Every small business owner invests a substantial amount of blood, sweat and tears into their business.  Late nights and early mornings, weekends away from their loved ones, hours lying sleepless, wondering what entrepreneurial surprises are coming next.  All this effort is intended to make the business a success – and to make it worth more than just the sum of its tangible parts.  So when the time comes to sell, every business owner wants, even expects, to be paid handily for their sweat equity.  And in most cases, the owner is disappointed that potential purchasers are not willing to pay what they consider a fair price for this equity.

 

Let’s start by defining the word “goodwill,” in the context of valuing a business.  The fair market value of any business is made up of the value of tangible assets (inventory, accounts receivable, equipment, land and buildings, etc.) and the value of intangible assets (customer lists, brand awareness, proprietary processes, etc.).  Some intangible assets are specifically identifiable and can be valued; the rest make up “goodwill.”  In most business valuations, the amount by which the fair market value of the business exceeds the value of its tangible and identifiable intangible assets is considered “goodwill.” 

 

From a purchaser’s perspective, goodwill is the premium they are willing to pay for a particular business, rather than just buying the tangible assets directly and starting the business themselves.  It represents the investment they are willing to make to buy an existing business, based upon the incremental income and cash flow it generates over starting the same business from scratch.

 

Valuing goodwill is by far the most challenging aspect of determining the fair market value of any business.  And it generally makes up the majority of the difference between what a seller is hoping to be paid, and what a buyer is prepared to pay, for any business.

 

Now we will break “goodwill” into two components:

 

  • Personal goodwill (also known as “professional goodwill”) attaches to a particular individual rather than to the business that the individual owns.
  • Business goodwill (or “enterprise goodwill”) is derived from characteristics specific to a particular business, regardless of who owns or operates it.

 

To highlight the differences between these two components of goodwill, consider the following example of two hypothetical hair salons, “Cut Above” and “Perfect Look.” The two businesses, located two miles apart, have virtually identical ownership structures, assets, liabilities, revenues and net income. Beyond those similarities, the salons have little in common.

 

Cut Above is in a busy shopping mall and serves customers on a walk-in basis. Profits are split evenly among the owners. In contrast, Perfect Look is in a quiet neighborhood and requires customers to make appointments, often weeks in advance, with a particular stylist. Profits are allocated based on the revenue generated by each owner.

 

Although both salons produce virtually identical benefits for their respective owners, there is a difference in the nature of the goodwill of Cut Above’s owners versus that of Perfect Look’s owners. The owners of Cut Above receive earnings tied directly to the enterprise, such as its location, business model and mechanism for distributing profit. The owners of Perfect Look, however, receive earnings tied directly to their personal skills, reputation and repeat clientele. Thus, an owner of Cut Above would typically possess a higher level of business goodwill, and a Perfect Look owner would have a higher level of personal goodwill.

 

In a business sale, a Cut Above owner would likely find it easier to transfer to a prospective buyer the goodwill associated with his/her ownership interest, due to the expectation that the earnings of Cut Above would continue at historical levels regardless of who owned the business. However, an owner of Perfect Look would likely have a harder time transferring his/her goodwill, due to the expected decline in earnings from the regular clients who are more loyal to him/her than to the salon.

 

To summarize, a potential purchaser is willing to pay more for business goodwill, because it is more likely to accrue to them when they are the owner.  However, they are likely to heavily discount personal goodwill, because it is unlikely to accrue to them when they are the owner.

 

Fortunately, given the availability of time and strategic planning/execution, there are ways to convert some personal goodwill to business goodwill.  Depending on the specific situation, these could include:

 

  • Building the business brand, so that customers become more familiar with the brand then with the individuals operating the business
  • Building and diversifying the management team, so that expertise, customer relationships and other intangible assets stay with the ongoing managers of the business, even if the owner has moved on to greener pastures (or sandier beaches!)
  • Standardizing and documenting processes and procedures, so that the departing business owner is not the “go-to” person for every situation
  • Encouraging the owner to spend more time “on the business” rather than “in the business” – even if a sale of the business is not contemplated, this is often a very healthy transition for most entrepreneurial businesses.

 

To maximize the success of converting personal goodwill to business goodwill, the process should begin years before the business is offered for sale.  Not only do some of the initiatives take time to implement, but showing a track record of the business thriving independently of the departing owner(s) will provide confidence to the prospective purchaser that the business goodwill is maintainable.

 

Written By Bob Lawrence, President, Breakaway Business Transition Planning Ltd.