What do you do when you need to value a company that is heavily reliant on one person? In another post, I had mentioned that the value of a company, or of any asset for that matter, is the present value of the future cash flows of that company. But what if those cash flows are mainly attributed to one person at the company? How does one handle that situation? This post deals with the concept of goodwill and to whom (or what) it is attributed.
There are two types of goodwill commonly encountered in the valuation of businesses: personal (or professional) goodwill and enterprise goodwill. The reason determining goodwill is so important and why a seller may be concerned with it is because the type of goodwill you have could create vastly different tax situations upon the sale of your company. The goodwill present in a company could be entirely personal, partially divided between personal and enterprise, or entirely enterprise goodwill. To make the determination of what is giving rise to the presence of goodwill, the facts and circumstances of the particular company must be analyzed, and the answer is seldom straight forward.
Although personal goodwill can be found in virtually any type of company, it is often more prevalent in professional practices such as physician clinics, engineering firms, professional service firms, etc. The intangible value or goodwill of a professional practice can be difficult to measure and can also be difficult to preserve in a transaction. Much of the value of a professional practice typically consists of professional goodwill unless specific measures are taken. To provide a common example, consider your family doctor. Many individuals have a strong loyalty to one doctor in particular, either because their parents took them to that doctor, or perhaps they even send their own children to that doctor. No matter the reason, people have very close ties to their doctors that are not easily severed. Individuals will go to great lengths to ensure that they are seen by their doctor and only their doctor when it comes down to it. They often will not even settle for a doctor in the same practice as their trusted doctor. In fact, you may even think that if your doctor were to leave their clinic, you would follow them to their new clinic; you are that loyal. If this describes your situation, your doctor likely has personal goodwill. This is goodwill that is derived by and attributed to the individual professional, either through their trusted relationships, specialized knowledge, industry reputation, etc.
Conversely, if your company attracts revenue mainly because of the company itself rather than one individual, the goodwill derived could be enterprise goodwill. A great example of goodwill being transferred from the individual to the company would be a company with a reputation for exceptional customer service. Perhaps the owner or founder has succeeded in imparting their work ethic and customer service skills on their employees carefully over the years, and everyone knows that the company’s employees reflect the values of the founder. Now the public views the company as a place with a reputation for treating customers with respect. A change in ownership may be less likely to affect the earning potential of the company.
Although a sizeable part of personal goodwill may not be transferable to another professional, there is often transferability to a qualified buyer with careful planning and cooperation between the seller and the buyer. The selling practitioner can transfer some client or patient trust by introducing them to the buying practitioner and by bringing the buyer into the practice as an associate, providing a transition period. A noncompete agreement between the buyer and seller can help ensure the successful transfer of clients, and the buyer is usually willing to pay an additional amount for this further assurance of the transfer of clients. In short, the better a clinic is able to prevent the drop off of patients after the departure of the selling professional, the better the value of the company is maintained.
When it comes to the creation of personal goodwill, the goodwill that would otherwise be attributed to the company is shifted to the owner/executive. The creation of personal goodwill gained notoriety in what has become a famous U.S. Tax Court case, Martin Ice Cream Co. v. Commissioner, 110 T.C. 189. In the Martin Ice Cream case, the Tax Court decided that, when a corporation has no employment contract with an employee (in this case, the owner), the employee’s personal relationships are not assets of the Company. It was recognized in the Martin Ice Cream case that personal goodwill is unique and is present only if supported by particular facts. For example, the seller should not be subject to a non-compete agreement in favor of his or her former company. Additionally, the seller should not be subject to any non-solicitation agreement that prohibits him or her from contacting and trying to do business with the former company’s customers or vendors. It should be noted that noncompete agreements are currently facing a possible extinction by the FCC, with a proposed exception for business sellers who own more than 25% of the company. This proposed removal is still in the preliminary phase and is subject to change, so I won’t speculate on how that will end up in this post.
One of the best ways to determine if personal goodwill exists is to have an honest conversation with yourself. If you were to leave your company and open a competing business directly across the street from your current company, who would follow you? Customers? Suppliers? Both? To what extent would they follow you? Approximately half? Three of your largest customers? Could you lure away all of your existing customers? Succinctly, this is how the existence of personal goodwill is determined and then bifurcated between personal and enterprise goodwill. As far as the IRS is concerned, if they decide to look more closely at your taxes and question your goodwill calculations, they will want to see an appraisal of the personal goodwill. They understand that assumptions are used in calculating the split between personal and enterprise goodwill, but you need to have a solid foundation to support your assumptions.
If you are considering a sale, the topic of goodwill needs to be mentioned early and often as being a part of the transaction, ideally beginning with the letter of intent. It is much more difficult to introduce the concept of goodwill into the transaction if the seller waits until the last minute to try and interject it into the purchase agreement. If you are looking at a potential sale, do you know how much goodwill you have? Contact us to discuss the possible existence of goodwill and how to handle it in your transaction.