N A I L B A M A G A Z I N E R E P R I N T

just work on policy maintenance - there is also

T here has been more than one occasion

that a business owner has asked me,
“What is the value of the goodwill of my
business?” Others will ask after we have deliv-
ered our opinion on the valuation of the busi-
ness whether we have included all of the
“goodwill” of the business in our conclusion.
Goodwill is a term that needs some definition
and context in order to be understood in an
insurance agency valuation.
There are related definitions of goodwill
that can be found on accounting industry Web
sites. Below is one definition of goodwill,
emphasizing its intangible aspect:
Goodwill is an intangible asset valued
according to the advantage or reputation a
business has acquired (over and above its
tangible assets)1
This second definition focuses on the fact
that goodwill is really a residual, not a value in
and of itself:
Goodwill is the amount that an enterprise
as a whole is worth in excess of the values
of its individual assets less individual
liabilities2
Which of these definitions is correct in the
context of an insurance agency valuation?
Before that question is answered, let’s focus on
the assets that create value in an insurance
agency.
Value Contributors
There are three major contributors to the
value of an agency. They are, in no particular
order of importance:
• Policies in force
• Assembled workforce
• Carrier relationships
The policies in force are valuable. A third
party could purchase the policies and hold
them, generating income in the form of com-
missions. The commission revenue stream is
saleable on its own as it represents a continu-
ing income stream. Different third party buy-
ers would almost certainly assign different val-
ues to the continuing commission revenues.
However, each would have a different take on
the long-term continuity of the revenue
stream.
The assembled workforce is valuable. The
workforce of agents and support staff repre-
sents the human capital that can be called
Goodwill
in Agency
Valuations
by James E. Ahern, President
Lakeshore Valuation Group, LLC
Sponsored by
American Brokerage Centers
SPEAKER PREVIEW
upon to shepherd renewals through the
process. This ensures that the revenue stream
of policies continues to produce for the com-
pany. And, the assembled workforce does not
a continuous business development effort.
This leads to new revenues, and growth in the
cash flow produced by the business.
Carrier relationships are the third leg of the
stool, so to speak. Without carriers paying
commissions for new or continuing business,
there would be no source of revenue for agen-
cies. Carriers must work hand-in-glove with
producers to maintain the policies, and under-
write future new business.
So, which of these value contributors is part
of the goodwill value? The answer is each con-
tributes, in separate but unique ways.
Determination of Goodwill Value
Before the value of goodwill can be deter-
mined, it is important to restate the definition
of value. The American Society of Appraiser’s
definition of fair market value (a value stan-
dard commonly used for tax and transactional
purposes) is:
Fair market value is the price, expressed in
terms of cash equivalents, at which proper-
ty would change hands between a hypo-
thetical willing and able buyer and a hypo-
thetical willing and able seller, acting at
arm’s length in an open and unrestricted
market, when neither is under any compul-
sion to buy or sell and when both have rea-
sonable knowledge of the relevant facts3
In other words, value is not determined just
through the eyes of a seller. It is determined in
the eyes of both buyer and seller. A negotiated
price between arm’s length parties with no
requirement to act is the ultimate definition of
value or fair market value.
So, how is value determined? It is based on
the revenue stream generated by the subject
company, the expense structure of the busi-
ness, and the residual profitability, all of which
impact the level of free cash flow available to
owners or investors. Put another way, an enter-
prise has no value if, over the long run, it is not
expected to generate free cash flow for its own-
ers or investors. Free cash flow must be avail-
able for shareholders in order for a business
enterprise to be saleable, and thus have value.
Naturally, the free cash flow will depend on the
three factors cited above.
Once the value of the free cash flow has
been calculated, the goodwill value can be

Fall 2003 NAILBA Magazine

 N A I L B A
determined. Using the subtraction definition
(goodwill is the amount that an enterprise as a
whole is worth in excess of the values of its
individual assets less individual liabilities); the
value of the goodwill can be calculated. Simply
restate all assets on the books of the business to
their market values, deduct the liabilities, sub-
tract the total from the free cash flow value,
and the residual is the value of goodwill.
When valuations are performed of a busi-
ness enterprise, they almost always incorporate
the goodwill value of a business. The only
instance when goodwill is not part of a value
determination is when specific instructions are
given for the appraiser to concentrate on spe-
cific assets, not the value of the overall busi-
ness. An example of this would be a value
based on the business’ assets, rather than its
cash flow.
Can a business have
negative goodwill?
Businesses can certainly have negative good-
will value. This is observed in asset-intensive
businesses where there is a high investment to
get into the industry, but there are poor returns
on investment. If a firm has $100 million in
equity investment, but generates only
$500,000 in profits each year, the return on
Fall 2003
M A G A Z I N E
equity is only 0.5 percent. Even in today’s low
interest rate environment, a return of 0.5 per-
cent is unattractive. So, the stock of this firm
would certainly sell for less than $100 million,
and negative goodwill would be the result.
Can goodwill be broken down into
individual producer values?
Arguably, a valuation exercise can be con-
ducted to determine the “goodwill” value of
each producer in your agency. But, this exer-
cise will be so dependent on assumptions that
I question whether the analysis will be at all
meaningful. As was stated previously, there are
three legs to the stool in the valuation of an
agency. To take one leg out, split it into parts
and state that the overall stool value can be dis-
James E. Ahern is principal and founder of
Lakeshore Valuation Group, LLC, a firm providing
financial advisory and business valuation services to
owners of privately-held companies.
He has valued equity interests in service businesses
such as insurance agencies, manufacturer rep agen-
cies, design firms, marketing and advertising agen-
cies, and other businesses. The assignments have
been performed for many purposes, including the
sale of stock to employees, management teams,
and third parties.
He has spoken on valuation subjects to audiences
as diverse as the Illinois CPA Society, the Employee
Stock Ownership Plan Association, and the National
Sporting Goods Association. He is an Accredited
Senior Appraiser of the American Society of
Appraisers, and is the Immediate Past President of
the Business Valuation Association of Chicago.
He obtained his bachelor’s degree in business
administration from the University of Illinois and
M.B.A. from the University of Chicago.
R E P R I N T
sected in this fashion seems inaccurate.
A producer does generate revenue for an
agency. It is not a simple straightforward calcu-
lation - many aspects of the agency interact to
produce the revenue for the agent and the
agency.
Conclusion
Firms that depend on human capital and
relationships to generate free cash flow are like-
ly to have goodwill value. But, goodwill is
often included in a valuation finding if the
finding is based on the free cash flow of the
overall enterprise. Goodwill is highest in the
firms that provide a return on equity in excess
of 20 percent annually. Firms who generate
poor returns on equity will be valued at a dis-
count to their equity base, in essence, assigning
them negative goodwill.
1 WordNet (r) 1.6, (c) 1997 Princeton University,
as taken from the dictionary.com Web site.
2 Executive Summary of the report of the
Association for Investment Management and
Research’s Financial Accounting Policy
Committee, 1992, p. 31.
3 International Glossary of Business Valuation
Terms, page 4, as published on the American
Society of Appraisers Web site
(www.appraisers.org).
NAILBA Magazine