In small and very small business valuation, goodwill is often used as the general classification for all intangible assets. Calculating goodwill is fairly straightforward. Goodwill is the residual when subtracting all physical assets value from the total business value. Goodwill in its broadest sense is the value attributed to all business assets and activities other than the physical assets.

There are many potential classifications of intangible assets. These include licenses, intellectual property, such as patents, copyrights, trademarks, trade secrets, and the like. There are intangible assets associated with the customer list and relationships with suppliers, contractors, and the like. These can all be broken down and estimated. The Generally Accepted Accounting Principles (GAAP) require this for larger companies but these estimates are rarely if ever done for small and very small businesses. With small and very small businesses, intangible assets are not further broken down except when there are reasons to determine personal goodwill and company goodwill.

In many jurisdictions for divorce, and in some federal tax matters including when C corporations are sold in asset sales, and for estate and gift tax, personal goodwill can be very important to determine.

In many states, in divorce, personal goodwill is a personal asset and not part of the marital estate. For federal tax purposes, if a C corporation is being sold in an asset sale, double taxation can provide an onerous burden and leaves little after-tax profit for the shareholder owner.¹ But, if personal goodwill exists, the owner can sell his or her personal goodwill directly to the buyer and that portion of the transaction will avoid double taxation.² There are also interesting planning situations that can arise in estate planning but that rarely comes up with small and very small businesses and will not be covered here.³

Many state courts have very different definitions of personal goodwill from those of other states and the IRS or Tax Court. In some cases, there is no consistent definition within a jurisdiction. Always make an attempt to understand the definition being used by your user and if it is applied consistently.

Small and very small businesses tend to have owner operators running the business. Therefore, there often is goodwill associated with the business and additional goodwill associated with the owner. Because the owner and the business are somewhat indistinguishable to customers, suppliers and the like, some of the value of personal goodwill can show up in the business value.

A few situations where business goodwill value and owner personal goodwill value may be lumped together as goodwill are:

• If the owner operator is well known by the suppliers and customers and people work with the company because of the owner.
• Sometimes the owner operator's name is part of the business name.
• In professional situations, such as medical centers, perhaps people only want “that” surgeon not the associates.
• Artists and high creatives may be desired like the surgeon, for their personal talents that do not pass to others well.

These are all situations that indicate personal goodwill may be present.

There are three categories of personal goodwill:⁴

1. “Pure” Personal Goodwill. This is goodwill completely owned by the owner. This cannot be conveyed under any conditions. In a properly prepared business valuation, it will not be shown other than perhaps with a value to the holder standard as it cannot be conveyed. If it cannot be conveyed and turned into future cash flow by a buyer, then under most standards it does not exist as business value. Because the past is usually looked at to estimate the future, the cash flows may not be properly adjusted to remove the “personal component” of the cash flow.⁵ So, there can be disputes about this value existing in a business valuation that must be countered but, in reality, if it is shown, it is an error as it does not exist as business value.
2. Transferable or Conveyable Personal Goodwill. Most personal goodwill qualifies under this category. It can be conveyed with proper non-compete clauses and perhaps a transition plan. Of course, the asset value is likely to be lost by the business if the owner chooses to compete or walks off and does not properly transition the business. For many businesses these transitions can be as short as a few weeks and in some personal service businesses, it can take two or three years. To restate this concept, people like buying from me but will happily buy from you if you can meet my price, terms and service level. A second version is the owner has a “special process” that needs to be (and can be for a reasonable cost) taught. This personal goodwill really exists but will often be shown as company goodwill. It really comes down to who owns the goodwill (do they think they are calling the owner or the business?) as opposed to how hard this is to convey.
3. Entity Goodwill. Entity goodwill is true business goodwill. No one really cares who the owner of a local McDonald's is (except perhaps the owner). Suppliers and customers are relying on the corporate franchise and the local managers and employees to take care of them. This is entity or corporate goodwill. If the business changes hands (and in this case keeps the franchise rights), there will be no impact because of the name, personality, or relationships or the like of the owner. The owner of a McDonald's franchise does not have personal goodwill.

A few “real-world” facts about personal goodwill. Most people, including clients, suppliers, employees and the like, are creatures of habit and a little lazy. They tend to go back if nothing was wrong. Therefore, some professional services that are required every day or year, such as bookkeeping, audit, and tax accounting, have high personal goodwill but it is transitional goodwill. Many traditional small businesses also have transitional goodwill. Remember the lead case “Martin Ice Cream” (cited below) was an ice cream distribution company.

Artistic-type businesses, such as architects, interior designers, advertising, that are subject to trend and style, still often have strong personal goodwill. This is particularly the case with smaller companies that only have one principal or maybe two, each of whom have their own following. There are often very few comparables for these types of firms in market data, again demonstrating that they are difficult to sell.

In medicine, small office general practitioners have little or no transferable personal goodwill anymore. Some people find primary care doctors through insurance lists, others through clinics and may change affiliations based on insurance. A few really highly ranked specialists have personal goodwill but this is true personal goodwill with little market value. Even where this does exist, the hospital system referral networks along with insurance have removed a lot of personal goodwill in the space.

CALCULATING GOODWILL

There are many tests for personal goodwill. Most valuators look at a range of indicators and use a chart format to create a weighting mechanism and then apply judgment to determine the ratio of company goodwill to personal goodwill. Similar to discounts for lack of marketability, the calculations are simple. Justifying the selected discount takes work and professional judgment. A typical calculation is shown in Figure 10.1. Typical indicators are discussed next.

MUM Method for Goodwill

Another commonly used method is the MUM or multi-attribute utility model.⁷ This is a methodology that attempts (the factors and analysis remain subjective) to add some standardization and quantification to the process. It is extremely detailed. In fact, some analysts are reported to be using a simplified model due to the “illusion of precision” when using MUM.

Again, the valuator must still choose the ranking for each item. The rankings are still based on professional judgment. The other problem with the method is a few attributes may carry significantly more weight than other attributes. This is hard to account for in a pre-determined matrix as there is no completely satisfactory quantifiable way to estimate entity vs. personal goodwill.