Personal/Professional Goodwill – How It Affects Value Of Small Business

Goodwill Defined.  The term “Goodwill Value” is a term of art that is applied to the incremental increase in value of an enterprise over and above the simple replacement value of the fixed assets.  Unless it is added to a balance sheet reflecting an actual purchase of goodwill in an acquisition, it almost never is seen on a balance sheet based upon Book Value.  It is the primary reason for business appraisals.  It is a necessary element to determine the actual Fair Market Value of a business enterprise.

Goodwill Has Two Basic Potential Components.

•    The basic form of Goodwill is “Enterprise Goodwill.”  It applies to the business as a whole and exists irrespective of the increment of value resulting from a key person’s personal knowledge, reputation, customer relationships, or any other attribute which resides in his persona.  It generally reflects a value which would exist without the participation or contributions of one or more key officers or employees.

•    Personal and Professional Goodwill are very similar and they attach to the individual that contributes them.  Personal goodwill is associated with individuals. It is the part of increased earning capacity that results from the reputation, knowledge and skills of individual people, and is non transferable and unmarketable.  An example would be the CEO of a small business that has long-term personal relationships with the customer base, which could (or likely would) be lost if the person no longer were to be involved in the business.

Similar to personal goodwill, professional goodwill is often characterized as ‘conceptually distinct from that associated with a trade or business’ and attached to the individual.  It is usually associated with reputation and experience.  In most professional practices, professional goodwill is largely dependent upon the skills and attributes of the individual practitioners.

Reasons for Valuing Personal/Professional Goodwill. There are really basically two purposes:  marital dissolutions and sales of businesses.

Marital Dissolutions. The most common reason for an actual appraisal of personal/professional goodwill value is marital dissolutions.  This is because it varies widely from state to state as determined by case law.  The two issues are whether Enterprise Goodwill and/or Personal/Professional Goodwill are included in the marital estate.  Our research shows the following:

•    In 6 states neither personal/professional or enterprise goodwill is included in the marital estate.

•    In 4 states the issues are undecided.

•    In 40 states enterprise goodwill is included, but in 24 of these, personal/professional goodwill is not.

Sales of Businesses.  Normally, a business appraisal obtained by a seller will not break down personal goodwill as separate from enterprise goodwill unless the entity is a C-Corporation.  This is because normally any personal goodwill is mitigated in the purchase and sale agreement to provide a means whereby the buyer will “inherit” the personal goodwill of the seller.  This is done with such tools as:

•    Non-Competition Agreements
•    Retaining the seller as a key employee for a defined period of time
•    Partial buy in, with a buy out later.

The objective of any of the above tools is to create time and exposure to the buyer by the client or customer base to allow them to become inured to the purchaser.

The principal reason a seller will want to know what percentage of the total Goodwill Value is personal/professional is that these can often be mitigated prior to the sale by effectively transferring the personal/professional goodwill to key employees.  This typically results in the buyer being willing to pay a higher price for the business.

If personal/professional goodwill is mitigated it also opens the field to investor-buyers as opposed to operator-buyers.   For more valuable businesses, the investor-buyer is likely the most efficacious way to sell.

Splitting the Sale in the case of a C-corporation.  The biggest problem for owners of C-corporations is the double taxation of capital gains upon a sale.  First it is taxable to the corporation, then when distributed to the shareholders it is taxed again at the personal tax level.  This is not the case with proprietorships, partnerships, LLCs or S-Corps.

However, where personal goodwill is part of the sale, it can be structured as two separate transactions.  One is a sale of the C-corporation’s interest (either stock sale or asset sale) and the other is a personal sale of personal/professional goodwill, which will then be taxed only at the personal rate.

Post by: Gerald W. Barney MS, CSBA, CMEA

American ValueMetrics Corp.
www. Americanvaluemetrics.com
info@americanvaluemetrics.com