Personal Goodwill

The Value of a Business is Not Always What it Seems (Part II of II)

Personal goodwill is taxed at the individual capital gains tax rate, not the higher corporate income tax rate. Therefore, a credible personal goodwill calculation can amount to significant tax savings. One that is not adequately defensible invites risk of an audit. Every personal goodwill calculation is unique to each business, and the management interview is crucial. In this second part of the article, the author discusses issues that arise valuing identifiable intangible assets if goodwill is derived by first valuing personal goodwill, questions to ask management, and factors to consider using the “with or without” method.

[su_pullquote align=”right”]Resources:

Allocating Goodwill: Learning to Trust the Multi-attribute Utility Model (MUM)

What You Can’t See Has Value—The Valuation of Intangible Assets

Exploring Professional, Personal, and Enterprise Goodwill in a Dissolution of Marriage

Analyzing Personal Goodwill in Matrimonial and Estate Valuations

Personal Goodwill; Where Are We Today?

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Issues with Discretely Valuing Identifiable Intangible Assets, if Institutional Goodwill is Derived by First Valuing Personal Goodwill

According to BVR’s Guide to Personal v. Enterprise Goodwill, a common method to calculate the value of personal goodwill is to first value the entity with the continued presence of the individual who represents the amount of personal goodwill, then value the entity as if the individual’s services ceased.  Lastly, subtract the value without the key person(s) (the “without” scenario) from the value with the key person(s) (the “with” scenario).[1]  This is known as the “with or without” method.  There are other methods, such as the multi-attribute method, which results in a personal goodwill percentage based on a weighted average of key components of personal goodwill.  Such computerized programs based on scales of, say, one to five, have flaws because an attribute may score a five while another scores a one, while the attribute that scores a five may have ten times the importance of the attribute scoring a one.  Also, such a computerized program may include attributes that are irrelevant to certain sectors, and lack attributes that are unique to other sectors.

After valuing total goodwill due to a conveyance (the “with” scenario) and then calculating personal goodwill (the difference between the “with” and “without” scenarios), institutional goodwill should equal total goodwill minus personal goodwill, after making balance sheet adjustments.  It is entirely possible that the sum of the identifiable intangible assets, previously not capitalized on the balance sheet, wind up being high enough that, for the balance sheet to balance, institutional goodwill is a negative number.  Although it is possible to wind up with negative goodwill for bargain purchases, let’s assume this is not the case.  Obviously, something is awry.  First, one should then double check the calculations for the personal goodwill and ensure that the financial forecast assuming the absence of the key person(s) is credible.  However, it may be that the personal goodwill, total goodwill, and residual institutional goodwill calculation are all correct, but the calculations of the identifiable intangible assets (such as the value of a workforce in place, proprietary technology, customer lists) are incorrect.  The reason this can occur is illustrated by the following example.

Let’s say a small company’s president 1) owns 15 percent of the equity; 2) commands all customer relationships and they are totally loyal to him, and he also performs much of the important work involved with projects for the clients; 3) has no noncompete or employment agreement; 4) it is a service business with very little startup capital costs and would be very easy for the president, disenchanted with having only 15 percent ownership while doing most of the work, to leave, form a competing company, and poach all the clients.  Let’s also assume that the company has proprietary technology that had not been capitalized on the balance sheet, and would be one of the components of institutional goodwill.

If there were a transaction giving rise to goodwill, we would first value the company “as is” (the “with” scenario), and replace the old shareholders’ or membership equity with the consideration paid in the transaction, make adjustments if needed to the pre-transaction balance sheet (is the depreciated, recorded value of the equipment equal to fair market value?), and wind up with a new line item—total goodwill.  The next step is to separate total goodwill by institutional and personal goodwill.  Under the “without” scenario of the “with or without” Income Approach method, assume that we find personal goodwill equals 90 percent of total goodwill.  This is because the loss of that key person, combined with him poaching the clients, would surely cause the business to crash within a year or two.  When valuing the identifiable intangible assets previously not capitalized on the balance sheet, we may find that the replacement cost of the proprietary software causes a negative figure for residual institutional goodwill.

The reason for that requires some deeper thinking into exactly what would happen to the company if they lost that key person.  Sure, the proprietary software coding may be valued at a one million dollar replacement cost, but what use is that software if the company is out of business?  Would it be fair to value the code under the “going concern” premise of value?  If not, nonetheless, is it worth the one million dollars spent if they tried to sell or license it during their “going out of business” sale?  If the code were valued under the restoration method of the Cost Approach, was the opportunity cost fully considered?  Also, identifiable intangibles usually have higher required rates of return than tangible assets.  If we had applied the excess earnings method, was the capitalization multiple too high?

If we valued it by comparable licensing fees, we may find it is valued at $1.3 million.  Who would the company license it to?  This may be a niche sector with all participants already having their own proprietary code, and there were few startups to license the technology to.  The company may have to wait around three years to find a single startup willing to pay for a license whose present value over the term were $1.3 million, but by that time, the technology could be obsolete.  The value to intangibles of any sort bears some similarity to valuation discounts conferred on any illiquid asset or ownership stake.  It may have value, but to whom, and how long would it take to find the licensee.  If there were any doubt to that train of thought, consider the real-life examples of property that the owner sinks money into to personalize or customize it for their own purposes, and which yields either zero return or a discount from what it would sell for at fair market value without the bells and whistles.  The refurbishments may have caused the value of the entire property to be less than without the refurbishments.  As would apply to residential property, bathroom and kitchen refurbishments can yield returns, but if one million dollars  spent on decorating the rest of the house makes it look like a garish eyesore, one may not get one dime of returns on that one million dollars.  That one million dollars spent may have served the seller well while they owned it, but at fair market value to a hypothetical, willing buyer, it is worthless.

What to Consider When Calculating the “Without” (the Key Person) Scenario of the “With or Without” Method

Making financial projections will require quantifying a host of qualitative attributes, not just determining the amount of the income stream attributable to the key person(s).  Additionally, one must determine how much of that income stream is surely jeopardized without the key person(s).

The management interview is very important for determining the extent to which one or more employees, not bound by contract, are responsible for the company’s income stream.  Very detailed information should be provided as to the daily activities of the office.

As relates to the key person(s) potentially responsible for some amount of personal goodwill, company management may be asked:

• How close are the relationships between the key person(s) and the customers?

Note: How much time per week the key persons spend with their clients is a factor.  Whether this is usually by phone or in person could be another factor depending on the type of business. 

• Did the key person(s) originally land the customers, or were they inherited?

Note: If the customers were inherited, it could be that if another existing employee inherited those accounts, the customers would be retained. 

• Exactly why are the customers so loyal to the key person? Did he perform some service for them in the past that they could not likely get from another company?  Or is it more of a personal nature?

Note: Do not marginalize the power of personal relationships in services whereby there is little differentiation between the products or services rendered by competing businesses.

• What is the age and health of the key person(s)?

Note: This has been a consideration in past court cases.  If the person is near retirement, or in ill health, they may not be a threat to compete and poach customers successfully.  In a service business whose services consist mostly of the intellect and knowledge of the individual rendering the service, clients may be lining up a younger successor not nearly as close to retirement. 

• If this involves a sale to new investors, does the key person(s) plan to relocate?

Note: If this is the type of business that is highly localized, then the key person(s) departure and relocation to another state, even if they started a similar type of business, may not have an impact. 

• How much is the creation of the service or product attributable to the key person(s)?

Note: If the business’s services or products are partly created by employees other than the key person(s), the key person may not be so “key.”  If the service is of an intellectual or experiential nature, then the key person(s) may be vital to the business’s future income stream. 

Company management may also be asked the following questions regarding the business itself:

• How much would it cost to recreate your business from scratch?

Note: If it would cost very little, or one could easily obtain a bank loan or raise equity to finance its launch, then the key person(s) may be more motivated to leave and poach clients, and would have a platform.   

• How long would that take, and are there regulatory hurdles?

Note: The longer it would take, the more time the existing company has to prepare for battle. 

• If the key person(s) joined another firm instead of forming their own firm, how long do you think it would take them? Is there a good chance that the client relationships could go stale by then?

Note: In a service business, sometimes being local is a big advantage.  One may also want to know what the key person(s)’ options are for employment locally. 

• What is the average churn rate of the client base?

Note: If most growth is generated from new customers, then losing existing customers may not be so damaging.

• How much recurring revenue is there?

Note: If it is a high amount, and a large portion of that amount is attributable to the key person(s), then personal goodwill could be significant.  However, if most revenue were from new customers, then the enumerated loss of the key person(s) would be confined to the amount of time it would take to replace them. 

• What is the typical length of a contract, especially the ones associated with a key person(s)? Are there opt out clauses, and what notification is required?

Note: Even if contracts are typically for three years, if there is an opt out clause with two weeks advance notice, then it would be far easier and quicker for the key person(s) to poach the clients. 

• What is the customer concentration like?

Note: If all the business is generated from, say, three customers, then it would be far easier and quicker for the key person(s) to poach the clients. 

There are additional considerations that should arise after gaining a thorough understanding of the nature of the business and its sector:

• What is the size of the business?

Note: The amount of personal goodwill tends to be higher for small businesses. 

• Is this such a localized business that the customers are lured by the proximity?

Note: If so, it would be important to know if the key person(s) can operate in the same geographic area and render the same services, replicating the same customer experience.  Even so, if location convenience were a big factor, this intangible would reside with the enterprise.  Sometimes a catchy phone number can have intangible value. 

• How important is company reputation for gaining and retaining customers?

Note: Many companies gain and retain customers mostly through their reputation.  If it is a service or product whereby customers do not care about the company name, but rather the knowledge, intellect, and abilities of the key person(s), then personal goodwill may be meaningful. 

There are many other aspects of the business that should be examined, and questions that should be asked of company management.  The foregoing may serve as a starting point, but just as every business is unique, every personal goodwill calculation is unique.

Conclusion

The work of the valuation analyst does not end with the financial modeling.  Once a valuation analyst has determined the answers to the questions previously cited and determined the value of personal goodwill, it is imperative that as much as possible be documented and kept as records, and that the narrative report contain a section devoted to citing all factors considered, and all factors that support the personal goodwill calculation.  The report section describing the “without” scenario of the “with or without” method should explain exactly why and how the key person(s) could defect, form a competing company, and poach customers, if that be the scenario.  This scenario must be fair, credible, and tenable.  

[1] Robert F. Reilly and Robert P. Schweihs, Guide to Intangible Asset Valuation (New York, New York: American Institute of Certified Public Accountants, Inc., 2014), 703–704.

Samuel S. Nicholls, MBA, is a manager with Willamette Management Associates and based out of the Atlanta, GA office. As a manager with Willamette Management Associates, he manages engagements related to the valuation of business entities and business interests, and the analysis of privately held and publicly traded securities. Mr. Nicholls has performed many types of valuation and economic analyses for a wide range of purposes and for various types of business entities, securities, and industries. He previously served for 12 years as an investment research analyst with both investment banks and investment managers, and for three years as a venture capital associate.

Mr. Nicholls can be contacted at (404) 475-2311 or by e-mail to SSNicholls@willamette.com.