If you’re starting to plan the sale of your business, at some point you’ll come across the term “goodwill.” We’ve found that for sellers goodwill can be one of the hardest things to conceptualize because it’s not tangible.
If you can’t see it, then how can you measure it?
Fortunately, there’s a step-by-step process you can follow to calculate the goodwill of any business.
At MidStreet, we have spoken to many business owners about the goodwill in their company and how that affects the sale price of their business. The more goodwill your business has, the more valuable the intangible part of your business is.
To help you understand what goodwill is in a business sale, this article will cover what it is, how you estimate it, and how it will impact the sale of your business.
Let’s hop in.
The Definition of Goodwill
If you’re a business owner, you know the tax man is waiting patiently for the day you sell your business. Much like selling stocks, you’ll have to pay taxes on the gains you experience from selling your business.
The good news is you and the buyer will have a chance to divide up the purchase price into buckets that get taxed differently. The purpose of this is to “allocate” the purchase price to different groups of assets so they are taxed at the appropriate rate.
For instance, some of the value of your business is in the vehicles and equipment you and your team use. But if your business is like most, the majority of the value of your business is in its ability to generate cash flow going forward. This bucket is known as “goodwill.”
The way you calculate it is by taking the purchase price (including earnouts and seller financing) and subtracting the other asset allocations. This would include FF&E (your equipment and vehicles), an amount for your training provided to the buyer, an amount for your non-compete agreement with the buyer, and the value of your inventory.
Example of How to Calculate Goodwill
In an asset sale, the purchase price must be allocated to certain assets - the balance will be goodwill. To help illustrate this, let’s go through an example of a machine shop.
Say you own a machine shop that does $1,800,000 in revenue and made $350,000 in Seller’s Discretionary earnings (SDE) last year. You receive an offer for $1,000,000 to buy your company.
Your broker tells you it’s best to negotiate the asset allocation at the beginning, in the letter of intent stage, rather than down the road. They advise you to do this because it affects how much you’ll get to keep after taxes and is often a point of contention.
After some back and forth, you and the buyer agree to the following allocation:
Furniture, Fixtures, and Equipment: $250,000
The value of your machinery, tools, desks, chairs, computers, vehicles, and other hard assets that are used in all areas of your business. This does not include inventory, though.
The amount of currently in-stock raw materials or finished goods you will be leaving with the buyer. The value of which should be taken at your cost, not what you sell it for.
The value assigned to your covenant not to compete with the buyer. You’ll have to agree to not compete with the buyer in a certain geography for an amount of time. This is typically limited to the area your company does business and a little beyond.
The value assigned to your consultation and training with the buyer post-closing for which you will not be paid (this is the payment).
This was calculated by taking the sale price of $1,000,000 and subtracting the sum of the other 4 categories ($400,000). This is the value of your brand, reputation, customers, knowledge, website, intellectual property, and any other intangible your business has created over the years.
By using the following equation, you can see how the value of goodwill is determined:
How is Goodwill Taxed in a Business Sale?
Since asset sales are more common in lower middle market sales, we will cover the taxation of goodwill in an asset sale in this article.
In an asset sale, goodwill is taxed at a long-term capital gains rate. Long-term capital gains rates will usually range between 15%-20%, but will ultimately be determined by the gain you receive from selling the asset.
The buyer who purchases your business can amortize (write-off on their taxes) the goodwill over 15 years but cannot write it all off at once. This means they will write off 1/15th of the goodwill each year.
What Amount of Goodwill do the Buyer and Seller Want?
The amount of goodwill in the sale will be affected by the amounts allocated to other asset classes. If there is less allocated to the other assets, then goodwill will be higher. If there is more allocated to other assets, then the goodwill will be lower.
The buyer wants low goodwill and high equipment allocation. You, as the seller, will want high goodwill allocation and less toward assets. Why?
- You (the seller) will pay more in taxes if the allocation to equipment is higher.
- The buyer will not be able to depreciate as much if the amount allocated to equipment is low.
In an asset sale, a buyer gets to step up the basis of assets. For example, say you as the seller bought a truck for $50,000 and then depreciated it to $0 over 3 years before the sale. That truck still has some service life left and the buyer will acquire it in the asset sale.
During the sale, a value needs to be allocated to that track - let’s say $25,000. Since you had previously depreciated the truck to $0, this would be a step-up in basis from $0 to $25,000.
After the sale, the buyer will have the truck on their balance sheet at $25,000, which means that they can depreciate it and receive the tax savings.
As the seller, you will have to pay ordinary income tax on the $25,000 that you received from selling the truck to “recapture” the depreciation you wrote off on your taxes.
Do All Businesses Have Goodwill?
All profitable businesses have goodwill unless the business has excessive assets. A business must generate a profit that justifies its assets. Your business may not have goodwill if:
- It is profitable but it requires a large amount of capital to operate
- You just started it and haven’t turned a large enough profit yet
- Your company has negative cash flow
If you own a machine shop that makes $250,000 per year in SDE (cash flow) but must own $10 million in equipment, there is not a goodwill balance. The purchase price of the business will be largely dictated by the equipment’s value.
Consider Goodwill in The Sale of Your Business
When you know how goodwill works and how it impacts your overall taxation, you can better prepare for your sale.
Allocations that are positive for the seller are usually neutral or slightly unfavorable for the buyer, while allocations that benefit the buyer usually disproportionately hurt the seller. Because of this, you should be prepared to make some compromises on the allocation of the purchase price but will want to hold a line.
Learn more about asset allocation in our article “What is Purchase Price Allocation in a Business Sale?”
We help hundreds of sellers choose the most beneficial allocation for the sale of their business. To find out more about how goodwill will impact the sale of your business, contact us today.