When meeting business owners, evaluating their financial statements and suggesting an asking prices for their companies, I am frequently faced with a big astonishment appearing on the owners’ faces. For some companies, the asking price I suggest is very close to the net book value of the assets. Business owners are understandably surprised to hear that all the hard work they have put on their businesses for so many years has no value at all. What about the reputation, the customer lists, the relationships, the employees, the know-how, the brand name, the experience and all the key success factors that have helped the owner make a decent living for all the past years? is it normal that all these assets have no value? What about goodwill. What is the value of this goodwill? How do you calculate it?
First lets understand what Goodwill is. In financial terms, Goodwill is the difference between the company value and the value of its tangible assets net of liabilities. You estimate the total company value and then you deduct the liabilities and the net book value of all tangible assets and the remaining (if any) is the value of Goodwill. In some circumstances the company value is less than its asset book value, so there is no goodwill value remaining.
While technically correct, this definition doesn’t seem very intuitive. How could goodwill have no value or even have a negative value? All this reputation over the years is certainly worth something. The problem is that it is worth something only if somebody is willing to pay something for it. If the seller is lucky enough to find that rare buyer who desperately needs this goodwill for whatever reason, they may get a lot of money for it.
However, when a business broker evaluates a company, they are looking for a fair market value of the business and certainly not a low probability price that sellers might get if they are so lucky that there is a unique buyer desperately in need to buy their business even at above market value. Fair market value is mostly based on the earning ability of the business not the book value of its assets.
In many circumstances, especially for Businesses with valuable tangible assets such as equipment, stock, receivables etc., the earning ability of the business hardly justifies a price higher than the book value of its assets. In these circumstances we can simply say that the buyer is not paying for any goodwill.
How can business owners maximise the value of their goodwill?
If owners increase or maintain their profits while reducing the value of their tangible assets, they can get a much higher value for their goodwill and could end-up with a much higher total proceeds from the sale of their businesses. Below are some concrete suggestions:
- Modernise stock management and reduce stock to its minimum level while maintaining good customer relationships.
- Increase machinery utilization and sell any unused/low utilization equipment.
- Offer customer incentives to reduce payment terms and reduce the need for working capital.
- Negotiate better terms with suppliers to increase accounts payable.
While I recognize that these suggestions are very difficult to implement in practice, owners can make some bold strategic choices that will make the above suggestions easier to implement. Choices include focusing on the 20% customers that produce 80% of the margins, limiting the number of SKU’s to a smaller more manageable number, standardizing products and/or services offered, increasing marketing and focusing it on the targeted profitable customers etc.