Understanding the distinction between personal and commercial goodwill is key to anticipating whether the value of a family business will be a significant factor in your client's case.
By Antonina Wasowska (Ontario)
In many family law disputes, the value of a business owned and operated by one or both of the spouses becomes an important factor in determining net family property and the resultant equalization payment between spouses.
While you will be relying on an expert Chartered Business Valuator to calculate the value of the business, it is useful for family lawyers to have a basic understanding of the different types of goodwill. Your understanding of how goodwill contributes to business value may help you plan your strategy early on in the engagement, and manage your client's expectations accordingly.
Goodwill in a business may be personal or commercial. The following table summarizes the key differences between each type of goodwill:
Goodwill Type: Derived From: Transferable to New Owner?
Personal Current Owner's No
Commercial Company's Yes
Personal goodwill depends on the particular knowledge, skills and connections of the business owner, and does not add to the value of the business. On the other hand, commercial goodwill is inherent in the business itself. Therefore, in some cases, even though the business may be profitable, and generate a good income for the business owner, the business itself may be worth very little on the open market as the goodwill is personal and would not be transferable (or only semi-transferable) to a new owner business. In other words, there is the risk that if the owner were to sell or step away from the business, the business would not continue.
The concept of personal goodwill is best illustrated through a case study. ABC Co. is a consulting practice that was started by Mr. Jones five years ago. Prior to starting ABC Co., Mr. Jones worked in business development for a widget manufacturer. Mr. Jones identified a niche market for the widgets, and he decided to start his own consulting business.
Today ABC Co.'s business can be summarized as follows:
• Contracts -- ABC Co. has secured contracts with Mr. Jones' previous employer, as well as several other competing manufacturers of related widgets, to promote and sell the manufacturers' widgets to end users in the niche market. The contracts with the three largest manufacturers (which make up 90% of ABC Co.'s revenue) can be terminated by either party with 30 days notice.
• Revenue -- ABC Co. earns its revenue through commissions earned from the manufacturers on sales to the end users, and mark-ups when it acts as a reseller.
• Employees -- Mr. Jones has two staff working for him. While both staff have some relevant industry experience, they do not have Mr. Jones' extensive product knowledge, or his contacts with key decision makers at the companies that are the end users of the widgets.
• Customer Relations and Knowledge Transfer -- Mr. Jones had hoped to be able to cut back on his hours by having the staff take over more of his duties; however to date he has been unsuccessful in transferring his expertise to his staff. In particular, the manufacturers are not receptive to dealing with anyone other than Mr. Jones, and have threatened to take their business elsewhere if Mr. Jones were to leave.
ABC Co. provides a good example of a business whose survival is dependent on the personal goodwill of its owner. Personal goodwill is most common in small, specialized service-based businesses where the owner has a unique skill set that cannot be easily taught to a successor, or in relationship-focused businesses. In such cases, the success of the business is directly attributable to the business owner running the business. Since personal goodwill would not be transferable to a new owner of the business, it does not form part of business value in a notional valuation. However, even in cases where there is no transferable goodwill, there may be some value in the company’s tangible assets such as investments and real estate holdings.
Unlike personal goodwill, commercial goodwill is fully transferable to a new owner, and therefore forms part of the business value. Commercial goodwill arises from a business’ location, supplier contracts, customer contracts, successful products, or reputation in the market place (versus the reputation of the business owner).
In situations where goodwill forms the majority of business value, it is useful to assess whether the business valuation expert identified the sources of the goodwill, and/or assessed the reasonability of the goodwill by comparing it to the level of maintainable earnings or cash flows generated by the business. If there is no clear rationale for why the business has commercial goodwill, this can provide ammunition for cross-examining opposing counsel’s expert’s valuation conclusion.
By understanding the distinction between personal and commercial goodwill and what they mean for business value, you will better anticipate whether the value of a family business will be a significant factor in your client's case.
Antonina Wasowska CAOCBV, CPA is a manager at Fuller Landau Valuations Inc.