The value of a business owner’s personal goodwill is relevant in divorce or the sale of the company. One way to estimate the value of an owner’s personal goodwill is to value the company with and without the owner’s involvement, similar to the way a non-compete agreement is valued.
Non-compete agreements are used to allow advantageous personal relationships with certain customers and employees that a covenantor may have to be institutionalized.
The term of the agreement (e.g., one year, three years, five years) is a reasonable proxy for the time period the parties agree will be required to institutionalize these relationships. This term reflects the time during which the covenantor will have an advantage over the covenantee compared to competitors who do not have these advantageous relationships.
This advantage will be greatest on day one of the agreement and, by definition, gone by the end of the agreement. The advantage decreases over time either as the covenantee institutionalizes the advantageous relationships or the advantageous relationships atrophy.
At the end of the term, the covenantor, the covenantee and the other competitors are all in the same competitive position: None have any advantageous relationships with any of the others’ customers or employees.
During the term of the agreement, it is reasonable to expect the covenantee’s remaining cash flows to grow at the same rate as they would in the absence of an agreement. There is no basis to expect they would grow faster in the absence of an agreement since this would require the covenantee to take more market share from the other competitors during the agreement term than what was expected without competition from the covenantor.
As a result, absent the covenantor’s involvement, the business will, in perpetuity, be smaller at any given time than it would have been given the covenantor’s involvement. Therefore, a terminal value is required to capture the value beyond the term of the non-compete agreement.
A Hypothetical Example
Suppose Brett, the owner of a dental practice, sells his practice without a non-compete agreement and opens a new practice around the corner. It’s reasonable to assume that a significant percentage of Brett’s patients will follow him to his new practice.
Let’s be conservative and say that 20% of Brett’s patients follow him to his new practice. Assuming the practice’s annual revenue was $1 million before Brett sold it, this would lower revenue to $800,000 after Brett leaves. The new owners of the practice are now operating from a revenue starting point that’s $200,000 lower than when they bought the practice.
This is likely to reduce or eliminate the amount of profits available for distribution, which will reduce or eliminate the value of the practice. The difference between the value of Brett’s practice with his involvement and the value with him competing against it is a measure of his personal goodwill.
More Accurate Valuations
Valuing personal goodwill is one of the most vexing challenges valuation professionals face. Using methods similar to those used to value non-compete agreements provides a mechanism to address this challenge.
Give us a call if you have questions about valuing personal goodwill.
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