The Fair Commission Model for Appraising Goodwill
1. A business has goodwill if it has repeat regular customers, clients, patients (CCPs) or referral sources. Click here for the kinds of businesses that typically have goodwill.
2. Goodwill has value only if it offers a potential buyer of the business a competitive advantage: the buyer must gain immediate access to CCPs for whom they would otherwise have to compete.
3. The economic value of goodwill, the value of the competitive advantage, depends upon how costly and difficult it is to gain CCPs through competition; how many CCPs will remain after ownership changes; how many future patronizations the transferred CCPs will generate; how much of a return the new owner will realize on these future patronization after factoring the costs of operations and the cost of acquiring the business.
4. Both the Buyer and Seller have at least some intuitive sense of what a fair price for the equity of a business with goodwill will look like. From an economic standpoint the negotiation of a fair equity price for a firm with goodwill is a negotiation of a fair commission or finder’s fee. Click here for a discussion of the importance of fairness in negotiation of a price for business goodwill.
The key first step in deriving a fair price for the equity of a firm with goodwill is identifying who would be qualified, motivated and capable of best utilizing the competitive advantage of having immediate access to a CCP base. This is the buyer who can generate the highest return on the seller’s CCP base. See the optimal buyer page for more detail.
The second step in deriving a fair price is forecasting the upper bound value of the seller’s CCP base. This I call the maximum competitive advantage of the CCP base. This is a forecast of the absolute highest return that an optimal buyer could expect from the future patronizations of the transferred CCP base before factoring the cost of buying the business. Click here for more on the maximum competitive advantage.
The next step involves a refined upper bound measure that takes into account the optimal buyer’s next best alternatives to buying the business. If the optimal buyer is currently an employee that employee will want to forecast the differential compensation: the difference between the amounts that could be earned if the employee buys the business versus what they could realize if they remain an employee. Click here for more information on the differential compensation forecast. If the optimal buyer is a competitor firm then the next best option for such a buyer is to continue to compete for customers. To establish a rational upper bound for such buyers a forecast that I term “compete or buy” is developed. Click here for more information on the “compete or buy” forecast.
The final step in developing a fair value is an analysis of the reference levels an optimal buyer will utilize in determining a fair bid. In addition to current levels of compensation or profit the level of return the seller currently realizes is often used as a guide to a fair level of return. Click here for more on the issue of reference levels.
The FCM utilizes computer probability simulation tools to develop forecasts of the maximum competitive advantage, the “compete or buy” and differential compensation. This is a significant departure from the methods now currently used by most credentialed appraisers and business brokers. Click here for a description of computer simulation forecasting. Credentialed appraisers use different methods that either do not rely on forecasts or utilize highly simplified static forecasts. Click here for more on static forecasts. Both these methods promise appraisal users what they most want to see: a single exact number of value for a business. Unfortunately, due to the many uncertainties involved in forecasting the financial performance of a business the single number that they deliver is either meaningless or not of much use.