02 Jan How Do You Put a Value on Goodwill?
When buying or selling a business, “goodwill” often comes up in discussions. Most buyers and sellers understand that goodwill refers to the intangible assets of a business—its brand reputation, loyal customer base, long-standing vendor relationships, and community presence. What’s less clear is how to value goodwill. While it’s straightforward to set a fair market value on tangible assets, putting a dollar value on something as intangible as customer loyalty can present a more challenging concept.
A Hypothetical Example: Park Avenue Groomers
To illustrate how goodwill is valued, let’s look at Park Avenue Groomers, a popular dog groomers. This business has been operating in a desirable location for eight years. Their schedule is booked months in advance, they have a waiting list, and they’re able to charge a premium for their services. The four licensed groomers have strong relationships with their clients and are trained to work with nervous and temperamental dogs. The owner spends about 30 hours a week on administrative tasks and only grooms a few dogs herself.
Park Avenue Groomers’ Tangible Assets:
- Kennels, wash tubs, grooming stations, and other equipment: $25,000
- Inventory of shampoos, conditioners, etc.: $5,000
Annual Sales and Profit:
- Sales: $900,000
- Owner’s earnings (salary and profit): $200,000
The Role of Goodwill in Business Valuation
Goodwill captures the value that comes from the business’s intangibles—reputation, loyal customers, and skilled groomers—rather than its physical assets. Valuation professionals use methods like Discounted Cash Flow (DCF) and the Market Approach to estimate goodwill, analyzing historical financials, market trends, and expected growth. For Park Avenue Groomers, this approach values the business at $600,000. The tangible assets are worth $30,000, which leaves $570,000 as the goodwill.
It may seem like a shortcut, but this approach is based on solid reasoning. Park Avenue Groomers generates $900,000 in sales largely because of its reputation, loyal client base, and talented staff—not just its grooming equipment.
Goodwill in Comparison: Happy Tails
Now let’s consider a hypothetical competitor, Happy Tails, which opened a few years ago with a $50,000 investment in a modern facility. Despite its shiny new equipment and high-tech setup, Happy Tails struggles with negative reviews, high staff turnover, and an inconvenient location. Its strategy to reduce its prices hasn’t been successful in attracting new clients. Some try it out on a limited basis but switch to Park Avenue Groomers as soon as this more reputable groomers has an opening. For a new owner, Happy Tails would require a significant investment in training, marketing, and rebranding to make it profitable.
Would you pay $600,000 for both businesses? Even if you were willing, it’s unlikely that a bank would finance the purchase of a business with unproven goodwill and cash flow insufficient to service the debt taken on by financing the purchase.
Goodwill Translates into Revenue and Earnings
This comparison demonstrates why goodwill holds real value in a business sale: strong goodwill, like that of Park Avenue Groomers, is based on a proven track record and customer loyalty, which translates into revenue. In the end, goodwill is what sets thriving businesses apart from struggling ones. It represents the strength of the brand, the trust of the customer base, and the stability of the business, all of which play a crucial role in determining a business’s true worth.
