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Memo Regarding Goodwill Cap
and Intangible Asset Valuation

NOTE: With the elevation of the goodwill cap to $500K via SOP 50-10(5)(B) and the ability of preferred lenders to process any size loan and goodwill amount (provided that the “equity” injection requirement of 25% is met) up to the traditional loan limits, the importance of understanding goodwill and its role in facilitating loan approval is greatly diminished. However, non-preferred lenders and even preferred lenders will still require SBA secondary approval in many cases, leaving the issue in play for the foreseeable future.


As of mid-May, 2009, the SBA is now into its third month of the “delay” in officially implementing the goodwill cap at $250K or 50% of the loan amount. As expected, the “delay” has not led to a rush on the part of lenders to obtain the “exceptions” granted by the SBA upon completion of their internal review for all change of ownership loans with goodwill in excess of $250K. The uncertainty associated with the introduction of the cap and the partial change via the acceptance and granting of “exceptions” has led to a continued contraction in the volume and value of 7(a) change of ownership loans.

In this appraiser’s opinion, the introduction of the cap and the six month “delay” period (via Information Notice 5000-1096) is being used as a means to gather detailed information involving the larger transactions which represent the greatest “risk” to the SBA in terms of potential defaults and charge-offs. It is likely that the cap will eventually be eliminated or elevated substantially at the end of the six month period ending August 31st, 2009. Alternatively, other changes will be forthcoming with the goal of reducing loan risk without penalizing those firms which happen to be comprised largely of intangible assets.

Ideally, the cap will be eliminated entirely after their six month review for a whole variety of reasons (see my write-up at the end of this memo titled “Did You Know…..? for a list of such reasons). Along these lines, it might be a powerful message if you and your counterparts at the ASA, NACVA, AICPA and ASA cooperated and crafted a common position paper which either supports elimination of the cap completely OR recommends the adoption of GAAP-like recognition of the various intangible assets which comprise the bulk of value in today’s companies in the U.S. If we do not collectively and firmly continue to address this issue, the consequences will be most negative for business owners and appraisers alike.

In the final analysis, it is my belief that the SBA and the final policy related to change of ownership loans will return to the former “status quo” whereby the lenders assess the credit risk of a given transaction and the amount of goodwill is no longer a primary or contentious issue. A solid credit analysis supported by a detailed and credible business appraisal will once again likely be the key to garnering approval (and sustaining guaranty rights) for change of ownership loans for PLP and standard lenders alike.

The good news is that the SBA has recognized that another option designed to minimize default and charge-off rates may be superior to the goodwill cap. This consistently underfunded government agency has been charged with ever more work while receiving ever less financial support from the Administration and the Congress. To their credit, they have already made a number of positive changes to the business valuation component of their SOP and plan on continuous improvements on a routine six month cycle (with the next cycle beginning on September 1st, 2009).

Goodwill Cap and Intangible Asset Valuation

As you may know, the SBA has partially “delayed” the implementation of the goodwill cap of $250K which was first mentioned in SOP50-10(5)(A) for six months – but they are requiring all such deals in the meanwhile to be reviewed separately by the SBA for case by case approvals.

They have provided some guidance in Information Notice 5000-1096 (which was presented earlier) as to what goodwill is and how it is calculated, etc., but they seem to shut the door on your idea regarding the appraisal of non-goodwill intangible assets. At a minimum, they don’t indicate or infer that such support would aid in obtaining loan approval.

Here is the pivotal commentary from the 5000-1096 notice:

“If the business being sold has intangibles such as licenses or patents on its balance sheet, the book value must be used for these assets. Intangibles that do not have an existing book value may not be subtracted from the selling price.”

The basic problem now is that the SBA will not allow use of any intangible asset which is not already on the balance sheet (tax return) and, if it is on the balance sheet, only its book value may be used. They do raise the hope of the lenders to a small degree with the following statement after a discussion of what goodwill is:

“Customer lists and non-compete agreements are documents that the seller may provide to support the goodwill the seller is requesting.”

To understand their logic, you must first recognize that they are thinking in terms of deal structure as much as they are thinking of deal value as they want to make sure that the seller does his or her part in helping the deal materialize. The prior SOP recommended that all goodwill be financed by the seller, but of course this was not possible and only rarely occurred. The newest version of the SOP, of course, introduced the goodwill cap at 50% of the total loan up to a maximum of $250K.

Hypothetically and ironically, the Information Notice comments infer that a business which just happens to have been acquired recently via an asset sale would or could have intangible assets on its balance sheet (from the historical “allocation of purchase price”) which theoretically could be used to help justify the given loan. Otherwise, most small businesses will not have any significant intangibles on their balance sheet (for book or tax purposes) - even though everyone knows that they exist and have value.

In response to these new rules and suggestions, it is conceivable that the target firm could file an amended return to "capitalize" certain intangibles, but this would be in accordance with IRS rules (as you well know), be time-consuming and costly to boot. It is questionable if internally-prepared or even compiled financial statements with comparable changes would do the job given the SBA focus on tax return data.

I have been communicating with one of the longtime SBA personnel who have been active in writing the SOP and helping with the hiring of new personnel to review the change of ownership deals with excessive goodwill and I hope to be able to get your question (and a few others) addressed directly some time this coming week. He has been extremely busy with the new rules and other changes (beyond the goodwill cap), so I am at his mercy with respect to gaining his attention. However, he has called me a couple of times and expressed a genuine interest in working with me to help clarify certain issues.

SBA Definition of Goodwill

Within the current SBA guidelines put forth in the Information Notice 5000-1096 on 2-27-09, goodwill value is to be considered equal to the:

SBA Definition of Goodwill

Asset Sale
“Selling price minus the sum of the book value of all assets being purchased.”

Stock Sale
“Selling price minus (the sum of the book value of all assets being purchased minus the sum of all liabilities that are being assumed).”

In effect, goodwill is equal to the value of all non-tangible assets or the excess of the purchase price beyond the book value (or fair market value if an appraisal is obtained for F,F&E or real estate) of listed tangible assets, i.e. if it is not a tangible or hard asset specifically identified by the SBA, then it will be considered “goodwill”.

There are several important deviations from this formulaic approach to calculating goodwill:

  1. If the acquired assets are appraised at a FMV greater than book value, the higher amount may be used to determine the amount of goodwill in the given deal.
  2. If the target firm’s balance sheet already includes listed intangible assets such as a patent or license, their respective book values must be used.
  3. Intangible assets which do not have an existing book value may not be subtracted from the selling price.
  4. If the pending deal is a “stock purchase”, the relevant assets include inventory, fixed assets and possibly real property as well as potentially accounts receivable/deposits/prepaid assets, etc. less the amount of accounts payable and long term debts assumed by the purchaser).

Rather than seeking to minimize the amount of goodwill in a given transaction (in order to meet the temporarily delayed “goodwill cap”) in order to maximize the potential SBA loan size, the new Information Notice appears to suggest that the lender should attempt to “justify” whatever amount of goodwill is included in the pending transaction (recognizing that goodwill as used by the SBA is a proxy for all intangible assets).

Accordingly, it states that:

“Customer lists and non-compete agreements are documents that the seller may provide to support the goodwill the seller is requesting.”

Whereas the SBA is effectively considering all intangible assets as goodwill (but encouraging the identification of non-goodwill components), the IRS or GAAP would differentiate between goodwill and other intangible assets such as patents or trademarks or even “customer lists” – while considering that these non-goodwill intangible assets may have value prior to a business sale or irrespective of whether or not the business is sold. A covenant not to compete, on the other hand, would have no value in any case except for as a direct result of the actual sale of the company.

As a policy consideration, it might be preferable for the SBA to rely on the IRS’ detailed development of asset categories associated with IRS Form 8594 and all business sales in the form of an “asset sale”. Both the buyer and seller MUST agree on this allocation or risk an unwanted IRS audit of this area (and potentially other areas). As shown later, the IRS allocation rightfully distinguishes between goodwill and other types of intangible assets. My contact at the SBA seemed to like this idea, but only time will tell.

Possible Interim Solutions (Prior to Adjustments in SOP 50-10(5)(B))

As the SBA performs its analysis of goodwill and related deal structures as they pertain to change of ownership financing over the next six months, there may be helpful steps which can be taken by the lender and/or the appraiser to help maximize the chances of receiving loan approval.

There are two immediate options which could be considered when seeking to justify a larger loan amount when the goodwill is determined to be “excessive”. First, the firm’s tangible assets such as inventory and equipment could be appraised in order to verify the common situation wherein the market value of such assets is greater than their book value. In addition, the value of equipment “in use” is often considerably higher than the original cost or its “value in exchange”, e.g. the inclusion of sales tax, freight charges, delivery and site preparation fees, employee training, the learning curve, etc., all are “normal and necessary” expenses related to the installation and optimal use of many different types of equipment.

The second option involves a careful review and assessment of the various intangible assets which are associated with the target operation. The ability to work around the new goodwill cap and related issues will depend almost entirely on what the SBA determines to be acceptable and helpful in terms of supporting the given loan request. For example, if the SBA eventually agrees to allow certain identifiable intangible assets to be separated from goodwill and recognized as having market value, this will open the door to a careful evaluation and valuation of those intangible assets (including intellectual property) which credibly or plausibly could be sold on the open market.

For clarity, it is helpful to keep in mind some of the basic concepts of identifiable intangible assets from a legal point of view:

  1. They must be separable from other assets.
  2. They must be subject to the rights of ownership with legal protections.
  3. They must be legally transferrable.
  4. They must convey a commercial benefit to owner.
  5. Their origin should be identifiable in time or resulting from an identifiable event.

In the current environment, it may be beneficial to review every deal with goodwill in excess of $250K with an eye towards identifying legally defensible rights such as:

  1. Contractors licenses, e.g. general contractor
  2. Professional licenses, e.g. medical or dental
  3. Special retail licenses, e.g. #12 Liquor
  4. Franchise licenses
  5. Protected territories
  6. Patents and copyrights
  7. Brand identity
  8. Others

If these assets exist but are not reflected on the firm’s balance sheet, it would be possible to make the appropriate adjustments to the internal financial statements (with or without an appraisal) or even amending federal income tax returns to “capture” the related value.

At the extreme, even certain internally generated (not purchased) intangible assets, e.g. workforce, customer lists, research and development, etc, could be identified and at least referenced in the lender’s or appraiser’s analysis. Although these intangibles are considerably more difficult to value and defend, there is little doubt that they do possess some degree of “value”. Furthermore, the unwillingness of the IRS to allow recognition of such assets for tax (amortization) purposes does not preclude its identification and presentation as a valuable asset for the SBA to consider.

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