What is a Fair Price for Business Goodwill?

How should the seller and buyer go about negotiating a fair price for business goodwill? The best way to look at negotiating a fair price is to look at the transaction as the negotiation over a fair commission or a finder’s fee for immediate access to the seller’s customers, clients, patients (CCPs) or referral sources. The seller is capable of bringing the buyer a collection of “presold” CCPs that the buyer would otherwise have to compete for. Depending upon local market conditions this can be a significant competitive advantage. In converging to a fair price for this competitive advantage the seller and buyer have different senses of fairness.

A Fair Price for Business Goodwill: The Seller’s Perspective

The seller realizes that it was their ability to provide quality services or products in the past that has earned the capacity to confer this competitive advantage on a buyer. It is expected that a large percentage of the seller’s repeat CCPs will heed their recommendation on a successor. On this basis they should be entitled to some share of future discretionary earnings (DE) from CCPs who agree to continue to patronize the firm after there is a change in ownership.

A Fair Price for Business Goodwill: The Buyers Perspective 

The transferred CCP’s willingness to continue to patronize a firm after an equity transfer depends upon the new owner being able to provide a comparable level of quality, convenience and price that was provided by the old ownership. After the first patronization inherited CCP’s willingness to continue patronizing the firm is due entirely to the fact that the new owner has proven its ability to provide adequate levels of satisfaction.

Under fairness considerations the new owner would appear to be entitled to most (if not all) future DE beyond the first patronization. The same fairness considerations apply to new CCPs obtained after the equity transfer. Because these new CCPs, by definition, have no previous experience with the firm, the old owners should not receive any credit for their willingness to patronize the firm under the new ownership.

There is another important buyer fairness consideration: the right to be fairly compensated for assuming the burdens and responsibilities of owning and managing the acquired customer or client base. Motivated buyers will be taking on the responsibility of providing services or products to more CCPs than they had previous to the equity transfer. The fact remains without an additional cash reward, there will be little incentive to taking on these responsibilities. Whatever the amount of additional reward is, it has to be net of all other expenses including anything paid out for the equity in the firm.

A Summary of Negotiated Fairness Constraints

  • The seller is entitled a commission for only those CCPs that transfer in to the new owner. CCPs acquired after the equity transfer are excluded.
  • The seller is entitled to a share of the DE on transferred CCPs subject to the buyer obtaining an economic reward level sufficient to induce the buyer to take on the extra responsibilities of servicing more CCPs.
  • Subject to the first two constraints, the allocation of any remaining economic value associated with a CCP base should reflect a decreasing share of DE to the seller and an increasing allocation of DE to the buyer due to the fact that the buyer is increasingly responsible for insuring future patronizations of inherited CCPs.

These fairness criteria provide a broad beginning level of understanding what constitutes a fair price. A more refined price is developed by considering the buyer's reference point as to what constitutes a fair return for assuming the burdens of servicing and managing the seller's CCP base. Click here for discussion of this topic.

 Isn’t Self-Interest the Only Thing that Matters?

Some might argue that the above fairness criteria have little bearing on negotiation of equity prices. However, the fairness criteria outlined above are embedded in many equity exchanges commonly called “earn outs”. Click here for a description of these “earn out” sales. Additionally, game theory has shown that fairness criteria play a role in two-person games that resemble price negotiations. Click here for a description of these games.

For a more general discussion on fairness in negotiations click here.

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Copyright 2018 Michael Sack Elmaleh