Decoding Personal Goodwill Valuation

The International Glossary of Business Valuation Terms defines goodwill as: 

‘‘That intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified.”

While the accounting body Financial Accounting Standards Board (“FASB”) does not distinguish between corporate and personal goodwill, the classification of enterprise and personal goodwill is critical from a tax standpoint to avail tax advantages upon the sale of a business entity.

Personal goodwill is an asset that is owned by an individual, not the business itself. It is generated from the personal expertise or business relationships of an individual employee or shareholder. On the other hand, enterprise goodwill is a set of business-owned characteristics that can be transferred to a buyer upon a sale. Enterprise goodwill’s existence stems from the business and is not related to any individual.

Scope

Personal goodwill valuation is crucial in business sales, shareholder disputes, estate planning, and marital dissolution/divorce proceedings. In the majority of cases, the valuation requirement for personal goodwill is seen in connection with the business sale or divorce proceedings.

Business Sale

The delineation of personal and enterprise goodwill benefits both the seller and buyer in the deal.

Seller Gains:

• If the selling shareholder owns the goodwill and is being sold directly by him to the buyer, there will be only a single layer of taxation. If, however, the goodwill was deemed to be owned by the selling corporation, the sale of the goodwill would be subject to both corporate and personal-level taxation.
• Personal goodwill is subject to long-term capital gains and receives a preferential capital gains tax rate, assuming it is held for more than 12 months, as opposed to the higher ordinary income tax rate.

• Creditors of the company can’t raise a claim against personal goodwill to satisfy the business’ debt obligations.
• Buyers may prefer and, therefore, may be willing to pay more for assets of the business versus stock, given the stepped-up basis of the assets received in an asset deal or a stock deal with a Section 338 election.

Buyer Benefits:

• The tax advantages for sellers increase the likelihood of closing of transaction.
• Buyer may amortize personal goodwill over a period of 15 years under §197, resulting in the reduction of the tax liabilities associated with the deal.

Marital Dissolution (Divorce)

In marital dissolution (divorce cases), the bifurcation of personal versus enterprise goodwill is necessary to quantify the marital(community) versus separate (personal) assets. 

Family courts in many jurisdictions require valuation practitioners to separate personal and enterprise goodwill. In many states, personal goodwill is not considered a marital asset.

The Client and The Ask: 

Valuation of the personal goodwill of partners in an investment management company in connection with the proposed sale. 

Scope included:

1. Business valuation through the income and market approach to calculate the company’s equity value, to corroborate the equity value in the proposed sale transaction.
2. Valuation of personal goodwill of individual investment partners.

Methodology: 

1. Business Valuation: Guideline Public Company Method, Deal Stats, and Gordon Growth Analysis (corroborative approaches with 0% weight) and Sale Transaction Indication (100% weight).
2. Personal Goodwill Valuation: WWO and MUM 

Valuation at a Glance

We have provided a brief summary of personal goodwill valuation below.

With and Without method

• We considered identical “With” scenarios for all three partners based on the premise that all partners will remain employed and thereby contribute to revenue and profits. 
• In the “Without” scenario, we assumed that it would take the company a period of time to regenerate similar revenue and profits that are lost from the absence of the individual partner. 
• Hence, in the “Without” scenario, the cash flows were adjusted downward to incorporate the absence of each partner. The impact was due to the loss of assets under management, which in turn impacted forecast revenue, and the further absence of key individuals led to reduced revenue growth rates in the projected period.
• The ‘‘With cash flows’’ and the ‘‘Without cash flows’’ were compared on an after-tax basis. The differential was then discounted to present value (including the present value of terminal value differential), and a tax amortization benefit (“TAB”) was added to determine the FMV of personal goodwill. 

MUM method

• Various attributes of personal and enterprise goodwill were identified, and each attribute was ranked for Importance Utility and Existence Utility. Importance Utility was ranked in three categories: 1 – Important, 3 – More Important, and 5- Key. Existence Utility was ranked from 0 to 4, where 0 indicated no presence, and 4 indicated strong presence.
• Key Personal Goodwill Attributes (“PGA”) include client relationships, personal reputation, unique skills and judgment, work habits, age and health, and other personal contributions that can influence business revenue and customer retention.
• Key Enterprise Goodwill Attributes (“EGA”) include business location, branding and marketing, systems and processes, business reputation, and name, among others.
• Utility score of each personal goodwill attribute and enterprise goodwill attribute was calculated based on the multiplication of Importance Utility and Existence Utility for respective attributes.
• For each attribute, % was determined based on the multiplicative utility for the attribute divided by the total multiplicative utility of personal and enterprise goodwill attributes.
• When these percentages are summed up for personal goodwill as well as enterprise goodwill, they yield personal goodwill proportion and enterprise goodwill proportion to total goodwill.
• See the snippet below for illustrative purposes.

Summary