By Elton Law Group
Goodwill is one of those words that gets thrown around in business sale conversations, yet very few people (including many business owners) can clearly explain what it is or why it matters. If you are about to buy or sell a business, that uncertainty can cost you. Goodwill often makes up the largest portion of the purchase price in established businesses, and the way it is treated in the contract can be the difference between a clean handover and a dispute that drags on for years.
This article breaks down what goodwill actually is, how it is valued, and how a properly drafted business sale contract should deal with it.
What is goodwill?
In simple terms, goodwill is the reputation, customer base and earning capacity of a business that goes beyond its physical assets. It is the reason customers walk through the door, choose this brand over a competitor, or keep coming back. Goodwill is sometimes described as the “drawcard” of a business, and without it there is arguably no business to sell at all.
There is no single definitive legal definition of goodwill. The High Court of Australia explored its nature in Commissioner of Taxation v Murry (1998) 193 CLR 605 and confirmed that goodwill is a form of intangible personal property similar in character to intellectual property. Under the Personal Property Securities Act 2009 (Cth), goodwill is also classified as personal property. So while you cannot pick goodwill up or put it on a shelf, it is legally treated as a real asset that can be owned, sold and protected.
How is goodwill valued?
Because goodwill is intangible, it can only really be quantified when a business is actually sold. The standard accounting formula is straightforward:
Goodwill = Value of Business − Value of Net Tangible Assets (Net tangible assets is calculated by deducting
the total liabilities of the business from its gross tangible assets), intellectual property and identifiable
intangible assets
Net tangible assets means the gross tangible assets of the business (equipment, stock, fit out and so on) less its liabilities. Once those are deducted from the sale price, along with the value of any intellectual property and identifiable intangibles, what is left over is the premium being paid for goodwill.
In practice, the goodwill figure is often the residual after the parties have agreed on values for the tangible and identifiable assets. This is one reason why apportioning the purchase price across asset categories matters so much. It affects accounting treatment, tax position and, ultimately, what the buyer is actually paying for.
Local goodwill versus personal goodwill
Not all goodwill is created equal. There is an important distinction between local goodwill and personal goodwill, and the difference can have a major impact on what a buyer is actually getting.
Local goodwill is tied to the physical location of the business. Think of a café with strong foot traffic, a medical practice with an established clinic address, or a retail store in a high volume shopping centre. Even if the owner walks away, the business keeps drawing customers because of where it is.
Personal goodwill is tied to the proprietor. It depends on the owner’s skills, personality, reputation and personal relationships with customers. A specialist consultant, a sole practitioner accountant or a high end hairdresser may have substantial personal goodwill, but most of it walks out the door with them.
Buyers should be cautious where the goodwill is largely personal. Without proper handover arrangements, training, restraints and customer introductions, much of what is being paid for can disappear shortly after settlement.
Can goodwill be sold separately from the business?
Usually goodwill is sold together with the business it is connected to, and that is by far the most common arrangement. However, it is not legally impossible to sell goodwill (or a portion of it) separately from the business. This tends to be relevant where customer patronage is largely driven by trade marks, trade names, packaging or other distinctive features that can be carved off and transferred independently.
These transactions are unusual and they need careful structuring, but they do exist.
Why goodwill matters for buyers
For a buyer, goodwill is often the most expensive thing in the deal and also the easiest to lose. The general law gives buyers some baseline protection, but it is far less than most buyers assume.
Without specific contractual protections:
- The vendor is not stopped from setting up or running a similar business nearby, unless they have signed a restraint of trade covenant
- The vendor can advertise that they have set up a new business, although they cannot represent that they are continuing with or relocating the business that was sold
- The vendor cannot canvass the customers of the business that was sold, and a court can grant an injunction to stop them if they try
- The buyer is allowed to use the vendor’s name when running the business, but cannot hold the vendor out as still being involved or expose them to personal liability
Notice the gap. Without a contractual restraint, a vendor can legally open a competing business across the street the day after settlement. That is why the sale contract has to do the heavy lifting.
Locking goodwill into the sale
There are two complementary ways to ensure the goodwill the buyer is paying for actually transfers and stays transferred:
- Transfer all the assets and rights that make up the goodwill. This includes the business name, registered trade marks, domain names, social media handles, customer lists, supplier relationships and licences.
- Stop the vendor from interfering with or eroding those rights through restraint of trade clauses, non-solicitation clauses and confidentiality obligations applied to the vendor and to key personnel associated with the business.
A well drafted business sale contract should also deal with:
- The status of any patents, registered or unregistered trade marks, designs and distinctive logos, and how each will be transferred on completion
- Whether the business name itself is registered, and whether it can be transferred cleanly
- Transfer of the business name, any domain names, email addresses, key phone numbers and licences to the buyer
- An agreement that the vendor will not use the business name (or anything similar) for a specified period after sale
- Restraints of trade on the vendor and key personnel associated with the business
- Tuition of the buyer by the vendor before completion of the sale
- Introduction of the buyer to customers and handover of customer lists on completion
- Obligations on the vendor to maintain the goodwill between exchange and completion (for example, not slashing prices, not letting key staff go, not allowing the customer base to drift)
- Transfer of any contracts that allow continued use of the name, such as licences or franchise agreements
- Securing the employment of key employees after completion through fresh employment agreements
Each of these items is a leak point. If the contract does not cover them, the goodwill can quietly drain away after settlement, leaving the buyer with assets and a name but no real business.
A note for sellers
Goodwill matters from the seller’s side too. Sellers should be alert to:
- The scope of restraints they are being asked to sign, including geography, duration and the kinds of activities being prohibited. Overly broad restraints can sometimes be unenforceable, but pushing back is much easier before the contract is signed than after
- Apportionment of the price across goodwill, plant and equipment, and stock, because it affects tax outcomes
- Their conduct of the business between exchange and completion, where any drop in performance can give the buyer grounds to renegotiate or walk away
The bottom line
Goodwill is often the most valuable asset in a business sale and the one most exposed to risk. Buyers can lose it through weak contractual protections, narrow restraints or a botched handover. Sellers can give away more than they intended through over broad restraints or unfavourable apportionment. The right outcome on both sides comes down to getting the contract right.
If you are preparing to buy or sell a business, the contract is where goodwill is either properly secured or quietly given away. It is worth getting that right the first time.