When selling a business, one of the most important aspects to consider is goodwill. Goodwill represents the intangible value that makes a business more profitable and desirable to buyers, so it is unlike tangible assets such as equipment or inventory.
Goodwill includes elements such as a strong customer base, brand reputation, loyal employees, and business relationships.
So, how do you value goodwill when selling a business? In Australia, goodwill is typically calculated using methods such as capitalised earnings, excess earnings, or market-based comparisons. The right method depends on your industry, financial performance, and market conditions.
What Is Goodwill, and Why Is It Important When Selling a Business?
Goodwill is the intangible value of a business that goes beyond physical assets. It’s what makes a business profitable even if someone else takes over. For example, if a café has a loyal customer base, a well-known name, and a prime location, these factors contribute to goodwill.
Why Does Goodwill Matter?
When selling a business, goodwill is often a major part of the purchase price. A business with strong goodwill can command a higher price because it’s already successful. Buyers want to know that after they take over, the business will continue to generate profits.
For sellers, goodwill represents years of effort spent building a reputation, fostering customer loyalty, and establishing efficient operations. When selling, it’s crucial to justify the goodwill value to maximise the sale price.
How To Calculate the Value of Goodwill in an Australian Business Sale
There’s no single way to calculate goodwill because it depends on the business type and industry. However, Australian business sales commonly use these three methods:
1. Capitalised Earnings Method
This method is based on the business’s future profit potential. It calculates goodwill by:
Taking the average annual earnings (net profit) over a set period.
Applying a capitalisation rate (based on industry standards and risk factors).
Formula:
Goodwill = (Average Earnings x Capitalisation Rate) – Net Tangible Assets
For example, if a business earns an average of $200,000 annually and has a capitalisation rate of 3, goodwill is:
(200,000 x 3) – 300,000 (tangible assets) = $300,000 goodwill
2. Excess Earnings Method
This method compares the business’ actual earnings to what an investor would expect from the tangible assets alone. If the business earns more than the expected return, the extra earnings are attributed to goodwill.
3. Market-Based Comparison
In this approach, goodwill is valued based on the selling prices of similar businesses. If similar businesses in your industry have sold for a price that includes a goodwill component, this can be used as a benchmark.
Each method has its pros and cons, and a professional valuation is recommended to get the most accurate goodwill estimate.
What Factors Influence Goodwill Valuation in Different Industries?
Goodwill varies significantly across industries. Some businesses rely heavily on brand reputation and customer loyalty, while others may have goodwill tied to location or industry demand. Here are key factors that influence goodwill valuation:
1. Industry Type
- Retail & Hospitality: Goodwill is influenced by brand recognition, location, and customer loyalty.
- Professional Services: Law firms, accounting firms, and medical practices rely on client relationships and reputation.
- Technology & Online Businesses: Intellectual property, brand recognition, and user base are major goodwill drivers.
2. Customer Base and Brand Recognition
A business with a strong, repeat customer base will have higher goodwill than one relying on one-time sales.
3. Location and Market Demand
A prime location can significantly boost goodwill value, especially in businesses like cafés, restaurants, and retail stores.
4. Contracts and Supplier Relationships
Long-term supplier contracts, exclusive agreements, and partnerships increase goodwill.
5. Competition and Market Trends
If your business has a strong market position, goodwill will be higher. However, if the industry is declining, goodwill value may decrease.
What Legal Considerations Should Sellers Be Aware of When Transferring Goodwill?
Selling goodwill involves several legal aspects that both sellers and buyers must address.
1. Goodwill Transfer Agreements
A Sale of Business Agreement must clearly define goodwill and how it’s transferred. Key terms include:
- Non-Compete Clauses: Prevents the seller from starting a competing business within a set period.
- Client List Transfer: Ensures the buyer receives customer relationships and databases.
- Employee Retention: If key employees contribute to goodwill, their continued employment may be included.
2. Intellectual Property Rights
If goodwill includes trademarks, brand names, or copyrights, these need to be legally transferred.
3. Lease Agreements
If goodwill is tied to location, ensure the lease is transferable or renegotiated with the landlord.
4. Legal Due Diligence
Buyers often conduct due diligence to verify goodwill value. Sellers should prepare by having:
- Financial statements
- Customer data
- Contracts and agreements
- Failing to address legal considerations can lead to disputes or delays in the sale.
Maximising the Value of Your Business Sale
Goodwill is a key part of your business’s sale price, and valuing it correctly ensures you get the best deal. Whether through earnings-based calculations, market comparisons, or industry analysis, understanding goodwill helps sellers justify their asking price.
It’s also essential to consider tax implications and legal requirements when transferring goodwill. Seeking expert legal and financial advice can help sellers take advantage of CGT concessions, structure a fair agreement, and protect their interests.
Thinking of selling your business? Walker Pender’s expert business lawyers can help you determine the true value of your goodwill, draft a solid sales agreement, and ensure a smooth transaction. Contact us today for professional advice tailored to your business.
