Goodwill is the component of price above the intrinsic value of the business.

The steps we have outlined below will help in determining if there is any goodwill value in addition to the intrinsic value associated with the asset.

To do this the seller/buyer must consider risks associated with running the business. That is, what are the risks associated with the business?

calculating business goodwill

Risks

Risks include:

  • Key employee risk (including owner/s)
  • Supply risks
  • Customer risks
  • Economic risks
  • Technological risks
  • Systematic risk
  • Market risk and
  • Tenure risks.

There may be additional risks associated with the business not mentioned in this article.

Key Employee Risk

Key Employee Risk is risk associated with key staff members or owners. There are a number of components to this risk. These include:

  • How much does the business rely on key personnel (including the owner)?
  • Would it be difficult to replace them without detriment to the business?
  • Can they easily be replaced at a fair market rate?
  • Are they being paid the fair market rate now?
  • Will any negative / positive answers to these questions affect the profitability of the business?

Supply Risk

Supply Risk is the risk associated with supply arrangements. There are a number of components to this type of risk.

  • What choice of suppliers are available?
  • Are supplier terms transferable to the new owner?
  • If they are not transferable will that increase working capital required?
  • How will this affect the value of the business?

Customer Risk

Customer Risk is associated with customers. There are a number of components to this type of risk.

  • Are sales distributed evenly among the customers?
  • What percentage of sales do the top 5 and top 10 customers hold?
  • Do the biggest customers choose the business due to price, quality, customer service or convenience?
  • If the business lost the two biggest customers would that significantly change the profitability of the business?

Economic Risk

Economic Risk is risk associated with the economy. There are a number of components to this risk.

  • How effected is the business in relation to local, national or regional economic conditions?
  • How likely are economic conditions to change?
  • Will this effect the profitability of the business?

Technological Risk

  • Will products or services offered be eliminated through technological innovation? If yes, when is this innovation likely to occur?
  • Will technology help the business to grow?
  • How technologically driven is the business?
  • How technologically driven are the competitors?
  • Does this require further investment into equipment and training?
  • Will this affect the profits?

Systematic Risk

This risk is associated with the systems that the business currently employs.

  • Are these systems effective?
  • Are these systems easily transferable?
  • How much of the business is systematised?
  • Does the business have a manual or documented standard operation procedures?
  • How much requires executive decisions?
  • Are there better systems available?
  • How easy is it to learn these systems?

Market Risk

This is risk that is associated with the market the business operates in. The first thing to consider is:

  • Where does the business conduct its operations? Manufacture, wholesale or retail.
  • How many competitors are there in that market?
  • Is there anything that differentiates the business from the competitors?
  • Is this a new market or a very old one?
  • Is this a growing market or a shrinking market?

Tenure Risk

This is risk associated with continued tenure.

  • Are the premises currently leased?
  • How long is the lease guaranteed for?
  • Is the business paying fair market rate?
  • Will the business have to move premises soon?
  • What are the additional costs associated with moving or creating a new lease or paying fair market rate? Will this affect the profitability of the business?

Once the risk set has been determined it is useful to look at the likelihood of these things changing in the immediate future. That is, what is the likelihood the business will become more or less risky in the coming years? Once all of these risks have been identified in respect to now and the immediate future the next step is to determine the profitability of the business.

Profitability

Different businesses are sold on different profitabilities. There are many measures of profitability some of which are:

  • Net profit
  • EBITDA
  • EBITD
  • EBIT
  • PEBITDA
  • PEBITD and
  • PEBIT.

Each one of these terms attracts a slightly different valuation technique.

Please refer to the article in relation to Business Terminology for further clarification of these terms