Goodwill is the difference between the purchase price and the fair market value of a business. Put simply, goodwill represents the intangible quality of the business you are buying that is not represented by its hard assets.
Goodwill is the one and only asset that competition cannot undersell or destroy. -Marshall Field
For example, you’ve agreed to a purchase price of $100,000 for the business you want to buy. You go and get the assets valued. You find out there is equipment that at today’s market value would be worth $60,000.
You are also acquiring $30,000 in stock. The hard assets are clearly worth $90,000, but you are paying $100,000. What does the $10,000 represent?
That’s the goodwill, which is represented by a number of factors including:
1. Brand reputation
2. Brand recognition
4. Dedicated staff
5. Unique operations
6. Developed processes and systems
7. Proprietary technology
8. Solid customer base and supplier list
9. Intellectual property such as copyright, trademarks and patents
10. Company website and domain name
Although they are intangible, they are quantifiable and can sometimes be worth more than the tangible items you’re buying as you purchase a business.
Here's a sample calculation in which goodwill is a huge part of the purchase price.
Why should you pay for goodwill?
As you can observe on the list above, business goodwill represents the hard, smart work of the seller over the years. You are paying for those intangible items, so you don’t have to reinvent it, or start from scratch.
Remember that it’s much easier to maintain rather than to establish those intangible assets that the seller has built over time.
By deduction, poorly run businesses obviously have little to no goodwill. And the really bad businesses can, in fact, have negative goodwill. That occurs where the value of the assets you are acquiring is greater than the purchase price you are paying. You wouldn't want to buy such business.