How lenders treat goodwill when you buy a business

A business sale price has three parts: plant and equipment, stock at valuation, and goodwill. Goodwill is whatever is left after the tangible assets are counted. It covers the customer base, the location, the brand, the systems, the staff and the expectation that profit will continue under a new owner. A cafe selling for $400,000 with $90,000 of equipment and $10,000 of stock has $300,000 of goodwill. In service businesses, professional practices and most retail, goodwill is commonly well over half the price. Asset heavy businesses such as transport, manufacturing and earthmoving sit at the other end, with most of the price in plant.

The split matters because each part is funded differently. Equipment can be funded with asset finance secured against the equipment itself. Stock can sometimes be supported by a working capital or trade facility. Goodwill has no title, no serial number and no resale market separate from the business. Read the apportionment in the contract of sale closely before you apply, because the lender will. A sound business acquisition loan structure starts with knowing how many dollars of the price are goodwill and how those dollars will be secured.

A lender's security is only worth what it can be sold for after a default. If a business fails, the goodwill has usually failed with it. Customers have left, the lease may be in arrears and the name is damaged. A receiver can auction the coffee machine and the delivery van, but there is rarely a buyer for the goodwill of a closed business. For that reason most major banks give goodwill little or no security value in general industries, even though they will take a general security agreement over the whole business as supporting security.

Goodwill also depends on the owner. If sales rely on the vendor's personal relationships, skills or licence, the income may not transfer to the buyer. Lenders look for signs that it will: written contracts, repeat customers, a spread of clients with no single one dominating revenue, a trained team that is staying, a secure lease and a vendor handover period with a restraint of trade clause. The more of these that are present, the more comfortable a credit assessor is that the earnings being paid for will still exist twelve months after settlement.

Some industries have income that is predictable, regulated or contracted, and lenders have long default histories for them. Healthcare is the strongest. Specialist health lenders will consider up to 100% of the purchase price of an established medical, dental or veterinary practice for a qualified practitioner, secured against the practice itself. Pharmacies are commonly funded to around 60% to 80% of an independent valuation, helped by the restrictions on who can own a pharmacy and where a new one can open. Childcare businesses with solid occupancy are commonly funded to around 50% of the leasehold business value without property.

Recurring fee businesses are the other group. Accounting practices and financial planning books are assessed on recurring fees, client retention and client concentration. Rent rolls are valued as a multiple of annual management income, and lenders commonly advance up to about 60% of the lower of price and valuation, usually to an experienced, licensed agent. Franchise systems that a lender has accredited can attract lending of around 50% to 70% of the cost without property security. In every case the policy belongs to a specialist team inside the lender. A general business banker at the same institution may quote something far more conservative.

Goodwill is only worth a multiple of the profit that a new owner can keep earning. The assessor starts with two to three years of vendor financials and works out maintainable earnings, usually EBITDA after adjustments. Add-backs are one-off or private costs the vendor ran through the business: a personal vehicle, a family member on the payroll who does not work there, a one-off legal bill. Deductions go the other way. If the vendor works 60 hours a week and pays themselves nothing, a market wage for a manager comes off. The logic is the same one used when lenders treat add-backs for self-employed income.

Small owner-operated businesses commonly sell for somewhere between 1.5 and 4 times adjusted earnings, depending on industry, size and how much the business relies on its owner. A lender may accept a lower multiple than the one the vendor has priced in. If the contract is struck at 4.5 times earnings and the lender or its valuer supports 3.5 times, the difference is the buyer's to fund. The lender then tests whether maintainable earnings cover the proposed repayments, commonly looking for cover of around 1.25 to 1.5 times after a market wage for the owner.

For most buyers the goodwill is funded against property. Equity in a home or investment property is the most common source, either by increasing the existing home loan or by taking a separate business loan secured by a mortgage over the property. Residential security commonly supports lending up to 80% of the property's value, and the loan term can be far longer than an unsecured business loan, which helps the business service the debt. The page on using home equity to buy a business covers how that is structured and what it puts at risk.

Where property does not cover the whole gap, the rest is usually made up from a mix of sources. Buyer cash is the first. Vendor finance is the second, with the vendor leaving part of the price in the deal for one to three years, ranking behind the senior lender. Equipment finance can carry the plant so that the property backed loan only has to cover goodwill and stock. Unsecured business loans exist but are smaller, shorter and more expensive. Director guarantees and a general security agreement over the business are standard with almost every structure.