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:

1. Modernise stock management and reduce stock to its minimum level while maintaining good customer relationships.
2. Increase machinery utilization and sell any unused/low utilization equipment.
3. Offer customer incentives to reduce payment terms and reduce the need for working capital.
4. 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.

When practicing my profession as a business broker in the Greater Toronto Area, the most frequent question I am asked is “how much is the business worth?”. While most are not ready to pay for a formal business valuation, both business buyers and sellers are extremely interested to know the value of the business they are trying to sell and buy. While  business valuation articles I have written before are very general, this one is more specific and describes most commonly used valuation methodologies used in Toronto and surrounding areas in Ontario for the purpose of selling or buying a business. Below are some of  the most commonly used methods:

EBITDA Multiples:

This method is mostly used for valuing middle market companies (values higher than one million dollars). Accountants, Mergers and Acquisitions Intermediaries and Middle Market Business Brokers. it consists of computing EBITDA (Earning Before Tax, Depreciation and Amortization) and applying a multiple to arrive at the Enterprise Value. The enterprise value is then reduced by the amount of interest bearing debt to arrive at the value of equity. This value included equipment, goodwill, inventory, accounts receivable and the necessary cash to arrive at a historical average of working capital. The computed EBITDA has to be normalized before applying the multiple. The normalization process involved the non exhaustive list below :

1. Adjusting the seller’s and his  family members’ salary to market salary. Not working family salaries should be added back to EBITDA,
2. Adding depreciation and amortization
3. Subtracting the  capital investment costs for the following year necessary to maintain the sales at their current level.
4. Adding back to profits any one time, non recurring costs such as a large bad debt resulting from a large client bankruptcy.
5. Adding seller’s personal expenses and perks not necessary for the operation of the business such as meals and entertainment, if not necessary for the business, car allowance, personal insurance etc.
6. Adjusting rent to market price if the owners  owns also the real estate or rents at below market rent that cannot be transferred to the buyer.

The multiple of EBITDA used for valuation is determined  from comparable transactions in similar industries. this is the most challenging step since private company transaction information are generally not available to the public. Some business for sale websites offer incentives to business brokers to collect pricing information for closed transactions and offer large databases of transaction to business valuators for fee based subscriptions. These large databases are not always reliable since business transactions have so many terms other than price that are generally interrelated and influence price, and terminology used by these websites do not always have standard meanings to all business brokers.

Transactions in the Greater Toronto Area are not necessarily comparable to transactions in other US cities mostly because of the difference between Canada and the US in currency, risk, tax rates etc. EBITDA multiples in Toronto vary between 3 and 5 with 4 been an average especially in challenging economic times. These multiples can reach 7 in good times for established companies. High growth companies especially in the technology sector can reach much higher multiples, especially for a strategic buyer.

Seller Discretionary Earnings (SDE)

This method is mostly used for small businesses with less than one million dollars in value. This method is very similar to EBITDA with two main differences:

• The salary of the owner is added to SDE and the same normalization process is applied
• Inventory, Accounts receivable and cash are not included in the valuation.

Multiples of SDE are much lower than those of EBITDA. Generally between 1 and 3 in Toronto. Larger companies tend to sell for larger multiples. Multiples are lower for companies with problems, high risk or who require a large amount of inventory and accounts receivable.

Asset Based Valuation:

This method is generally used when the EBITDA or SDE methods cannot be used, especially when companies are unprofitable or when profits are very low compared to the value of assets. This method is generally the calculation of the net book value of the company. Most buyers acquiring a company based on the method are turnaround buyers with clear plans to make dramatic changes to the acquired companies to improve the bottom line.

While valuation is an important step before listing a business for sale, sellers should understand the the sale price will be the price a buyer is willing to pay irrespective of what a formal valuation is. A strategic seller for example can pay much more than the company valuation.

Assessing the value of a business is often a combination of financial calculations and personal judgment based on the evaluator experience of similar transactions and a variety of adjustments to reflect differences in business models, environment, regulations, markets etc.

A small business is only worth what somebody is willing to pay for it. That introduces the notion of the value to the buyer as opposed to the intrinsic value of the business. Potential buyers who can see some synergies with the business will probably pay more for the business. Examples of synergies include cost reduction due to increased economies of scale, access to distribution channels enabling cross selling, access to new technologies, access to valuable brands etc.

Unfortunately the assessment of the synergistic value has always been extremely uncertain. Various acquisitions turned into financial disasters simply because most of the expected synergies never materialized. Research have shown that in large corporations, most of the enthusiasm for large acquisitions is mostly driven by executives seeking more power.   The larger the corporation, the larger the power of executives and their pay.

In the small business arena, most valuations are based on the companies history of profits not on the possible synergies. This is mostly because small business buyers are conscious of the high uncertainty in the small business environment. Why would somebody pay for the potential the the business might have. Small business buyers buy a business because of its potential but they only pay for its past results.

However, this doesn’t mean that a business with a bright history but a bleak future will still sell based on its history. The future is still the principal element buyers use in their decision to purchase a company.

Valuing a business before deciding to sell it is certainly a good decision. However, a business seller should understand the various limitations of business valuation and should remain flexible to the market reaction to his listing.