Summary: Richard Claywell was recently asked to review a business valuation report when a company was sold for $91 million. The appraisal report shows sales of $116 million, profit margin of $28 million, an “approximate” multiple of 3.25 and a value of $91 million. The appraiser assigned 80% of the sales price to personal goodwill. That goodwill number was unsupported, and the IRS challenged it. Here’s how to avoid having that happen to your clients!
Determining the Initial Goodwill in an Acquisition: Is the Initial Goodwill Reliable and What Portion Represents Personal Goodwill?
Determining the Initial Goodwill in an Acquisition
It is important that the initial goodwill in an acquisition be determined and the report provide sufficient credible information to support the initial cost of goodwill. The goodwill may be adjusted in future years but if the initial analysis has been performed correctly, future adjustments to goodwill could be minimal and not indicate, in error, that the acquisition price was overstated.
What is Goodwill?
Goodwill is actually a very simple concept. Goodwill is the intangible value of the earnings that a company generates above its identifiable assets. The key items that contribute to goodwill is the fact that the company is a going concern, the company is making profits and there is an expectation that profits will be continuing in the future.
Real World Example.
I currently have a business valuation report that I have been asked to review. A company was sold for $91 million. The appraisal report shows sales of $116 million, profit margin of $28 million, an “approximate” multiple of 3.25 and a value of $91 million. The appraiser assigned 80% of the sales price to personal goodwill. There was no discussion of nor support to indicate how the 80% goodwill was determined. Obviously, the Internal Revenue Service has challenged the allocation of 80% of the purchase price to personal goodwill.
This type of appraisal poses several problems for both the buyer and seller. First, the report is not credible. The report has been summarized so much that there is no detail to support any of the calculations. The report cannot be relied upon by anyone to provide any sufficient relevant data. Second, the report did not identify any other intangible assets other that goodwill that was owned by the company. There was no analysis or discussion to support any values for the company’s customer list, Brand Name, Operating Systems and Software, Development Processes, Distribution Rights, etc.
There should have been a value placed on as many intangible assets as could be identified. Third, there was no Form 8594 filed with any of the companies Federal income tax returns. Form 8594 requires the allocation of the purchase price and the reporting of the allocation to the Internal Revenue Service. Fourth, since other intangible assets were not identified, there is an improper allocation of goodwill.
The improper and overstatement of allocation of goodwill will have a negative impact on the future earnings of the acquiring company. Since the goodwill is overstated, there is a strong probability that the overstatement will be disclosed when the first impairment testing is performed. Fifth, the seller needs to know the value of goodwill for Federal income tax purposes. If the goodwill is not determined properly, there will be income tqax returns that will be improperly filed.
The goodwill must be a credible and supportable number. It is extremely important to select a valuation expert that has experience with determining goodwill and understands how to value various intangible assets that are not part of the goodwill and provide a credible report.