Understanding Goodwill and When to Appraise the Loss Presented to the 1 st Joint Luncheon IRWA – Chapter 1 and The Los Angeles Chapter of the ASA by Dave Girbovan, ASA and Dave Girbovan, ASA and Vanita Spaulding, CFA, ASA

Today’s Discussion Intangible assets valued in Purchase Price Allocation Studies Intangible assets valued in Purchase Price Allocation Studies The Micro and Macro Approach The Micro and Macro Approach Goodwill can be narrowly or broadly defined Goodwill can be narrowly or broadly defined The basics of the Aklilu case The basics of the Aklilu case When lost goodwill is appraised. When lost goodwill is appraised. The effects of relocation on specific intangible assets. The effects of relocation on specific intangible assets.

Purchase Price Allocation Studies Purpose – To allocate the premium paid for a company in excess of the tangible assets to specific categories of intangible assets. Purpose – To allocate the premium paid for a company in excess of the tangible assets to specific categories of intangible assets. Provides additional amortization resulting in tax savings. Provides additional amortization resulting in tax savings.

Historical Example MegaHuge Conglomerate acquires the assets of PalTron for $100 million. MegaHuge Conglomerate acquires the assets of PalTron for $100 million. The current assets and fixed assets have a value of $60 million. The current assets and fixed assets have a value of $60 million. The company was not allowed to amortize the residual of $40 million if booked as goodwill. The company was not allowed to amortize the residual of $40 million if booked as goodwill. Significant tax savings result when a portion of the premium is allocated to identified, amortizable, intangible assets. Significant tax savings result when a portion of the premium is allocated to identified, amortizable, intangible assets.

Two Phases of the Study Macro Approach – An income approach resulting in the acquisition price. Macro Approach – An income approach resulting in the acquisition price. Micro Approach – All intangible assets are value and assigned a useful remaining life. Micro Approach – All intangible assets are value and assigned a useful remaining life.

Categories of Intangible Assets Trademarks Trademarks Trade Names Trade Names Proprietary Technology Proprietary Technology Internally Created Software Internally Created Software Assembled Work Force Assembled Work Force Favorable Contracts Favorable Contracts Advertising Programs Advertising Programs Distribution Networks Distribution Networks Training Materials Training Materials Customer Lists Customer Lists Going Concern Value Going Concern Value Licenses and Certifications Licenses and Certifications Favorable Leases Favorable Leases Goodwill Goodwill

Broad and Narrow Definitions of Goodwill Goodwill narrowly defined in purchase price allocation studies. Goodwill narrowly defined in purchase price allocation studies. Goodwill in eminent domain is broadly defined. Goodwill in eminent domain is broadly defined. Marketable licenses (Liquor) are separated. Marketable licenses (Liquor) are separated. Favorable leases are separated. Favorable leases are separated. Everything else is included in goodwill. Everything else is included in goodwill.

Broad Definition of Goodwill Although goodwill is broadly defined in eminent domain, considering the components is useful to: Although goodwill is broadly defined in eminent domain, considering the components is useful to: Determine if and why a business may have goodwill, Determine if and why a business may have goodwill, Where a business may need to relocate so that goodwill can be preserved, and Where a business may need to relocate so that goodwill can be preserved, and Analyze how a relocation may affect goodwill Analyze how a relocation may affect goodwill

Methods to Value Intangibles Income Approach Income Approach Preferable Preferable Value based on income potential Value based on income potential Market Approach Market Approach Rarely used Rarely used Cost Approach – Cost to Create Cost Approach – Cost to Create Represents a sunk cost Represents a sunk cost

Cost to Create Method By acquiring an operating company one can avoid the costs to create those assets and the costs represent their value. By acquiring an operating company one can avoid the costs to create those assets and the costs represent their value. An investor would pay no more for an asset than the cost to create the asset. An investor would pay no more for an asset than the cost to create the asset.

Cost to Create Method Examples Examples Assembled work force Assembled work force Cost to hire, train and orient employees Cost to hire, train and orient employees Going concern value Going concern value Can avoid start up losses Can avoid start up losses Key Point Key Point The actual sale of the company established that intangible asset exists The actual sale of the company established that intangible asset exists As confirmed by the macro approach, the business is expected to be profitable. As confirmed by the macro approach, the business is expected to be profitable.

Cost to Create Method Drawbacks Drawbacks Method does not incorporate economic benefits of the intangibles. Method does not incorporate economic benefits of the intangibles. Information regarding the trend of the economic benefits is lacking. Information regarding the trend of the economic benefits is lacking. Duration of the benefits not considered. Duration of the benefits not considered. Sunk costs. Sunk costs.

Inglewood Redevelopment Agency v. Aklilu, Cal.App 2 Dist., 2007 Facts Facts Auto Inn Lube and Oil was started in 1997 by Elias Aklilu Auto Inn Lube and Oil was started in 1997 by Elias Aklilu Believed it would take 3 to 5 years to be successful. Believed it would take 3 to 5 years to be successful. Construction of the Marketplace at Hollywood Park disrupted the business from 1999 to Construction of the Marketplace at Hollywood Park disrupted the business from 1999 to In 2003 the Marketplace was largely completed, traffic returned to normal, and the business became profitable. In 2003 the Marketplace was largely completed, traffic returned to normal, and the business became profitable. Complaint filed in October Complaint filed in October 2004.

The Aklilu Case Valuation Approaches Valuation Approaches Both appraisers agreed no goodwill using historic statements and traditional approaches. Both appraisers agreed no goodwill using historic statements and traditional approaches. Chris Pedersen for the business owner used a cost to create method. The adjusted historic losses were added to arrive at goodwill of $238,761. Chris Pedersen for the business owner used a cost to create method. The adjusted historic losses were added to arrive at goodwill of $238,761. Chris Pedersen qualitatively established goodwill, citing a fine location, outstanding exposure, excellent parking and access, and no competition. The business had a “very promising future”. Chris Pedersen qualitatively established goodwill, citing a fine location, outstanding exposure, excellent parking and access, and no competition. The business had a “very promising future”.

The Aklilu Case Issue on Appeal – Is the cost to create method valid to appraise lost business goodwill? Issue on Appeal – Is the cost to create method valid to appraise lost business goodwill? The Appellate Court said yes. The Appellate Court said yes. Adopted a point of view from Muller case that Code Section should be liberally construed. Adopted a point of view from Muller case that Code Section should be liberally construed.

The Aklilu Case Discussion Points Discussion Points The business’s past was not indicative of its future The business’s past was not indicative of its future Historic losses are sunk costs Historic losses are sunk costs Goodwill was qualitatively established Goodwill was qualitatively established A dangerous precedent A dangerous precedent What method has more typically been used to appraise goodwill under these circumstances? What method has more typically been used to appraise goodwill under these circumstances? Distinction from Redevelopment Agency of the city of San Diego v. Ahmad Mesdaq. Distinction from Redevelopment Agency of the city of San Diego v. Ahmad Mesdaq.

The Effects of Relocation on Goodwill Can examine each category of intangible assets to determine how goodwill may be affected. Can examine each category of intangible assets to determine how goodwill may be affected. Also helps to establish primary and secondary relocation areas Also helps to establish primary and secondary relocation areas Primary relocation area is where the most goodwill may be preserved Primary relocation area is where the most goodwill may be preserved Secondary relocation area may preserve some goodwill. Secondary relocation area may preserve some goodwill.

When to Appraise the Loss Possibilities Possibilities Before relocation Before relocation After relocation After relocation Often do not have a choice Often do not have a choice Not always better off waiting Not always better off waiting Must recognize appraising lost business goodwill is somewhat subjective. Must recognize appraising lost business goodwill is somewhat subjective.

Examining Goodwill Before and After Relocation If appraising goodwill in the after condition prior to an actual relocation, the before condition model is alter to reflect the anticipated effects of relocation on the business. If appraising goodwill in the after condition prior to an actual relocation, the before condition model is alter to reflect the anticipated effects of relocation on the business. If appraising goodwill in the after condition after the actual relocation, the appraiser must be careful to consider changes not attributable to relocation. If appraising goodwill in the after condition after the actual relocation, the appraiser must be careful to consider changes not attributable to relocation.

Examples of When to Appraise the Loss Some agencies have given the business owner the choice on when lost business goodwill is appraised. Some agencies have given the business owner the choice on when lost business goodwill is appraised. Value loss before example. Value loss before example. Value loss after example. Value loss after example.