Allocation of Goodwill Towards Business and Personal
April 20, 2017
© 2017, by Daniel T. Jordan, ASA, CBA, CPA, MBA, Florida Business Valuation Consultants
Goodwill is an intangible asset of an enterprise. It is the essence of a business that makes it more than just a collection of other assets, like real estate, equipment, inventory, receivables, and cash. Goodwill is a concept based in old English law dating from the early 1800’s. Goodwill “is the probability that customers will return to the old stand.”[1]
In the early 1900’s in the United States, Justice Cardozo captured the essence that goodwill was the tendency for customers to return to the same location or company because of its name or other reasons, regardless of its location.[2]
Goodwill is defined as the total value of an enterprise less those other assets, such as current assets, investments, and fixed assets, whose value can be determined through other means. Goodwill can be separated into two parts: personal goodwill and enterprise goodwill. They are defined as follows:
Personal goodwill is the value of earnings or cash flow directly attributable to the individual’s characteristics or attributes. Personal goodwill, sometimes referred to as professional goodwill, is a function of the earnings from repeat business that will patronize the individual as opposed to the business, new consumers who will seek out the individual, and new referrals that will made to the individual.
Enterprise goodwill is the value of earnings or cash flow directly attributable to the enterprise’s characteristics or attributes. Enterprise goodwill, sometimes referred to as practice goodwill, is a function of the earnings from repeat business that will patronize the business as opposed to the individual, new consumers who will seek out the business, and new referrals that will be made to the business.[3]
In two instances, we are asked to separate professional goodwill from enterprise goodwill:
- For divorce purpose, there are many states that do not consider professional goodwill as marital property. This reduces the value of the Company.
- When selling a business, the capital gains tax is lower for personal goodwill (20%) than for business goodwill (35%). This saves our clients substantial amounts of money.
How do we separate professional goodwill from enterprise goodwill?
Multiattribute Utility Model (“MUM”)
We use the multi-attribute utility model (MUM), which is a court-accepted method of measuring goodwill attributes for importance and presence in the business, developed by David Wood, CPA, ABV, CVA.
The Multiattribute Utility Model is an allocation model for distinguishing enterprise goodwill from personal goodwill.[4]
MUM is a well-defined method used in many disciplines — economic, political, and scientific — to establish decision support for subjective problems. MUM lends itself to consistency, introduces objectivity into an otherwise subjective assignment, and provides for sensitivity analysis of the outcome.
MUM’s objective is to determine the value of the two elements of goodwill, personal and enterprise, from the total goodwill, such that a reasonable, well-founded basis for the allocation can be formed and communicated.
MUM divides attributes into those that tend to indicate either enterprise or professional goodwill, and then uses the relative weights to determine the attribute’s importance and presence in the business.
Personal Goodwill Attributes (“PGA”)
A personal goodwill attribute is one that is indicative of goodwill directly associated with an individual. Assessment of these attributes are a direct reflection of the consumers that seek out the individual, are referred to the individual, or repeat patronage due to the attributes of the individual as opposed to other attributes that are reflective of the business.
Enterprise Goodwill Attributes (“EGA”)
An enterprise goodwill attribute is one that is indicative of goodwill directly associated with the business. Assessment of these attributes is a direct reflection of consumers that seek out the enterprise, are referred to the enterprise, or repeat patronage due to the attributes of the enterprise as opposed to other attributes that are reflective of the individual.
Measure the “Utility” of Each Attribute
“Utility” as used in MUM is an assessment of each attribute. There are two utilities assessed in this step – the “importance utility” and the “existence utility.” The importance utility is a relative measurement of each attribute’s importance to the valuator. Each attribute has some measure of importance, since it has been selected as an attribute, therefore, the attribute must have a weight greater than zero.
a. Importance Utility
Each attribute’s relative importance is determined by the valuator and weighted according to a scale. The scale is a weighted scale with each attribute in relative importance from a “least important” to a “most important” attribute. The assessment and weighting of the importance of each attribute results in the Utility of Importance.
b. Existence Utility
The valuator examines the business to determine the existence of each attribute. The scale is a weighted scale, similar to the weighted scale for the importance utility. The existence utility weights are continuous with unit weights beginning at zero. This scale allows the valuator to score an attribute with a zero if its presence is weak or absent. The assessment and weighting of the existence of the attributes result in the Utility of Existence.
Aggregate the Results
Aggregating the results is essentially performing MUM’s math. The math underlying the use of MUM in the allocation of goodwill is multiplicative. The attributes are divided into the two groups – personal and enterprise. The importance utility is multiplied by the existence utility for each attribute to determine the multiplicative utility of each attribute.
We then establish the respective percentages of each attribute for professional and enterprise goodwill. We can now calculate the dollar amount of professional and enterprise goodwill based on these percentages. We typically also include a sensitivity analysis for different outcomes of personal goodwill.
Endnotes
[1] Cruttwell V. Lye, 34 Eng. Rep 129, 134 (1810).
[2] In re Brown, 242 N.Y. 1, 6, 150 N.E. 581, 582 (1926).
[3] “Goodwill Attributes: Assessing Utility,” The Value Examiner, David Wood, January/February, 2007, Edition.
[4] “An Allocation Model for Distinguishing Enterprise Goodwill from Personal Goodwill.” American Journal of Family Law, Volume 18, Number 3, David Wood, Fall 2004.
