Business Goodwill - What is it?

Goodwill is an intangible asset derived from other assets of the business. Its existence depends upon proof that the business generates and is likely to continue to generate earnings from the use of the identifiable assets, locations, people, efficiencies, systems, processes and techniques of the business.

The High Court of Australia has provided an extensive discussion of goodwill in Commissioner of Taxation v Murry [1998] HCA 42

Goodwill is a valid inclusion in a business valuation to the extent it possesses the following attributes:

• goodwill must be of an enduring nature;
• goodwill is attributable to cash flows expected from future business activity; and
• goodwill must have commercial value (i.e., must be transferable to a third party).

Goodwill by its very nature cannot exist independently of the business which created and maintains it.

"goodwill is not something which can be conveyed or held in gross: it is something which attaches to a business. It cannot be dealt with separately from the business with which it is associated". Barwick CJ  in  Geraghty v. Minter[1979] HCA 42 at 181

The value of goodwill is tied to the fortunes of the business in terms of its profitability and cashflow and the value of the net tangible assets utilized in the business. The value of goodwill will therefore fluctuate with the performance of the business.

It should be noted that the legal definitions of goodwill and the accounting definitions of goodwill are very different. A legal definition may result in a finding that the business has goodwill but an accounting definition may result in the goodwill having no value.

Goodwill can be derived from one or more of the following sources:

• Location: based on the notion that a company's success is, to some extent, based on the physical location of the premises;
• Product/Service: where a particular product/service offered by the company has developed name brand recognition/reputation in the market place, the favourable attitude of consumers often results in incremental cash flow to the company; and
• Operations: a company which has fostered a superior working relationship with its employees and lenders, investors, suppliers and customers, or has assembled a superior management team, etc. is at a competitive advantage vis-à-vis other companies in the industry. This competitive advantage often results in incremental cash flow to the company.

In general, goodwill is classified as commercial or personal.

Commercial Goodwill

Commercial goodwill refers to goodwill which is sellable and which will provide the investor/purchaser with future economic benefits (measured in terms of cash flow). Since the economic benefit supporting the calculation of commercial goodwill is transferable to third parties, commercial goodwill is a valid consideration in the determination of value.

Personal Goodwill

Personal goodwill pertains to the favorable attitudes of customers, suppliers, etc., which are derived from the efforts of a particular individual in the business. In many cases, personal goodwill can be transferred to a potential purchaser through client introductions, and so on. This is a common operating model for the sale of service businesses, including medical practices and accounting practices. In some cases, goodwill associated with a particular individual may also be secured using non-compete contracts, management contracts or other prudent business arrangements. In these cases, personal goodwill as it is transferable would be commercial goodwill.

Personal goodwill resides with the individual and technically cannot be transferred. Personal goodwill would apply for example to the skills, training and reputation of medical specialists, barristers, sports people and celebrities.