Tag: Valuation

  • 409A Valuation for Startup: Everything You Need to Know

    409A Valuation for Startup: Everything You Need to Know

    Gain insights into 409A valuation for startup. Learn how this independent appraisal helps determine fair market value for stock options and ensures IRS compliance.

    What is a 409A Valuation?

    A 409A valuation is an independent appraisal used to determine the fair market value (FMV) of a company’s common stock. This valuation is essential for private companies, particularly startups, to ensure compliance with Section 409A of the Internal Revenue Code. The primary purpose of a 409A valuation is to set a fair value for issuing stock options to employees, which helps avoid potential tax liabilities and penalties.

    Key Features of a 409A Valuation

    1. IRS Compliance: Ensures that stock options are granted at fair market value to meet Internal Revenue Service (IRS) requirements. This prevents the IRS from deeming the options as underpriced, which could lead to heavy tax penalties.
    2. Independent Appraisal: Conducted by an independent third party, typically a qualified valuation firm, which evaluates the company’s financial health, market conditions, and comparable company data.
    3. Comprehensive Analysis:
      • Financial Performance: Examines historical and projected revenues, profits, and expenses.
      • Market Conditions: Considers industry trends, economic outlooks, and investor sentiment.
      • Comparable Company Analysis: Utilizes valuations of similar companies within the same industry to gauge the market value.
    4. Valuation Methodologies:
      • Market Approach: Based on recent transactions involving comparable companies or equity interests.
      • Income Approach: Focuses on the present value of expected future cash flows, often using discounted cash flow (DCF) models.
      • Asset-Based Approach: Considers the company’s net asset value, including both tangible and intangible assets.

    Importance of a 409A Valuation

    • Tax Compliance: Helps avoid severe IRS penalties by ensuring stock options are issued at fair market value.
    • Employee Retention: Assures employees that their stock options are valued appropriately, fostering trust and motivation.
    • Investor Confidence: Provides a clear financial valuation that can attract investors and facilitate funding rounds or acquisitions.
    • Strategic Planning: Aids in overall financial planning and management by providing a clear and defensible valuation.

    When and Why Do Startups Need a 409A Valuation?

    Startups encounter several pivotal events that necessitate obtaining a 409A valuation. One of the primary scenarios is the issuance of stock options. When a startup decides to grant stock options to its employees, a 409A valuation ensures that these options are priced at fair market value. This valuation not only complies with IRS regulations but also protects both the company and its employees from potential tax penalties.

    Another significant event prompting the need for a 409A valuation is preparing for an acquisition or merger. During these transitions, a current and accurate 409A valuation is crucial to provide a defensible basis for the company’s equity value. This helps in negotiations and ensures that all stakeholders have a clear understanding of the company’s worth, thereby facilitating smoother transactions.

    Additionally, substantial funding rounds are critical junctures requiring a 409A valuation. When a startup secures significant investment, the valuation of its common stock must be updated to reflect the new funding status. This reassessment ensures that stock options granted to employees are still priced accurately, maintaining compliance with IRS guidelines and safeguarding the company’s financial integrity.

    Beyond compliance, obtaining a 409A valuation offers numerous benefits. It establishes a defensible basis for stock option pricing, which is fundamental for attracting and retaining top talent. Employees can be assured that their stock options are valued correctly, fostering trust and motivation within the workforce. Furthermore, a well-documented 409A valuation can serve as a robust defense in the event of an IRS audit, providing the company with an added layer of security.

    Key events

    Startups typically require a 409A valuation during key events such as:

    1. Issuing Stock Options: To determine the fair market value of the stock options granted to employees.
    2. Funding Rounds: Updating the valuation to reflect the company’s new financial status post-investment.
    3. Mergers and Acquisitions: Providing a defensible basis for the company’s equity value during these transactions.
    4. Annual Updates: At least once per year or whenever a significant financial event occurs that could impact the company’s valuation.

    In summary, a 409A valuation is a critical tool for maintaining regulatory compliance and supporting the financial integrity and transparency of a startup. By ensuring that stock options are fairly valued, companies can attract and retain top talent, secure investor trust, and strategically manage their financial growth and stability.

    Obtaining a 409A valuation is a strategic move for startups during key events such as issuing stock options, mergers, and funding rounds. It not only ensures regulatory compliance but also fortifies the company’s credibility and financial stability.

    The 409A Valuation Process

    Obtaining a 409A valuation is a critical step for startups to ensure compliance with IRS regulations and to establish a fair market value for their common stock. The process typically begins with the selection of a reputable valuation firm that possesses expertise in 409A valuations. These firms consider several key factors to determine the value of a company’s stock, including financial performance, market conditions, and comparable company analysis.

    Financial performance is a primary consideration, where firms analyze the company’s historical and projected revenues, profits, and expenses. Market conditions play a significant role as well, encompassing industry trends, economic outlook, and investor sentiment. Comparable company analysis involves examining similar companies in the same industry to gauge how they are valued in the market. This triangulation helps ensure that the valuation is both accurate and defensible.

    Valuation firms employ various methodologies to arrive at a 409A valuation. The market approach, for instance, looks at recent transactions involving comparable companies or equity interests. The income approach focuses on the present value of expected future cash flows, often using discounted cash flow (DCF) models. The asset-based approach, on the other hand, considers the company’s net asset value, taking into account both tangible and intangible assets.

    Preparation for a 409A valuation involves gathering extensive documentation, such as financial statements, business plans, and details of recent funding rounds. Companies should also be ready to provide information on their competitive landscape and any significant developments that may impact their valuation.

    The timeline for completing a 409A valuation can vary, but it generally takes between four to six weeks from the initial engagement to the delivery of the final report. This includes time for data collection, analysis, and review. By understanding the 409A valuation process and preparing adequately, startups can ensure a smooth and efficient valuation experience.

    Choosing the Right Valuation Firm

    Selecting the appropriate valuation firm for your 409A valuation is essential to ensure accuracy, compliance, and credibility. Here’s a guide to help you make an informed decision:

    Considerations When Choosing a Valuation Firm

    1. Expertise and Experience: Look for firms with a proven track record in performing 409A valuations. Experience in your specific industry can be a significant advantage, as these firms are more likely to understand the nuances and complexities of your market.
    2. Reputation: Consider firms with strong reputations and positive testimonials from previous clients. A reputable firm is more likely to deliver high-quality and reliable valuation services.
    3. Methodology: Ensure the valuation firm employs rigorous and standardized methodologies. They should be knowledgeable in various valuation approaches such as market, income, and asset-based methods.
    4. Compliance: The firm should have a deep understanding of IRS regulations and ensure that their valuations are compliant with Section 409A. Firms that routinely handle IRS audits of their valuations can provide an added layer of security.
    5. Customization: Your selected firm should be able to tailor their services to your specific needs. Cookie-cutter approaches may not adequately address the unique aspects of your startup.
    6. Transparency: The firm should be clear about its processes, timelines, and fees. Transparent communication helps build trust and ensures there are no hidden surprises.
    7. Support and Guidance: Choose a firm that offers ongoing support and guidance. They should be available to answer questions, assist with documentation, and provide insights throughout the valuation process.
    8. Technology and Tools: Firms that utilize advanced technology and data analytics may provide more accurate and timely valuations. Modern tools can streamline communication and data management.

    Top Questions to Ask Potential Valuation Firms

    1. What is your experience with 409A valuations, specifically within my industry?
    2. Can you provide references or case studies from past clients?
    3. What methodologies do you use, and why do you prefer them?
    4. How do you ensure compliance with IRS Section 409A?
    5. Can you describe your process and timeline for completing a 409A valuation?
    6. What type of documentation and information will you need from my company?
    7. How do you handle updates to the valuation if significant events occur?
    8. What are your fees, and what exactly do they cover?
    9. Do you provide any additional support or resources after the valuation is complete?
    10. How do you ensure the confidentiality and security of my company’s information?

    Recommended Actions

    1. Conduct Thorough Research: Before reaching out to potential firms, conduct detailed research to identify firms with strong industry relevance and positive client feedback.
    2. Request Proposals: Contact multiple firms and request detailed proposals. Compare their offerings, methodologies, timelines, and costs.
    3. Evaluate Firm Credentials: Verify the credentials and qualifications of the firm’s valuation experts. Look for certifications such as Accredited Senior Appraiser (ASA) or Chartered Financial Analyst (CFA).
    4. Arrange Consultations: Schedule initial consultations to discuss your specific needs, ask pertinent questions, and gauge the firm’s responsiveness and expertise.
    5. Review Sample Reports: Request sample valuation reports to assess the firm’s thoroughness and the clarity of its documentation.

    By carefully evaluating potential valuation firms based on these criteria, startups can select a partner that not only delivers accurate and compliant valuations but also adds strategic value to their financial planning and operations.

    Pros and Cons of 409A Valuations for Startup

    Pros

    1. Regulatory Compliance: Ensures adherence to IRS Section 409A regulations, avoiding hefty fines and penalties. This compliance is crucial for maintaining the legal and financial integrity of the startup.
    2. Fair Market Value (FMV): Establishes a credible and defensible FMV for common stock, essential for issuing stock options. This valuation aligns the interests of the company, employees, and investors by providing a transparent and fair pricing mechanism.
    3. Investor Confidence: Provides a clear financial snapshot that can attract investors and facilitate funding rounds or acquisitions. A proper valuation indicates a well-managed startup with reliable financial practices, making it more appealing to potential investors.
    4. Talent Acquisition and Retention: Offers employees accurately priced stock options, fostering trust and motivation. Stock options are a powerful tool in recruiting top talent and retaining them by making them stakeholders in the company’s success.
    5. IRS Audit Defense: A well-documented 409A valuation acts as a robust defense in the event of an IRS audit. This documentation helps prove that the company has taken the necessary steps to comply with tax laws, thereby mitigating risks associated with non-compliance.
    6. Strategic Planning: Helps in overall financial planning and management by providing a clear valuation. This assists the startup in making informed strategic decisions regarding growth, expansion, and financial allocations.
    7. Consistency and Transparency: Brings standardized processes to stock option pricing, reducing inconsistencies and potential abuses. This reduces the risk of conflicts and misunderstandings related to stock option grants, fostering a healthier corporate culture.

    Additional Pros

    1. Benchmark for Valuation: Provides a benchmark for subsequent valuations, making future financial analyses smoother and more consistent. This historical data can be invaluable in tracking the company’s growth trajectory and making predictive financial models.
    2. Enhanced Credibility: Enhances the credibility of financial statements which can be useful in negotiations with partners, customers, and suppliers. Trustworthy financial data builds credibility and can lead to more favorable terms in business dealings.
    3. Facilitates Mergers and Acquisitions (M&A): An accurate 409A valuation can streamline M&A processes by providing third parties with reliable financial information. This benefits negotiation and due diligence phases, making acquisitions and mergers less cumbersome.

    Cons

    1. Cost: This can be expensive, especially for early-stage startups with limited financial resources. The costs can include fees for hiring valuation firms and the potential need for repeated evaluations.
    2. Time-Consuming: The process can take several weeks, which may be challenging for startups that need rapid decisions. The valuation process requires gathering extensive financial data and performing detailed analyses.
    3. Complexity: Requires extensive documentation and a comprehensive understanding of one’s financials and market conditions. This complexity can be daunting for startups without a dedicated finance team or with limited financial knowledge.
    4. Frequent Updates Needed: Startups need to update their 409A valuation at least annually or whenever a significant event occurs, adding ongoing administrative overhead. Consistent updates ensure that stock options are based on current valuations, but they also mean continuous monitoring and evaluation.
    5. Potential Low Valuation: This might result in a lower-than-expected valuation which can affect employee morale or perceived market value. This may discourage employees or create a negative perception among potential investors and stakeholders.
    6. Dependency on External Firms: Relies on the expertise and credibility of external valuation firms, which can vary. Trusting external firms necessitates due diligence to select reliable partners, adding another layer of complexity to the process.
    7. Administrative Burden: Adds another layer of complexity to the financial administration of a startup. The ongoing need for maintaining up-to-date financial documentation, liaising with valuation firms, and ensuring compliance requires significant administrative effort.

    Additional Cons

    1. Strict Compliance Requirements: Adhering to rigid regulations can stifle flexibility in financial planning and structuring. This stringent compliance environment can feel limiting for startups that thrive on flexibility and innovation.
    2. Market Fluctuations: Unpredictable market conditions can impact the valuation results, potentially leading to discrepancies. Market volatility can create challenges in maintaining accurate and reflective valuations.
    3. Internal Resource Allocation: Diverts critical internal resources to focus on compliance activities rather than core business operations. Time and effort spent on managing the 409A process could be utilized in product development and strategic growth initiatives.

    In conclusion, while 409A valuations provide crucial regulatory compliance, transparency, and financial benefits, they also bring costs, complexities, and administrative burdens that startups must carefully consider. Balancing these pros and cons is essential for determining the appropriate timing and approach for obtaining a 409A valuation, ensuring that it aligns effectively with the startup’s growth strategy and resource capacity.

  • Difference between Average and Super profit

    Difference between Average and Super profit

    Average and Super Profits; The valuation of goodwill depends upon assumptions made by the valuer. Meaning; The average profit is the average of the profits in the past few years; Or, super profit is an excess of average profit over normal profit. This article explains the difference between Average and Super profit; Methods to adopt in the valuation of goodwill would depend on the circumstances of each case and are often based on the customs of the trade.

    The distinction/difference between Average profit and Super profit.

    Methods of Goodwill Valuation; Goodwill is the value of the reputation of a firm built over time concerning the expected future profits over and above the normal profits. Also, Goodwill is an intangible real asset which cannot see or felt but exists in reality and can buy and sell. In partnership, goodwill valuation is very important. Thus, we will here discuss the various methods of Goodwill Valuation.

    The various methods that can adapt to the valuation of goodwill are the following:

    • Average Profit Method.
    • Super Profit Method.

    Now, explain each one;

    Average Profit:

    Average profit is the average of all the agreed profits of past years. It calculates by dividing the total profits by the number of years. This is the most common method of calculating goodwill.

    Average Profits = Total Profits/Number of years

    A buyer always wants to estimate the future profits of the business. Also, Future profits always depend upon the performance of the business in the past. Past profits indicate what profits are likely to accrue in the future. Therefore, past profits are averaged.

    The first step under this method is the calculation of average profit based on the past few years’ profits. As well as, Past profit adjust in respect of any abnormal items of profit or loss which may affect future profit. Also, Average profit may be based on a simple average or weighted average.

    If profits are constant, equal weight-age may give in calculating the average profits i.e., the simple average may calculate. However, if the trend shows increasing or decreasing profit, it is necessary to give more weight-age to the profits of recent years.

    Types of Average Profits Method:
    1. Simple Average: Under this method, the goodwill values at the agreed number of years of the purchase of the average profits of the past years.
    2. Simple Average: Under this method, the goodwill values at the agreed number of years of the purchase of the average profits of the past years.

    Super Profit:

    This Profit is the excess of average profit over the normal profit. It shows the exceptional ability of the firm to earn more profits in comparison to other firms in the industry.

    Super Profits = Actual Profits – Normal Profits

    It calculates by deducting the normal profits from average profits. Super profit is the excess of estimated future maintainable profits over normal profits. Super profit represents the difference between the average profit earned by the business and the normal profit i.e., the firm’s anticipated excess earnings. As such, if there is no anticipated excess earning over normal earnings, there will be no goodwill.

    An enterprise may possess some advantages which enable it to earn extra profits over and above the normal profit that would earn if the capital of the business was invested in some other business with similar risks. Also, the goodwill under this method ascertains by multiplying the super-profits by a certain number of year’s purchases.

    Types of Super Profits Method:
    • The Number of Years Purchase Method: Under this method, the goodwill values at the agreed number of years’ purchase of the super-profits of the firm.
    • Annuity Method: This method considers the time value of money. Here, we consider the discounted value of the super profit.

    Difference between Average and Super profit table
    Difference between Average and Super profit table.

    References:

    1. commerceiets.com/average-profit-vs-super-profit/
    2. www.toppr.com/guides/principles-and-practice-of-accounting/treatment-of-goodwill/methods-of-goodwill-valuation/
    3. www.yourarticlelibrary.com/accounting/goodwill/accounting-procedure-for-valuation-of-goodwill-4-methods/57243
  • Valuation of Goodwill: Meaning, Need, Factors, and Methods

    Valuation of Goodwill: Meaning, Need, Factors, and Methods

    Valuation of Goodwill: What is Goodwill? Meaning of Goodwill; Goodwill is the value of the reputation of a firm built over time concerning the expected future profits over and above the normal profits. So, what is the topic we are going to study; Valuation of Goodwill – Meaning, Need, Factors, and Methods (In Hindi). A well-established firm earns a good name in the market, builds trust with the customers, and also has more business connections as compared to a newly set up business. Goodwill in accounting is an intangible asset that arises when a buyer acquires an existing business.

    Here are explained how to Valuation of Goodwill? Meaning, Need, Factors, and Methods.

    Goodwill represents assets that are not separately identifiable. Goodwill does not include identifiable assets that are capable of being separated or divided from the entity and sold, transferred, licensed, rented, or exchanged, either individually or together with a related contract, identifiable asset, or liability regardless of whether the entity intends to do so.

    Valuation of Goodwill Meaning:

    There are various circumstances when it may be necessary to value goodwill. Some of the circumstances are;

    First, In the case of a partnership, when there is an admission, retirement, death or amalgamation, or a change in the profit-sharing ratio take place, the valuation of goodwill becomes necessary.

    Secondly, In the case of a company, when two or more companies amalgamate, or one company absorbs another company, or one company wants to acquire controlling interest in another company or when the Government takes over the business, valuation of goodwill becomes necessary.

    Third, In the case of a sole trader concern, goodwill is valued at the time of selling die business, to decide the purchase consideration.

    Finally, In the case of individuals, goodwill is valued for Estate Duty, Death Duty, etc. On the death of a person.

    Need for Valuation of Goodwill:

    Valuation of goodwill may make due to any one of the following reasons:

    A Sole-Proprietorship Firm:

    • If the firm sells to another person.
    • It takes any person as a partner, and.
    • It converts into a company.

    A Partnership Firm:

    • If any new partner takes.
    • Any old partner retires from the firm.
    • There is any change in the profit-sharing ratio among the partners.
    • Any partner dies.
    • Different partnership firms amalgamate.
    • Any firm sale, and.
    • Any firm converts into a company.

    A Company or Firm:

    • If the goodwill has already been written-off in the past but the value of the same is to records further in the books of accounts.
    • An existing company taking with or amalgamated with another existing company.
    • The Stock Exchange Quotation of the value of shares of the company is not available to compute gift tax, wealth tax, etc., and.
    • The shares are valued based on intrinsic values, market value, or fair value methods.

    Factors Affecting the Value of Goodwill:

    The following factors affect the value of goodwill:

    Location:

    A business which locates in the main market or at a place where there is more customer traffic tends to earn more profit and also more goodwill. If the firm centrally locates or locate in a very prominent place, it can attract more customers, increasing turnover. Therefore, the locational factor should always consider while ascertaining the value of goodwill.

    Time:

    The time dimension is another factor that influences the value of goodwill. The comparatively old firm will enjoy a more commercial reputation than the other one since the old one is better known to its customers, although both of them may have the same locational advantages.

    Nature of Business:

    A firm that deals with good quality products or has stable demand for its product can earn more profits and therefore has more value. This is another factor which also influences the value of goodwill which includes:

    • The nature of goods.
    • Risk involved.
    • Monopolistic nature of the business.
    • Benefits of Patents and Trade-marks, and.
    • Easy access to raw materials, etc.

    Capital Required:

    More buyers may interest to purchase a business that requires a comparatively small amount of capital but the rate of earning a profit is high and, consequently, raise the value of goodwill. On the contrary, for a business that required a large amount of capital but the rate of earning a profit is comparatively less, no buyer will interest to have the business and, hence, the goodwill of the said firm pull down.

    Owner’s Reputation:

    An owner, who has a good personal reputation in the market, is honest and trustworthy attracts more customers to the business, and makes more profits and also goodwill.

    Market Situation:

    The organization has a monopoly right or condition in the market or having limited competition, enables it to earn high profits which in turn leads to a higher value of goodwill.

    The trend of Profit:

    The value of goodwill may also be affected due to the fluctuation in the amount of profit (i.e., based on the rate of return). If the trend of profit is always rising, no doubt the value of goodwill will be high, and vice versa.

    The efficiency of Management:

    Efficient management may also help to increase the value of goodwill by increasing profits through properly planned production, distribution, and services. An organization with efficient management has high productivity and cost-efficiency. This gives it increased profits and also high goodwill. Therefore, to ascertain the value of goodwill, it must note that such efficiency in management must not be curtailed.

    Special Advantages:

    A firm that has special advantages like import licenses, patents, trademarks, copyrights, assured supply of electricity at low rates, subsidies for being situated in a special economic zone’s (SEZs), etc. possess a higher value of goodwill.

    Other Factors:

    • The condition of the money market.
    • The possibility of competition.
    • Government policy, and.
    • Peace and security in the country.

    Precaution to Take in Valuing Goodwill: We know that the amount of goodwill always pays for in the future. The buyer will pay a little more than the intrinsic value of assets only when he expects that he will enjoy some extra benefits from such goodwill shortly. On the other hand, if the buyer thinks that there is no possibility of having such advantages in the future, he will not be ready to pay anything for goodwill—even if the value of goodwill is very high.

    Methods of Valuing Goodwill:

    There are two methods of valuing goodwill:

    1. Simple profit method, and.
    2. Super-profit method.

    Simple Profit Method:

    There are two methods based on simple profit:

    • Purchase of Past Profit Method, and.
    • The capitalization of the Average Profit Method.
    A. Purchase of Past Profit Method:

    Under this method, goodwill is expressed as a purchase of a certain number of years’ profit based on the adjusted average profit of a given number of years.

    This method involves two steps:

    • The profits for an agreed number of years preceding the valuation average to ar­rive at the average annual profit earned during that period. This will have to adjust in the light of future possibilities and the average future maintainable profit determined. If the profits have been fluctuating, a simple average use. If profits show a steadily increasing or decreasing trend, appropriate weights are used giving greater weightage for profits of the later year.
    • The average future maintainable profit is multiplied by a certain number of years to find out the value of goodwill. The number of years selected for this purpose base on the expectation of the number of years’ benefit to derive in the future from the past association.

    For example, if the average future maintainable profit is Rs.25, 000 and it expects that this profit would earn for at least another 3 years, then the goodwill will be:

    Goodwill,

    = Rs. 75,000 (25,000 x 3).
    = Average of profit x number of years.

    The number of years over which the profits are averaged and the number of years’ purchase applied may vary considerably in practice but generally falls between one and five years. Estimating future profit beyond a period of say, 5 years would be quite difficult and unrealistic.

    The method suffers from two defects:

    • The difficulty of finding out the right number of years’ purchase of profits as it depends on so many factors and
    • Ignoring capital to employ in the business.
    B. The capitalization of the Average Profit Method:

    The following steps are to take in ascertaining the value of goodwill under this method:

    • Ascertain the average future maintainable profit, as explained already.
    • Capitalize this average profit at the normal rate of return on investment on the type

    Of business under consideration:

    This will give the net worth of the business.

    • Find out the value of net tangible assets (i.e., net assets other than goodwill) of the business.
    • Deduct the net tangible assets from the capitalized net worth of the business and the difference is goodwill.

    Super-Profit Method:

    Strictly speaking, goodwill can attach only to a business that is earning above-normal profits of super-profits. If there is no anticipated excess earning over normal earnings, there can be no goodwill.

    Such excess profits know as super-profits and it is the difference between the average profit earned by the business and the normal profit based on the normal rate of return.

    Hence for find­ing to the super-profits, the following information will require:

    • The estimated average future profits of the firm (ascertained as already explained),
    • The normal rate of return on investment and
    • The fair value of the average capital employed in the business.

    The normal rate of return:

    The normal rate of return refers to the rate of earnings that inves­tor, in general, expect on their investments in a particular type of industry. It varies depending upon general factors like the bank rate, general economic conditions, political stability, etc., and specific factors like period of investment, risk attached to the investment, etc.

    Normal profit and Super-profit:

    If the average capital employed and the normal rates of return know, the normal profit can ascertain. For example, if the average capital employed is Rs. 1, 00,000 and the normal rate of return is 10%, the normal profit is 1, 00, 000 x 10/100 = 10, 000.

    Super-profit is the simple difference between the actual average profit earned and the normal profit. If in the above example, the average profit is Rs. 25,000, then the super-profits will be Rs. 25,000 – Rs. 10,000 = Rs. 15,000

    Goodwill based on Super-Profit:

    There are four methods of calculating goodwill based on the super-profit.

    They are:

    • Purchase of super-profits Method,
    • Sliding-scale Valuation of Super-profit Method,
    • Annuity of Super-Profit Method and
    • The Capitalization of Super-Profit Method.
    1. Purchase of Super-profit Method:

    Goodwill as per this method = Super profit * Number of years. If, for example, the super-profit is Rs. 15,000 and goodwill agree to be 3 years’ purchase of super-profits, then the goodwill will be s.45,000 (15,000 * 3)

    2. Sliding-scale Valuation of super-profits Method:

    This is the only variation of the first method. It is based on the logic that the greater the number of super-profits, the more difficult it would be to maintain. Higher profit will naturally attract competition and soon the firm’s ability to make super-profits is curtailed.

    3. Annuity super-profit Method:

    Under this method, goodwill calculates by finding the present worth of an annuity paying the super profit per year, over the estimated period discounted at the given rate of interest. Usually, the reference to the Annuity Table will give the present value of an annuity for the given number of years and at the given rate of interest.

    Goodwill = super-profit * annuity.

    For example, if the super-profits are Ts. 15,000 and the annuity of re. 1 at 10% for 3 years is 2.48,685, then the goodwill is = Rs. 15,000 * 2.48,685 = Rs. 37,302.75. This method takes into consideration the interest loss involved in paying a lump sum as goodwill in anticipation of the future of profit.

    4. The Capitalization of Super-Profit Method:

    This is similar to the capitalization of the average profit method as already explained. Under this method, the super-profits when capitalized at the normal rate of return will give the value of goodwill.

    Goodwill,

    = Rs. 1, 50, 000 (Rs. 15, 000/10 x 100).
    = Super Profit/Normal rate of return x 100.

    This method gives the maximum value for goodwill. Since the contention that super-profits will continue for long is unreasonable, this method is not safe for one to follow.