What Is Goodwill? Doesnt Every Business Have It?

One of the biggest misconceptions about goodwill is that every business owner thinks his or her business has enormous goodwill; meaning they typically think that their business is worth a great deal more than it is. Business owners often have the idea that since the business has been around for decades that there is goodwill. The term goodwill is also thrown around in situations where it is really not applicable. The technical definition of goodwill is the value of a business attributable to the excess earnings that a business generates over and above that which would be expected to be generated on the net equity in the business. The table below hypothetically illustrates how goodwill can be determined using Zenith Manufacturing as an example. For simplicity, we will group all intangible assets together with goodwill to determine the collective value for all intangible assets and refer to it as goodwill. For illustrative purposes, we have used the excess earnings model, whereby an investor or business owner would expect to earn a risk adjusted rate of return on the tangible equity in the business of say 3 times the risk free bond rate, or 13%. This would equate earnings of approximately $2.3 million. The remaining earnings would be attributable to goodwill, meaning the things that the business does differently than its competitors that translate into higher returns for the shareholders or hidden assets the business has that contributes to higher earnings. To determine the value of the goodwill one has to look at the expected rate of return an owner or investor would expect to earn, consistently, on the group of intangible assets if one were to own the business. In this example we have used three times the rate expected on the tangible net worth or 39%. The reason the expected rate of return is so much higher on intangibles is that there is nothing to fall back on or to recover if those earnings start to decline or disappear, unlike on tangible assets that can always be sold or auctioned.
Zenith Manufacturing EXCESS EARNINGS VALUATION INDICATOR Tangible Net Worth Expected Return on Tangible Net Worth (3 times long bond rate) Profit Attributable To Tangible Net Worth Maintainable Pre-Tax Profit Less: Profit Attributable to Net Worth Profit Attributable to Goodwill (& other intanbibles) Expected Rate of Return on Goodwill 3.0 times rate on TNW Value of Goodwill Add: TNW Implied Value of Business Expected Multiple of EBITDA Note: Maintainable EBITDA a b 3,000,000 13.00%

a*b=c d c d-c=e f

390,000 1,200,000 (390,000) 810,000 39.00%

e/f=g a g+a=v

2,076,923 3,000,000 5,076,923 4.23 1,250,000

What Is Goodwill? Doesnt Every Business Have It?

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Equicapita is a private equity fund that acquires established, private, small and medium sized enterprises (SMEs) located primarily in Western Canada. Equicapitas investment drivers are to acquire operating companies at attractive valuations, with a history of generating sustainable cash flow and proven management teams. Equicapita believes that there is: - a generational opportunity to acquire baby boomer SMEs; and - a funding gap in the $2 to $20 million enterprise value range. The retirement of baby boomer business owners has been described as triggering one of the biggest transfers of corporate assets on record in Canada. This creates an environment with an abundance of opportunities to acquire SMEs with long-term operating histories, at attractive cash flow multiples. Equicapita provides investors with access to this alternative asset class via an efficient RRSP eligible structure.

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What Is Goodwill? Doesnt Every Business Have It?