwill in valuations performed in the context of divorce.

In many jurisdictions, courts require the separate identification and valuation of personal and enterprise goodwill, since personal goodwill is not deemed to be a marital asset and is therefore excluded from the marital estate. Other states, such as Arizona, include personal goodwill in the marital estate and as a result, do not require the delineation of personal and enterprise goodwill.

Valuation of Personal Goodwill

Once the existence of personal goodwill has been identified, the next step is to calculate its value. This is generally accomplished using two primary methods: the "with and without" method and the "multi-attribute utility model" method.

With and Without Method. The with and without method of determining personal goodwill is an income approach that attempts to value a business using two scenarios:

  • with the particular individual continuing to work in the business, and

  • without the individual’s continuing involvement.

The with and without method utilizes discounted cash flow models to project the revenues, expenses and net cash flows that a business would expect to realize over a specified period under each scenario.

Under the with scenario, the projections usually reflect the overall assumptions and cash flow projections for the business "as is." As a result, this scenario includes the value attributable to personal goodwill of the subject key individual.

The without scenario assumes that the enterprise would earn less revenue due to the loss of the subject individual. While the model may also assume that the subject company could hire a replacement for the key individual, most practitioners assume that it would take several years until the new individual could generate revenues and earnings comparable to those generated by the departing individual. Accordingly, this scenario reflects a lesser value due to the enterprise’s loss of involvement by the subject individual.

The difference in value between each scenario is based on the incremental cash flow a company can generate from the key individual’s efforts, reputation, personal relationships, etc., and can collectively be attributed to his or her personal goodwill.

Multi-Attribute Utility Model Method. The multi-attribute utility model (MUM) is a mathematical tool for evaluating alternatives and assisting in decision making. The usefulness of a MUM model in determining the allocation of personal versus enterprise goodwill can be credited to David N. Wood, who utilized the MUM approach in a 2003 Illinois family law case.[1] While the detailed mechanics of the model are beyond the scope of this article, the MUM method at its most basic level provides a mathematical framework to assist valuation professionals in quantifying an otherwise subjective allocation.

The methodology begins with the valuation professional defining the various attributes of personal and enterprise goodwill. For instance, the attributes of personal goodwill often include the owner’s specialized knowledge, strong personal reputation, personalized business name, and relatively young age and good health. Alternatively, attributes of enterprise good will include enterprise-wide business systems, high-caliber staff, multiple offices, and excellent business location(s).

After defining the various personal/enterprise goodwill attributes, the valuation professional next weights each attribute on its existence and relative importance, using a pre-determined scale (e.g., 1-5 or 1-10). The importance and existence factors are next multiplied together to arrive at a "multiplicative utility" factor for each attribute.

Finally, the multiplicative factors for the personal and enterprise attributes are combined, and the respective percentages of each attribute can be determined. Personal and enterprise goodwill can then be expressed as percentages of total goodwill (for instance, 70% personal goodwill, 30% enterprise goodwill). While certainly not a precise methodology, the MUM method does provide a quantifiable framework for the allocation decision that has been accepted by family law courts.

Conclusion

The valuation of personal goodwill is a specialized area of business valuation. At a time in which tax considerations and financial reporting requirements are increasingly complex, the identification and valuation of personal goodwill can produce important outcomes for the parties involved. If you have questions on personal goodwill in business valuation that require analysis beyond the general discussion contained in this article, please contact Don Wenk.

[1]See "An Allocation Model for Distinguishing Enterprise Goodwill from Personal Goodwill," David N. Wood, CPA/ABV, American Journal of Family Law, Volume 18 Number 3, Fall 2004.