Chapter 10 Valuation of Debtor Company Goodwill

• Jurisdiction: United States

Chapter 10: Valuation of Debtor Company Goodwill

A. Goodwill Valuation

The value of a debtor company's intangible value in the nature of goodwill is often an issue in business bankruptcy proceedings. Such valuations may affect the debtor company's solvency or insolvency at various points in time, the creditor protection regarding certain debtor-in possession (DIP) transactions, the pricing of a § 363 sale of a debtor division or line of business, the assessment of reasonably equivalent value for various transactions, the reasonableness of a proposed plan of reorganization, and so on.

This section describes the factors that create debtor company enterprise or entity goodwill, and summarizes the generally accepted valuation approaches and methods that analysts use to measure the value of debtor company goodwill. There are three general components of debtor company-owned entity or enterprise goodwill.

The first component of goodwill is the existence of the debtor company's operating business assets that are in place and ready to use. This component is sometimes referred to as the going-concern element of goodwill. The fact that all of the debtor's business elements are physically and functionally assembled creates intangible value. These elements include capital (e.g., equipment), labor (e.g., employees) and coordination (e.g., management). Some analysts measure this going-concern value as a separate intangible asset of the debtor company. Other analysts measure going-concern value as one component of the debtor company's entity goodwill.

Going-concern value may enhance the value of the debtor company's operating assets. For example, a debtor company's equipment value is typically greater when that equipment is appraised on a value in continued use (or going concern) premise of value, rather than on a value-in-exchange (or piecemeal disposition) premise of value. Going-concern value may attach to the debtor company's intangible assets. For example, a company's patent, copyright or trademark value is typically greater when that intellectual property is appraised on a value-in-continued-use (or going-concern) premise of value rather than on a value in exchange (or piecemeal disposition) premise of value.

The second goodwill component is the existence of excess income (however that may be measured). Excess income is any income greater than the amount needed to provide a fair rate of return on the debtor company's tangible assets and identifiable intangible assets. This excess income relates to goodwill as the business value that cannot be specifically assigned to the debtor company's tangible assets or identifiable intangible assets.

The third goodwill component is the expectation of future events that are not directly related to the debtor's operations. Goodwill may be created by the expectations of future capital expenditures, future mergers and acquisitions, future to-be-developed projects or services, and future customers or clients. This future expectations component relates to the debtor company's goodwill as the current value of future assets (both tangible and intangible) that do not yet exist on the analysis date.

Residual Analyses

The goodwill that develops in the normal course of business is rarely recorded on the debtor company's financial statements. Furthermore, accounting recognition for internally created goodwill is different than the accounting recognition for purchased goodwill. Internally created goodwill is rarely recorded on the debtor company's balance sheet. In contrast, purchased goodwill is recorded on the acquirer's balance sheet as soon as the purchase transaction is completed.

Under the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) topic 805, acquisition accounting requirements,⁹⁷ the fair value (calculated as a residual from total purchase consideration) of purchased goodwill is recorded as an intangible asset on the acquirer's balance sheet. Accountants sometimes value goodwill as the residual value that is calculated by subtracting the fair value of all the acquired tangible assets and identifiable intangible assets from the acquired company's total purchase price.

Income Analyses

Income analyses may be more useful in the valuation of a debtor company's discrete goodwill, as opposed to the valuation of the debtor company's total intangible value.

First, the analyst typically quantifies all of the debtor company's income, which can be measured many different ways. The income measure should be consistent with the measure of the fair rate of return on the debtor company's operating assets.

Second, the analyst typically allocates some portion of this total income to each tangible asset category and intangible asset category. These contributory assets include the debtor company's working capital, tangible personal property, real estate and identifiable intangible assets. This income allocation procedure is typically based on a fair rate of return multiplied by the value of each contributory asset category.

Third, the analyst typically quantifies the debtor company's income that cannot be associated with any other tangible asset or intangible asset. That residual income is often called excess income (or excess earnings). This excess income is assigned to goodwill.

Fourth, goodwill value is typically calculated as excess income capitalized as an annuity in perpetuity. The excess income is capitalized by a risk-adjusted and growth-adjusted direct-capitalization rate. The result of this direct-capitalization procedure is an indication of the debtor company's goodwill value.

Valuation Approaches and Methods

There are several generally accepted methods to value debtor company goodwill. Each of these valuation methods may be categorized into one of the following three generally accepted intangible asset valuation approaches.

Cost Approach

Using the cost approach, the analyst estimates the amount of current cost required to recreate the debtor company goodwill elements. The cost approach typically involves a component restoration method.

The first procedure in this method is to list all of the individual components of the debtor company's goodwill. The second procedure is to estimate the amount of the current cost required to replace each goodwill component (i.e., the "restoration"). This restoration method procedure is based on the concept of goodwill as the value of all assets in place and ready to use.

There is an opportunity cost component to the restoration method. This method assumes that the debtor company has to replace de novo all of its tangible assets and intangible assets. The opportunity cost is the lost income that the debtor company is not earning during this restoration period — while it is replacing all of its assets.

For example, let's assume it would take two years for a debtor company to assemble all of its tangible assets and identifiable intangible assets. This time period represents the total elapsed time required for the assembled assets to reach the same levels of utility, functionality, capacity and income-generation as they currently exist in the actual debtor company. This restoration process includes the following procedures:

1. the purchase and installation of all equipment;
2. the construction or purchase of all real estate;
3. the selection of suppliers;
4. the creation of a distribution system;
5. the hiring and training of employees;
6. the building of a level of consumer recognition and confidence; and
7. the recreation of the current level of customer relationships.

Let's assume that the debtor company earns $10 million annually in income (however that income metric is defined) during an expected two-year asset-restoration period. The present value of the $20 million forgone income during an asset-restoration period is the opportunity cost component in the goodwill value restoration method.

Market Approach

There are two common market-approach goodwill valuation methods. The residual from purchase price method values goodwill as the residual from a business acquisition price. The sales comparison method estimates goodwill value based on an analysis of guideline sale transactions.

Goodwill is rarely sold separately from any other assets of a going-concern business. Therefore, the selected guideline sale transactions usually involve the sale of a going-concern business. The analyst selects publicly reported transactions that report the allocation of the sale price between the purchased goodwill and all of the other acquired assets...