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Home , Goodwill (accounting)

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Goodwill Approaches, Methods, and Procedures Robert F. Reilly, CPA

Financial advisers are often asked to value goodwill within a corporate transaction environment. These goodwill valuations may be performed in the due diligence phase of the corporate transaction for transaction pricing and structuring purposes. These goodwill valuations may be performed in the consummation phase of the corporate transaction—as part of the preparation of a transaction or solvency opinion. And, these goodwill valuations may be performed within the controversy phase of the corporate transaction—to defend against dissenting shareholder appraisal rights claims or claims that the transaction resulted in a fraudulent transfer. For some transaction-related purposes, financial advisers may value goodwill as a residual amount (i.e., the residual of a total business or professional practice value minus the value of all identifiable tangible and intangible assets). For other transaction-related purposes, financial advisers may value goodwill as an individual, income-producing intangible . This discussion summarizes the generally accepted goodwill valuation approaches, methods, and procedures. And, this discussion presents an illustrative example of a goodwill valuation analysis.

ntroduction defend against dissenting shareholder appraisal I rights claims or claims that the corporate transac- There are different types of goodwill, including (1) tion involved a fraudulent transfer business or institutional goodwill and (2) personal This discussion summarizes the generally accept- or professional goodwill. Financial advisers are often ed approaches and methods related to the valuation asked to value these different types of goodwill for of goodwill. This discussion focuses on business transaction, taxation, financial , litiga- enterprise (or institutional) goodwill. However, this tion, and other purposes. This discussion describes discussion also considers personal (or individual) the various components of goodwill and the various goodwill. reasons why independent financial advisers may be asked to value goodwill. This discussion starts with a definition of good- will. Since there is no single definition of goodwill Financial advisers are often asked to value good- that is applicable to all purposes, this discussion will within a corporate transaction environment. considers alternative definitions. This discussion These goodwill valuations may be performed in the describes the types and attributes of goodwill. And, due diligence phase of the corporate transaction this discussion considers the many reasons why for transaction pricing and structuring purposes. financial advisers are asked to value goodwill. These goodwill valuations may be performed in the consummation phase of the corporate transac- Finally, this discussion mentions many of the tion—as part of the preparation of a transaction common internal and external data sources related fairness opinion or solvency opinion. And, these to the goodwill valuation. These data sources pri- goodwill valuations may be performed within the marily include sources of transactional data regard- controversy phase of the corporate transaction—to ing the sale of goodwill within the context of a busi- ness acquisition.

10 INSIGHTS • SPRING 2015 www .willamette .com Some financial advisers believe that only income concern) premise of value—rather than on a value approach methods are applicable to value goodwill. in exchange (or piecemeal disposition) premise of However, this discussion describes approach, value. market approach, and income approach valuation Some going-concern value may attach to the methods. This discussion concludes with an illustra- business entity’s specifically identified identifiable tive goodwill valuation example. intangible assets. For example, an entity’s patent, copyright, or trademark value is typically greater when that is appraised on a value in Goodwill Components continued use (or going-concern) premise of value There are many interpretations of goodwill. These rather than on a value in exchange (or piecemeal interpretations are generally grouped into two cat- disposition) premise of value. egories: residual interpretations and income inter- The second goodwill component is the exis- pretations. While income interpretations may be tence of excess income (however measured). This more common, financial advisers should be familiar component is described later in this discussion. with both categories of interpretations. Both inter- For a business entity, excess income is income pretations agree on the components of (or the fac- generated by the entity that is greater than the tors that create) goodwill and the types of goodwill amount needed to provide a fair rate of return on (or situations in which goodwill arises). all of the entity’s tangible assets and identifiable There are three principal components of good- intangible assets. will. Financial advisers consider these three compo- This excess income component relates to the nents as either (1) the factors that create goodwill concept of goodwill as that portion of business or (2) the reasons why goodwill exists in certain that cannot be specifically assigned circumstances. The first and third components pri- to the entity’s tangible assets or identifiable intan- marily relate to business goodwill. And, the second gible assets. For an individual (e.g., professional component relates to both business goodwill and practitioner, athlete, celebrity), excess income is personal goodwill. the income generated by the individual that is The first goodwill component is the existence of greater than the amount that would be expected to operating business assets that are in place and ready be accrued by a comparably skilled individual work- to use. This component is sometimes referred to as ing in comparable circumstances. the going-concern element of goodwill. The fact that The third goodwill component is the expectation all of the elements of a business enterprise are phys- of future events that are not directly related to the ically and functionally assembled creates intangible entity’s current operations. Goodwill may be created value. These business enterprise elements include by the expectations of future capital expenditures, capital (e.g., equipment), labor (e.g., employees), future , future to-be-devel- and coordination (e.g., management). oped products or services, and future customers or Some financial advisers identify and measure clients. This future expectations component relates this going-concern value as a separate intangible to the concept of goodwill as the current value of asset of a business. This separate identification future assets (both tangible and intangible) that do may be appropriate for certain taxation or forensic not yet exist on the analysis date. analysis purposes. Investors assign a goodwill value to a business Other financial advisers measure going-concern entity if they expect that the of value as one component of the entity’s business the income associated with future events is positive. goodwill. This aggregate identification is appropri- The positive net present value of the expected future ate for purposes of Standards income associated with assets that are already in Board (FASB) Accounting Standards Codification existence (for example, capital assets, product lines, (ASC) Topic 805, Business Combinations, and customers) is appropriately assigned to those accounting for business combinations. respective tangible assets and intangible assets. Either identification procedure may be appropri- ate depending on the purpose and objective of the goodwill analysis. The Residual Interpretation of This going-concern value may enhance the value Goodwill of the business entity’s individual operating assets. Under generally accepted accounting principles, the For example, a business entity’s equipment value is goodwill that an entity develops in the normal course typically greater when the equipment is appraised of business is rarely recorded on the entity’s financial based on a value in continued use (or going- statements. And, the accounting recognition for

www .willamette .com INSIGHTS • SPRING 2015 11 internally created goodwill is different than the intangible assets. This allocation of the entity’s accounting recognition for purchased goodwill. income is typically based on a fair rate of return Internally created goodwill is rarely recorded on on the asset category multiplied by the value of the the entity’s . In contrast, purchased asset category. goodwill is recorded on the acquiror’s balance sheet Third, the financial adviser typically quantifies as soon as the purchase transaction is completed. the portion of the entity’s income that cannot be Under FASB ASC topic 805 acquisition accounting, associated with any other tangible or intangible the fair value (calculated as a residual from total asset. That residual income is often called excess purchase consideration) of purchased goodwill is income (or excess earnings). This excess income is recorded as an intangible asset on the acquiror’s then assigned to goodwill. balance sheet. Fourth, goodwill value is typically quantified often use a fairly broad definition as this amount of excess income capitalized as an of goodwill. This broad interpretation of goodwill is annuity in perpetuity. The excess income is capital- the residual value that is calculated by subtracting ized by a risk-adjusted and growth-adjusted direct the fair value of all the acquired tangible and iden- capitalization rate. The result of this direct capital- tifiable intangible assets from the acquired entity’s ization procedure indicates the goodwill value. total purchase price. Sometimes this goodwill definition collectively quantifies all of the intangible value of the acquired Goodwill Types company. This is the case when all of the identifi- There are three general goodwill types. These three able intangible assets are not adequately identified goodwill types may affect the identification and and valued. ownership of the goodwill. But, the distinction of This collective goodwill valuation may occur these three types of goodwill should not affect the when the fair values of the individual identifiable valuation results. intangible assets are immaterial compared to the The first goodwill type is institutional goodwill. total business purchase price. In this circumstance, This is the goodwill that relates to an industrial this residual definition of goodwill may capture or commercial business enterprise. This goodwill the total intangible value of the acquired business type typically results from the collective operations entity, with little consideration of the identifiable of—and the collective assemblage of—the entity’s intangible assets. assets. Institutional goodwill is typically owned by the industrial or commercial business. However, in the case of a professional services The Income Interpretation of business (for example, a manufacturers representa- Goodwill tive company or other professional sales organiza- tion), some or all of the institutional goodwill can be The income interpretation of goodwill may be more created by the individual employee/owners. conceptually robust than the residual interpretation of goodwill. As a result, the income interpretation of The second goodwill type is professional practice goodwill may be more useful to the financial adviser goodwill. This type of goodwill relates to a medi- who is interested in the valuation of the entity’s dis- cal, dental, legal, accounting, engineering, or other crete goodwill—as opposed to the valuation of the type of professional practice. This goodwill type is entity’s total intangible value. distinguished from the other goodwill types because it has two distinct components: the practitioner (or First, the financial adviser typically quantifies personal) component and the business (or practice) all of the income of the entity. For purposes of this component. excess income analysis, income can be measured many different ways. The only requirement is that The practitioner component relates to the good- the measure of income is calculated on a basis con- will created by the reputation and skills of the indi- sistent with the measure of the fair rate of return on vidual professional practitioners (the actual physi- the entity’s operating assets. cians, dentists, lawyers, CPAs, engineers, and other professionals). The business component relates to Second, the financial adviser typically allocates the goodwill created by the location, reputation, (or assigns) some portion of this total income to longevity, assembled assets, and operating proce- each tangible and intangible asset category that dures of the institutional professional practice. contribute to the income production. These asset categories typically include working capital, tan- One issue that often arises with regard to this gible personal property, real estate, and identifiable goodwill type is who owns each of the two compo- nents. This ownership question can be controversial

12 INSIGHTS • SPRING 2015 www .willamette .com in marital dissolutions, shareholder disputes, or in 2. the operations of the company or practice other types of litigation. are not functionally or economically sepa- Ultimately, the ownership of the goodwill com- rate from the individual, and ponents is a legal question with a legal answer. 3. the success of the business entity is directly However, the financial adviser may be tasked with related to the activities of the individual. the identification and the valuation of these two components of professional practice goodwill. In the early stages of an entity’s operations, most The third goodwill type is celebrity goodwill. internally created goodwill is typically personal This is the goodwill associated with being a famous goodwill. As the entity matures (as it increases in individual. Typically, there are three categories of size and complexity), goodwill usually shifts from celebrities who enjoy such goodwill: sports celebri- the personal category to the institutional category. ties, entertainment celebrities, and achievement celebrities. These various categories of celebrity goodwill Reasons to Value Goodwill are distinguished by the factors that created the There are many reasons why a financial adviser may goodwill. For example, the sports celebrity goodwill be asked to value goodwill. Some of these reasons is created by the individual’s physical prowess. That follow: prowess (and the associated goodwill) may wane n Economic damage analyses. When a busi- with the age of the athlete. ness has suffered a breach of contract or Entertainment goodwill relates to singers, musi- a tort (such as an infringement, breach of cians, actors, television talk show hosts, and so on. a fiduciary duty, or interference with busi- This type of goodwill also relates to the individual’s ness opportunity), one measure of the dam- skill and ability. But for many entertainers, pro- ages suffered is the reduction in the value fessional skill and ability may increase (and not of the entity’s goodwill due to the wrongful decrease) with age. action. The category of achievement celebrities includes This analysis may encompass the com- prominent corporate executives, politicians, cler- parative valuation of the entity’s goodwill gy, or organizational leaders. The goodwill of an before and after the breach of contract or achievement celebrity often relates to the career tort. This before and after method is also or other professional accomplishments of that indi- useful for quantifying the economic effects vidual. Unlike the other types of goodwill, it may be of a prolonged labor strike, a natural disas- difficult to transfer celebrity goodwill. ter, or a similar phenomenon. It is often important for the financial adviser to n Business or professional practice merger. separately identify and individually value the three When two businesses merge, the of types of goodwill. There may be different legal, eco- the merged entity typically is to be allo- nomic, and taxation consequences for each goodwill cated to the merger partners. One common type. way to allocate equity in the merged entity is in proportion to the relative value of the The following factors affect which type of good- assets contributed, including the contrib- will exists: uted goodwill. 1. The type of services or products offered by n Business or professional practice separa- the business entity tion. When a business separates, the assets 2. The individual’s personal relationships with of the consolidated business typically have customers or clients to be allocated to the individual business 3. The individual’s direct impact on the man- owners. agement and direction of the business entity One common way to allocate the assets to the separating business partners is in proportion to the relative value of the assets Most goodwill is likely to be personal goodwill controlled by or developed by each partner, (that is, goodwill owned by the business owner/ including the goodwill of each business operator, individual practitioner, or celebrity) if: partner. 1. the individual makes essentially all signifi- cant management decisions regarding the n Solvency test. The solvency of a business business entity, entity is an issue with regard to lender’s fraudulent conveyance concerns during a

www .willamette .com INSIGHTS • SPRING 2015 13 financing transaction or a financial restruc- goodwill (if any) may be useful in assessing turing. whether the business is worth reorganizing. One of the individual tests to determine A valuation of the debtor’s goodwill (for if a business entity is solvent is: Does the example, before and after the plan of reor- fair value of the entity’s assets exceed the ganization) may be useful in assessing the value of the entity’s liabilities (after consid- reasonableness of the proposed plan of eration of the financing transaction)? One reorganization. Such an assessment may be of the entity’s assets that is considered in a of interest to the debtor in possession, the solvency analysis is goodwill. secured and unsecured creditors, the bank- n test. The degree of insolvency of ruptcy court, and other interested parties. a business entity may have federal income n Conversion of a C corporation to an S cor- tax consequences if debt is forgiven (in poration. One factor in the analysis of the whole or in part) during a refinancing and benefits of converting an entity’s transaction or financial restructuring. One federal income tax status from a C corpora- of the specific tests to determine if a busi- tion to an S corporation is the quantifica- ness entity is insolvent for federal income tion of any built-in gains (BIG) tax associ- tax purposes is: Is the fair market value of ated with the value of the corporation’s the entity’s assets less than the value of the assets. entity’s liabilities (before the debt forgive- The federal income tax regulations relat- ness)? ed to the BIG tax are clear that the corpo- The cancellation of debt income is not ration’s goodwill is one asset that should be recognized as taxable income to the extent considered in the valuation. that the taxpayer debtor is insolvent. The n Business enterprise valuation. The iden- federal income tax regulations specifically tification and quantification of goodwill is indicate that one of the assets that should one procedure of the asset-based approach be considered in an insolvency analysis is to . An asset-based goodwill. approach is often used in the valuation of n Intercompany transfer price. When intan- an industrial or commercial company or gible assets are transferred between related professional service business. entities (for example, between a parent Such business valuations are routinely corporation and a less than wholly owned performed for taxation, ownership transi- ), an arm’s-length price should be tion, financing, bankruptcy, corporate gov- estimated for the intercompany transfer of ernance, litigation, and other purposes. the assets. n Deprivation analysis. The goodwill valua- Such an intercompany transfer may tion may be one component in the damages affect the profitability and return on invest- analysis associated with a business that is ment of, say, two —one that is subject to a condemnation, expropriation, wholly owned and one that has a 10 percent or eminent domain action. Financial advis- owner. ers sometimes only consider the value of While the intercompany transfer of good- the entity’s real estate and tangible personal will is not subject to Internal Code property subject to the condemnation or Section 482 considerations, intercompany other “taking.” goodwill transfers may also have other However, even if the entity is relocated income tax ramifications. Such intercom- to a new location as part of the eminent pany transfers may have state income tax domain action, the business may have suf- consequences if the various related entities fered a loss of all or part of its goodwill. The are located in different state tax jurisdic- loss of institutional or practice goodwill tions. value may be a claim in the condemnation n Bankruptcy and reorganization. Parties in or eminent domain action. interest to a bankruptcy estate often have n Ownership allocation litigation. Several to decide if the debtor corporation is worth forms of litigation involve the allocation of more as a going-concern business (pursu- direct or indirect ownership interests in a ant to a plan of reorganization) or as a mass business entity. Two examples of such liti- disposition of assets (pursuant to a plan gation include the following: of liquidation). A valuation of the debtor’s

14 INSIGHTS • SPRING 2015 www .willamette .com 1. Marital dissolution cases (which involve Because goodwill (whether personal or institu- the allocation of the business entity tional) is often measured based on future earnings, ownership interest within the marital the cost approach is less commonly used to value estate). goodwill. In practice, for both personal and institu- 2. Dissenting shareholder rights and tional goodwill, the income approach is more com- shareholder oppression cases (which monly used. involve the allocation of the business Financial advisers may also use some version entity ownership interests to the dis- of a residual analysis in the valuation of personal senting or oppressed stockholders). or institutional goodwill. In such a valuation, the This second category of litigation involves financial adviser estimates the total amount of both dissenting shareholder appraisal rights goodwill associated with the business entity (how- claims and shareholder oppression claims. ever defined). Using this residual analysis, goodwill In such litigation claims, the valuation of is measured indirectly using business valuation the entity’s goodwill is often an important approaches. issue. Using a residual analysis, goodwill represents the n Ad valorem property tax. In some taxing residual of the overall business value less the total jurisdictions, state and local ad valorem value of all tangible assets and identifiable intan- property tax only applies to real estate and gible assets used in the business enterprise. tangible personal property. The existence of The financial adviser may also use some version economic obsolescence (a form of external of the with and without method (also called the obsolescence) may have a direct effect on comparative business value method) in the valu- the value of the taxpayer’s real estate and ation of personal or institutional goodwill. To use tangible personal property. Accordingly, an the with and without method, the financial adviser assessment of the existence of economic estimates the value of the business entity with and obsolescence may be an important proce- without the goodwill in place. dure in the valuation of such industrial or The with and without method is more commonly commercial operating property. used to value an individual’s personal goodwill than There are several methods for quanti- it is to value institutional goodwill. Typically, based fying economic obsolescence, and most on the different sets of financial projections and the methods incorporate some analysis of the different discount or capitalization rates, the entity entity’s goodwill. value is greater with the subject individual in place Typically, if the entity enjoys positive than without the subject individual in place. goodwill value, then the tangible assets may Using the with and without method, the value not experience economic obsolescence. If of personal goodwill is estimated as the difference the entity experiences negative goodwill, between: then the values of the industrial and com- 1. the “with the individual in place” entity mercial operating assets are likely to be value and affected by economic obsolescence. 2. the “without the individual in place” entity value.

How the Different Goodwill The personal goodwill value is the difference Types Are Valued between the two business value estimates based on All generally accepted intangible asset valuation the two alternative sets of projections. The financial approaches are appropriate to value the different adviser may also estimate the value of the institu- goodwill types. tional goodwill using a combination of a residual method analysis and a with and without method Typically, goodwill (whether personal or insti- analysis. tutional) is not sold or otherwise transferred sepa- rately in the marketplace. Therefore, the market The value of the entity’s institutional goodwill approach is less commonly used to value goodwill. may be estimated as the difference between: When the market approach is used to value goodwill 1. the business entity goodwill value (based on (for example, the goodwill of medical, dental, or the residual method analysis) and other professional practices), the empirical market 2. the personal goodwill value (based on the data are often based on purchase price allocations of with and without method). the acquired entities.

www .willamette .com INSIGHTS • SPRING 2015 15 The Goodwill Valuation The Cost Approach In most valuation analyses, goodwill includes con- Using the cost approach, the financial adviser esti- cepts from both the residual and the income defi- mates the amount of current cost required to rec- nitions. Financial advisers sometimes identify and reate the goodwill component elements. The cost value goodwill collectively as the total intangible approach typically involves a component restora- value of a business entity. In this regard, goodwill tion method. may be valued using an aggregate residual analysis. The first procedure in the component restora- In such an analysis, the goodwill can be either tion method is to list all of the individual compo- a residual from a total business acquisition price nents of the entity’s goodwill. The second procedure or a business value. In this analysis, the total is to estimate the amount of current cost required to goodwill value is measured as the unidentified replace each goodwill component. This procedure is residual amount after the values of the identified based on the concept of goodwill as represented by tangible assets are subtracted from the total busi- the intangible value of all entity assets in place and ness value. ready to use. Financial advisers often measure goodwill as a One procedure in the restoration method is the discrete (or separate) intangible asset. Using this analysis of forgone income (considered an oppor- definition, goodwill is measured as the remaining tunity cost in the cost approach) during the time unidentified intangible value of the entity after period required to assemble all of the entity’s tan- subtracting the values of all tangible assets and all gible assets and identifiable intangible assets. identifiable intangible assets. For example, let’s assume that it would take Accordingly, this discrete goodwill may be quan- two years to assemble all of the entity’s component tified using either a residual analysis or an income tangible assets and identifiable intangible assets. analysis. In either type of analysis, goodwill is This time period represents the total elapsed time the residual business value (or capitalized excess required for the assembled assets to reach the same income) that is not allocated to any of the following level of utility, functionality, capacity, and income assets: generation as exists in the actual going-concern 1. Working capital assets (for example, receiv- business entity. ables, prepaid , and ) This hypothetical asset restoration process may 2. Tangible personal property (for example, include the following procedures: machinery, equipment, and vehicles) 1. The purchase and installation of all equip- 3. Real estate (for example, land, buildings, ment and improvements) 2. The construction or purchase of all real 4. Intangible personal property (for example, estate patents, copyrights, trademarks, and trade 3. The selection of suppliers secrets) 4. The creation of a distribution system 5. Intangible real property (for example, lease- 5. The hiring and training of employees hold interests, rights of way, and ease- 6. The building of a level of consumer recogni- ments) tion and confidence 7. The recreation of the current level of cus- tomer relationships Goodwill Valuation Approaches and Methods In this method, all of these component tangible There are several generally accepted methods appli- assets and identifiable intangible assets are assem- cable to the goodwill valuation. After considering bled at the level required to immediately accommo- the similarities and differences, each method may date the actual entity’s current level of operations. be categorized into one of the three intangible asset Let’s consider a simple example of the restora- valuation approaches. tion method. Let’s assume that the actual entity As stated above, cost approach and market earns $10,000,000 per year in income (however approach valuation methods are less commonly defined) during an expected two-year asset restora- used, and income approach valuation methods are tion period. The present value of the $20,000,000 in more commonly used in the goodwill analysis. The forgone income during an asset restoration period is following discussion summarizes these valuation one indication of the opportunity cost component in methods. the goodwill value restoration method.

16 INSIGHTS • SPRING 2015 www .willamette .com The Market Approach earned by the entity that was sold in the transac- tion. There are two common market approach methods related to goodwill. The first method estimates the These market-derived goodwill pricing multiples value of goodwill as the residual from an actual busi- are then applied to the subject entity to estimate ness acquisition price. This method is called the the entity’s goodwill value. It is noteworthy that the residual from purchase price method. The second multiples are also estimated; that is, these transac- method estimates the value of goodwill based on an tional pricing multiples are themselves based on an analysis of guideline sale transactions. This method allocation of the purchase price for each business or is called the sales comparison method. professional practice included in that transactional data source. Goodwill is rarely sold separately from any other assets (either tangible assets or intangible assets) of a going-concern business. Therefore, the selected The Income Approach guideline sale transactions usually involve the sale With regard to goodwill, the income approach meth- of a going-concern business. ods include the residual from business value meth- The financial adviser selects publicly reported od, the capitalized excess earnings method, and the transactions in which the allocation of the sale present value of future income method. price between the purchased goodwill and all other Each of these valuation methods is based on the acquired assets is reported. Accordingly, this mar- concept of goodwill as the present value of future ket approach method effectively relies on a residual income not associated with the entity’s tangible from purchase price procedure to estimate the good- assets or identifiable intangible assets. will value. To use the residual from purchase price method, The Residual from Business Value Method there has to be a sale of the actual entity. The residual from business value method is based First, if there is such a sale transaction, the on the principle that the value of total assets (the financial adviser confirms that the transaction was “left hand” side of the entity’s balance sheet) equals an arm’s-length sale. the value of total liabilities and equity (the “right Second, the financial adviser confirms that the hand” side of the entity’s balance sheet). purchase price represents a equivalency price Goodwill is valued as the total entity value less: for the entity. For example, if there are noncash consideration components or deferred payments 1. the value of all net working capital (or (for example, an earn-out ) as part of the financial) assets, purchase price, the financial adviser converts the 2. the value of tangible assets (e.g., real estate entire consideration to a cash equivalency price. and tangible personal property), and Third, the financial adviser estimates the value 3. the value of identifiable intangible assets. of each of the entity’s tangible assets and identifi- able intangible assets. There are several generally accepted business Fourth, the financial adviser subtracts the total valuation methods. Financial advisers typically syn- value of all of the tangible assets and identifiable thesize the value indications of one or more of these intangible assets from the business purchase price. methods to estimate the value of the subject entity. The residual amount represents the goodwill value. Because there are many judgments made as part of To use the guideline sale transactions method, any valuation, the objective of using more than one the financial adviser identifies and selects actual valuation method is to develop mutually supporting sales of guideline entities that are sufficiently simi- evidence as to the business value conclusion. lar to the subject entity. For purposes of this analy- The business valuation methods that are com- sis, comparability is typically based on the criteria monly used in the residual from business value of investment risk and expected return. method include: For certain types of businesses, such as cer- 1. The direct capitalization method (an tain types of professional practices, guideline sale income approach method) transactional data are fairly easy to assemble. Such 2. The discounted or yield capi- transactional data are reported in publicly available talization method (an income approach publications and periodicals. With regard to these method) sale transactions, the purchased goodwill may be typically expressed as a percent of the total transac- 3. The guideline merged and acquired com- tion price or a percent of the total annual revenue pany method (a market approach method)

www .willamette .com INSIGHTS • SPRING 2015 17 4. The guideline publicly traded company ous procedures, including the direct capitalization method (a market approach method) (or annuity in perpetuity) method. Based on these valuation analyses, the periodic The selection of these business valuation meth- (typically annual) cash flow from the subject entity ods depends on the following: is projected for a discrete projection period. The 1. The financial adviser’s experience and judg- term of the discrete projection period varies based ment on the financial adviser’s judgment. Typically, the term of the discrete projection period approximately 2. The quantity and quality of available finan- equals the average length of the industry business cial and operational data regarding the sub- cycle. The discrete cash flow projection is discount- ject entity ed at an appropriate discount rate to determine a present value. Any of these methods may be used in a residual The residual value of the entity is estimated at from business value analysis. The discounted cash the end of the discrete projection period. The resid- flow method is a common business valuation method ual value is also discounted to determine a present for the purpose of quantifying goodwill as the residu- value. The present value of the discrete cash flow al from a business value. projection is summed with the present value of the The method is based on the residual value. principle that business value is the present value of This summation calculation indicates the entity’s the total future income to be derived by the entity’s total value. The entity’s total value less the tangible stakeholders. The discounted cash flow method typi- assets value and the identifiable intangible assets cally involves revenue analysis, analysis, value indicates the entity’s goodwill value. investment analysis, analysis, and residual value analysis. The Capitalized Excess Earnings Method The revenue analysis involves a projection of prospective revenue from the sale of products or The capitalized excess earnings method involves the provision of services from the entity. This analysis quantification and capitalization of excess income may include consideration of the following market (as defined) earned by the entity. There are several factors: expected unit sales volume, average selling variations of the capitalized excess earnings method. price or contract rate, market dynamics, competitive The following discussion presents a common applica- pressures, price elasticities of demand, regulatory tion of this method. changes, and technological changes. First, the capitalized excess earnings method The expense analysis may include consideration requires the financial adviser to estimate the required of fixed versus variable costs, product versus period amount of income that an investor would expect costs, cash versus noncash costs, direct versus given the risk of the subject entity. This procedure indirect costs, overhead cost absorption principles, often involves the financial adviser’s assessment of cost efficiency relationships, and cost-volume-profit industry average rates of return on investment. relationships. Some financial advisers apply an asset-specific The investment analysis may include consider- rate of return on investment to each asset category. ation of required minimum cash balance, days sales Alternatively, some financial advisers apply the outstanding in , inventory turn- entity’s cost of capital as the overall required rate of over, plant utilization, and planned capital expendi- return on investment. The entity’s cost of capital is tures. typically measured as the weighted average cost of capital. The cost of capital analysis may include consid- eration of current entity , current In either case, the required return on investment industry capital structure, optimal (or target) capital is multiplied by the value of the net identified assets structure, cost of the various capital components, in order to quantify the amount of the required weighted average cost of capital, risk-free rate of income. The net identified assets typically include all return, systematic and nonsystematic equity risk of the entity’s working capital assets, tangible assets, premiums, and marginal cost of capital. and identifiable intangible assets. The residual value analysis may include the esti- Second, the financial adviser quantifies the dif- mate of the value of the prospective cash flow gener- ference between this required amount of income and ated by the entity at the end of a discrete projection the actual amount of income earned by the entity. If period. The residual value may be estimated by vari- the actual amount of income exceeds the required

18 INSIGHTS • SPRING 2015 www .willamette .com amount of income, then excess earnings exist at the expiration of the entity’s entity. current income sources “Using the present (such as the identified Third, the financial adviser capitalizes the excess value of future income earnings (if any) as an annuity in perpetuity using current customers) and an appropriate direct capitalization rate. The deri- continues into perpetuity. method, goodwill may vation of the direct capitalization rate should be The present value of consistent with the level of income used to measure this prospective income be estimated as the the required amount of income of the entity and the stream (which typically present value of the actual amount of income of the entity. The result provides for a capital of the direct capitalization procedure indicates the charge or a fair return on future income to be goodwill value. all the tangible assets and earned from provid- intangible assets used to ing future goods or The Present Value of Future Income Method service the unidentified future customers) indi- services to future, un- The first procedure in this method is to identify all cates a goodwill value. of the future income that is not associated with the Using this method, the identified, customers.” entity’s tangible assets and identifiable intangible goodwill value is the assets. This identification procedure may include present value of future future capital expenditures, future mergers and income earned from the acquisitions, new product or service lines, new sales future sales to future (unidentified) customers. territories, or new customers. The present value of future income method is Generally, this future income is not included a conceptually sound method to value goodwill. in the entity’s current business plans or forecasts. Consistent with the income-based concept of good- This future income is typically not associated with will, this method quantifies and assigns all of the entity’s tangible assets or identifiable intangible entity’s income that cannot be associated with any of assets in place as of the analysis date. Otherwise, the entity’s tangible assets or identifiable intangible that future income would be included in the value of assets. the entity’s tangible assets or identifiable intangible Goodwill is quantified as the present value of all assets. Creating a projection of that future income is prospective income that cannot be associated with a challenge. the current sources of income (for example, the enti- For purposes of illustrating this method, let’s ty’s tangible assets and identifiable intangible assets limit the discussion to analyzing the present value that are in place as of the analysis date). of the expected future customers of an entity. In any Long-term projections of income derived from residual method goodwill analysis, it is common for unidentified sources (for example, from unidentified the financial adviser to estimate and present value future customers) are uncertain. As a result, it may the prospective income associated with the current be difficult in practice to use this method to estimate customer base. goodwill value. This income projection (and the present value procedure) is typically made over the expected remaining useful life of the current customer rela- Goodwill under Alternative tionships. The value of the entity’s current customer base is the present value of the income to be earned Premises of Value from providing future products or services to current A premise of value is an assumption about the set of customers. actual or hypothetical transactional circumstances Using the present value of future income method, applicable to the analysis. The premise of value goodwill may be estimated as the present value of describes the facts surrounding the operational the future income to be earned from providing future environment in which the defined standard of value goods or services to future, unidentified, customers. transaction will take place. The premise of value These future customers are unidentified new cus- may have an impact on the value of an entity’s or an tomers who (presumably) will take the place of the individual’s goodwill. entity’s current customers as the identified current All intangible assets, including goodwill, can be customers retire. valued under the following alternative premises of The present value of future income method value: requires a projection of the entity’s income- 1. Value in continued use as part of a going generating capacity. The projection begins with the concern

www .willamette .com INSIGHTS • SPRING 2015 19 for a bankruptcy purpose often may not involve the identification or valuation of goodwill. When the financial adviser selects the appropriate premise of value on which to conduct the business valuation, he or she considers whether the entity has goodwill. If goodwill exists within the entity, then it is likely that the entity does not have going-concern risk. In other words, the entity’s HABU is likely to be as a going concern. Therefore, it is likely to be appro- priate to value the entity (and the tangible assets and intangible assets) based on the premise of value in continued use. However, if no goodwill exists in the entity, then that entity may suffer from going concern risk. If there is no goodwill, the financial adviser may conclude that a value in exchange premise of value 2. Value as an assemblage of assets in place but represents the HABU. Typically, the selection of the not in current use appropriate premise of value is based on the HABU of the entity or the tangible assets and intangible 3. Value in exchange as part of an orderly dis- assets. position of asset Of course, there may be circumstances when the 4. Value in exchange as part of a voluntary liq- entity is not being operated at its HABU. In those uidation of asset circumstances, the goodwill may have a greater value 5. Value in exchange as part of an involuntary based on a value in exchange premise of value rather liquidation of assets than on a value in continued use premise of value.

The same goodwill of the same entity will likely have a different value conclusion depending on the Goodwill Data Sources premise of value that is applied in the analysis. Goodwill data sources can be either internal or A value in continued use, going-concern value external to the entity. indication is influenced by the relative contribution Internal data sources typically relate to documen- and mutual economic benefits that are created by all tation regarding the entity’s historical or prospective assets of the entity. results of operations. Accordingly, the business value of most com- External data sources typically relate to empirical panies is greater than the sum of the values of the pricing data with regard to the goodwill of guideline component tangible assets and identifiable intangible business or professional practice sale transactions. assets. One goodwill component relates to the incre- mental value that is created by assembling these tangible assets and identifiable intangible assets in Internal Data Sources an income-producing, going-concern business. The financial adviser considers all available data Goodwill is often identified and quantified in sources regarding the goodwill owner/operator. These a business valuation that is conducted based on a internal data sources typically fall into the following going-concern premise of value. However, a busi- categories: ness valuation conducted on the various value in 1. The existence of identified tangible assets exchange premises of value may not include the and intangible assets, including a detailed contributory value of all assembled tangible assets listing of working capital accounts, real and intangible assets. This is because the entity’s estate, tangible personal property, and iden- tangible assets and intangible assets are valued on tifiable intangible assets (including intellec- an individual or piecemeal basis. Goodwill value is tual property) often limited in a business valuation that is con- 2. The valuation of tangible assets and iden- ducted based on one of the alternative value in tifiable intangible assets, including recent exchange premises of value. appraisals of any asset category For example, a business valuation that is based on 3. The historical results of business operations, a value in exchange or liquidation premise of value including historical income statements,

20 INSIGHTS • SPRING 2015 www .willamette .com balance sheets, cash flow statements, and Many medical and dental practice con- capital statements sultants, financial advisers, and others find 4. The prospective results of business oper- the information published in the Goodwill ations, including current , plans, Registry to be an extremely useful tool, not forecasts, and projections prepared for any only for ad hoc and formal practice valua- purpose tions, but also for practice value trend analy- sis and more. n The Lawyer’s Competitive Edge: The Journal Information from these internal data sources can of Law Office Economics and Management be used in the goodwill valuation. (Eagan, MN: West, monthly). Practical man- agement information to minimize falling prof- External Data Sources its, client loss, and employee dissatisfaction. n Merger & Acquisition Survey of Architecture, For certain industries (principally professional prac- Engineering, Planning & Environmental tices), there are publications, periodicals, and online Consulting Firms (Natick, MA: Zweig White data sources that report on the goodwill components & Associates, annual). This comprehensive of actual business sale transactions. Some of these report includes all the latest data on the data sources are listed in the next section. state of merger and acquisition activity in the design and environmental consulting Directors, Periodicals, and Newsletters industry. n Bank M&A Weekly (Charlottesville, VA: SNL n Public Accounting Report (Chicago: Financial, weekly). Bank M&A Weekly is the Commerce Clearing House (CCH), biweek- only source dedicated to comprehensive ly). The newsletter provides competitive coverage of bank and thrift industry con- intelligence for public accounting firms and solidation, including branch deals and other the profession. It is renowned for its straight asset transactions. Delivered via e-mail reporting and analysis of the news, devel- every week, each issue includes key deal opments, and trends that have defined the ratios, buyer and target financials, industry profession for more than 20 years. trends, and feature stories. Public Accounting Report is written for n Cable TV Investor: Deals & Finance public accounting firm partners and pro- (Charlottesville, VA: SNL Kagan, monthly). fessionals, opinion leaders, and industry Cable TV Investor: Deals & Finance pro- observers. A subscription includes 23 issues vides access to data, deals, and valuation plus periodic special reports and extras, metrics in the cable TV sector. In each issue, including the exclusive Public Accounting Cable TV Investor: Deals & Finance brings Report Top 100 ranking of accounting firms. in-depth analysis of the latest market trends n Valuation Survey of Architecture, Engineering, and what they mean for the future. Planning & Environmental Consulting Firms Data covered include private market (Natick, MA: Zweig White & Associates, values of public cable TV , details on annual). Valuation Survey of Architecture, recent top cable TV deals, analysis of cable Engineering, Planning & Environmental multiple-system operator (MSO) key grow- Consulting Firms is the definitive resource ing revenue streams, operating data analy- for architectural, engineering, planning, or sis, commentary, trends in financing, environmental consulting firms. details on initial public offerings (IPOs), The survey data included in this report quarterly MSO census, and annual detailed and the Zweig White exclusive Z-Formulas cable industry forecasts. are useful for a firm sale or merger or inter- n Goodwill Registry (Plymouth Meeting, nal purposes, such as ownership transition PA: The Health Care Group, annual). The or employee stock ownership plan (ESOP) Goodwill Registry is the nation’s largest purposes. database of health care practice transactions and the only source of actual goodwill values Financial Ratios paid. Published every spring since 1981, the n Almanac of Business and Industrial Goodwill Registry contains data organized Financial Ratios, by Leo Troy (Chicago, by medical and dental specialty, state, loca- CCH, annual). This source contains finan- tion, and other practice characteristics. cial ratios derived from federal tax returns.

www .willamette .com INSIGHTS • SPRING 2015 21 Ratios for each of about 200 industries are n RMA Annual Statement Studies arranged according to company asset size. (Philadelphia: PA: The Risk Management n Industry Profiles (Camp Association, annual). Five-year comparative Hill, PA: BizMiner, database). Five-year com- analysis includes income and expenses, bal- parative analysis includes income statements, ance sheets, and key industry ratios catego- balance sheets, and key financial ratios for rized by sales and assets size range for over more than 10,000 lines of business. 740 industries. analysis includes cost Income and expense ratios include gross of sales, officer compensation, payroll, rent, profit, operating expenses, officer compen- taxes, interest, and deprecia- sation, and and amortization tion, advertising, employee benefits, and expense as a percentage of sales. other selling, general, and administrative expenses in both dollars and as a percentage of sales. Available in all firms, small busi- Trade and Professional Organizations ness, sole proprietor, and business start-up n American Bar Association. 321 North Clark versions. Street, Chicago, IL 60654. Phone: (800) n Integra Industry Reports (Kennesaw, GA: 621-6159 or (312) 988-5000, www.ameri- Integra Information, Microbilt Corporation, canbar.org. database). Available in QuickTrends, 3-Year, n American Institute of Architects. 1735 New and 5-Year versions, which include income York Ave., NW, Washington, DC 20006. statements, balance sheets, and key busi- Phone: (202) 626-7300, www.aia.org. ness ratios by sales size range for over 900 industries. n American Institute of Certified Public Accountants. 1211 Ave. of the Americas, The five-year report includes cost of sales, New York, NY 10036-8775. Phone: (800) officer compensation, employee benefits, 862-4272 or (212) 596-6200, www.aicpa.org. advertising, bad debts, rent, depreciation, and other selling, general, and administra- n American Medical Association. 515 N. State tive expenses in both dollars and as a per- St., Chicago, IL 60610. Phone: (800) 621- centage of sales. 8335, www.ama-assn.org. n FINTEL Industry Metrics Reports (Madison, WI: Fintel LLC, database). Reports provide financial information drawn from a database Goodwill Value Illustrative of over 900,000 privately held firms in over 2,500 industry groups as classified either Example by standard industry classification or North This simplified example applies the capitalized American Industry Classification System. excess earnings method to estimate the professional Size breakdowns are into small, medium- practice goodwill value in a small corporate transac- sized, and large segments specific to each tion. industry rather than breakdowns based on In this example, let’s assume that the physician fixed size thresholds. owners of Zeta Physicians Clinic (Zeta) and Eta Common-sized income statement and Medicine, Inc. (Eta), have decided to enter into a balance sheet data (major accounts) for joint venture to provide certain acute care medical each size segment (as-if statements) are dis- services. The joint venture will be called the Theta played as are 14 commonly used and insight- Medical Group (“Theta”). ful financial ratios for each industry. In this transaction, Zeta provides the Theta joint n IRS Corporate Ratios (Libertyville, IL: Schonfeld & Associates, annual or data- venture with the following: base). Ten years of corporate tax return data 1. The use (but not the ownership) of its trade- and financial ratios for over 250 industry mark and trade name and its associated groups is provided. positive reputation Information provided includes income 2. Access to (but not the ownership of) its and expenses, balance sheets, and key busi- patient charts and records and the associ- ness ratios, with data categorized within an ated patient loyalty industry group by asset size.

22 INSIGHTS • SPRING 2015 www .willamette .com To simplify this example, let’s assume that the financial adviser is asked to value these discrete Exhibit 1 intangible assets collectively as goodwill. Let’s Zeta Physicians Clinic Goodwill Valuation assume that this goodwill is the only asset to be con- Balance Sheet as of December 31, 2014 tributed by Zeta to Theta. Eta will provide all of the tangible assets and all of the working capital assets Assets (but no liabilities) to Theta. Current assets $3,000,000 Eta will contribute tangible assets and work- ing capital assets to the Theta joint venture in an Property, plant, and equipment 2,000,000 amount equal to the goodwill value contributed by Total assets $5,000,000 Zeta. The Theta joint venture will be formed as of December 31, 2014. Liabilities The owners of Eta and Zeta have to divide the Current liabilities $1,000,000 equity ownership of the Theta joint venture. The owners have agreed to allocate the equity value Long-term debt 1,000,000 based on the relative values of the assets contributed by each party. Total liabilities 2,000,000 The objective of the analysis is to estimate the value of the goodwill contributed by Zeta to the Owner's Equity 3,000,000 Theta, as of December 31, 2014 (the valuation date). Total liabilities and owner’s equity $5,000,000 The purpose of the analysis is to allocate the Theta equity ownership.

Most of the value in the Theta joint venture is Exhibit 2 related to its expected future revenue and income. Zeta Physicians Clinic Goodwill Valuation Based on the specific facts of this assignment, Projected Income Statement as of December 31, 2014 the financial adviser concludes that the income approach and the capitalized excess earnings method is appropriate to value the Zeta goodwill. Projected Exhibit 1 presents the projected balance sheet as of the December 31, 2014, date of inception Ended 12/31/15 of the joint venture. Exhibit 2 presents the joint Net revenue $8,000,000 venture projected next year income statement as Operating expenses of December 31, 2014. The projected income state- ment is based on the financial adviser’s projection of Cash expenses 5,400,000 revenue and expenses. The joint venture projected Depreciation expense 1,000,000 net cash flow as of December 31, 2014, is presented Interest expense 100,000 in Exhibit 3 on the following page. Total expenses 6,500,000 For purposes of this analysis, the financial Pretax income 1,500,000 adviser defines excess earnings as the difference between the Theta projected total income and a Income tax expense (600,000) total fair return on the Theta tangible assets and $900,000 working capital assets. The fair rates of return applied to the Theta working capital assets, tangible assets, and goodwill are based on market-derived assets are expected to earn a higher asset-specific evidence. rate of return than financial assets are expected to Intangible assets (including goodwill) generally earn. have a greater level of financial and operational risk Exhibit 4 presents the financial adviser’s esti- than do tangible assets. And, tangible assets gener- mate of the joint venture excess earnings. Exhibit 5 ally have a greater level of financial and operational illustrates the procedure for capitalizing the excess risk than do working capital (or financial) assets. earnings into an estimate of goodwill. Based on this Typically, intangible assets are expected to earn illustrative analysis, the value of the Zeta goodwill a higher asset-specific rate of return than tangible contribution to the Theta, as of December 31, 2014, assets are expected to earn. Typically, tangible is $2,700,000.

www .willamette .com INSIGHTS • SPRING 2015 23 Accordingly, Zeta contributed $2,700,000 Exhibit 3 of intangible asset value to Theta. And, Eta will Zeta Physicians Clinic Goodwill Valuation contribute $3,000,000 of current assets and Projected Net Cash Flow as of December 31, 2014 $2,000,000 of tangible assets ($5,000,000 in total) to Theta. Therefore, the Theta equity will be allocated Projected Fiscal 35 percent to Zeta ($2,700,000 ÷ $7,700,000) and 65 Year Ended percent to Eta ($5,000,000 ÷ $7,700,000). Net Cash Flow (to invested capital) 12/31/2015 Projected net income $900,000 plus: Tax-affected interest expense 60,000 Summary equals: After tax net operating income 960,000 There are different types of goodwill, including (1) plus: Depreciation expense 1,000,000 business or institutional goodwill and (2) personal less: Capital expenditures 1,000,000 or professional goodwill. Financial advisers are often less: Increase in net working capital 100,000 asked to value these different types of goodwill for equals: Projected net cash flow $860,000 transaction, taxation, financial accounting, litiga- tion, and other purposes. This discussion describes the various components of goodwill and the various reasons why financial advisers—particularly inde- Exhibit 4 pendent financial advisers—may be asked to value Zeta Physicians Clinic Goodwill Valuation goodwill. Estimate of Excess Income as of December 31, 2014 This discussion considered the types of business Valuation Analysis goodwill and personal goodwill and summarized the common components and types of goodwill. Projected net cash flow $860,000 This discussion explained that the income Working value 2,000,000 approach is not the only approach to value goodwill. The cost approach and the market approach may Required rate of return [a] 6% also be appropriate to a goodwill valuation. Fair return on working capital assets (120,000) The independent financial adviser should care- Tangible asset value 2,000,000 fully consider which valuation approach is most appropriate for the specific type of entity and the Required rate of return [a] 10% specific type of assignment. Fair return on net tangible assets (200,000) In addition, with consideration of any instruc- Total fair return on working capital tion provided by legal counsel, the financial adviser assets and tangible assets (320,000) should apply a valuation approach and valuation method that concludes the standard of value and premise of value appropriate to the purpose and Excess income $540,000 objective of the goodwill valuation. [a] Based on market-derived rate of return evidence.

Exhibit 5 Robert Reilly is a manag- ing director of the firm and Zeta Physicians Clinic Goodwill Valuation is resident in our Chicago Capitalized Excess Earnings Method Value Conclusion as of December 31, 2014 office. Robert can be reached at (773) 399-4318 or at Indicated [email protected]. Valuation Analysis Value Excess income $540,000 Divided by: Selected direct capitalization rate 20% Equals: Intangible value in the nature of goodwill $2,700,000

Value of the Zeta Physicians Clinic goodwill contributed to the Theta joint venture (rounded) $2,700,000

24 INSIGHTS • SPRING 2015 www .willamette .com