9031 / What factors are used in determining the intangible value of a small business?

As is typical in small business valuation, the IRS has indicated that the extent to which a business’ value is attributable to intangible value in the form of goodwill must be determined on a case by case basis.¹ At its most basic level, the value that exceeds the value of the business’ tangible assets is attributed to its goodwill. Goodwill is determined by deciding how much a purchaser would pay for this excess value, which is the product of intangibles such as reputation and market position (see Q 9030).

Because of the fact-intensive nature of the inquiry, there are no specific factors that must be considered in determining the goodwill of a small business. Often, the value of goodwill will depend upon the business’ earning capacity and projected future earning capacity, but it can also include value attributable to the business’ prestige, whether it owns a trademark or brand name and its record of successful operation over a prolonged period of time.²

A business that derives much of its success from the services provided by its owners, such as a group of doctors or accountants, will often assign significant value to the goodwill generated by the reputations of these professionals. Conversely, if the business is primarily asset-driven, where the physical equipment or structures producing a product may be more important than the personal services of a business owner, goodwill may be assigned a lesser value. However, even in a product-driven business, if the reputation of concrete products produced by the business provides motivation for repeat business, the business’ goodwill should be assigned a higher value.

The courts have held that the value of personal relationships established by a shareholder-employee or other business owner are generally not corporate assets, and therefore may not be considered in determining the value of goodwill, unless the individual has committed to continuing services to the business, whether contractually or otherwise. In this context, non-compete agreements and traditional employment agreements may be useful in establishing such a commitment³ (see Q 9030).

Because the standards for valuing goodwill are so amorphous, the IRS has proposed a formula that may be used to value goodwill in the event that the parties are unable to assign value based upon past earnings performance and perceived reputational value. Under this formulaic approach, the owners must first determine the return on the average annual value of the business’ tangible assets over a period of time (the IRS recommends five years). The percentage of returns that are based on tangible assets is subtracted from the total average earnings of the business over the same period of time. The remaining value is considered to represent earnings from the business’ intangible assets, including goodwill. This value is then capitalized (at a suggested rate of 15 to 20 percent, depending upon the individual level of business risk) to allocate a value to those intangible assets.⁴

Any abnormal years should be excluded from the period used for averaging under this formula. In determining the rate of capitalization that is most appropriate, the IRS has indicated that the owners must consider factors such as (1) the nature of the business, (2) the risks involved in the business and (3) the stability or irregularity of earnings.

It is important to note that the IRS only recommends use of this formula if the parties are unable to otherwise realistically assign value to a business’ goodwill through another reasonable approach that is based on factors more specific to the particular business. The IRS advises that the formula approach should not be used if there is better evidence available from which the value of intangibles can be determined. If the assets of a going business are sold upon the basis of a rate of capitalization that can be substantiated as being realistic, though it is not within the range of figures indicated here as the ones ordinarily to be adopted, the same rate of capitalization should be used in determining the value of intangibles.⁵