Goodwill is an intangible value associated with a business and is based on the business' potential to provide a future flow of earnings beyond the current owner.
Stock, plant and equipment, and other fixed assets, are tangible items that can be relatively easily valued on a market. Goodwill is intangible; essentially it is the risk premium around how and what business maintainable earnings (BME) will be delivered into the future if the business is acquired by someone else and run in basically the same way.
One way of looking at BME is to think of it as the business’ current 'run rate'. The run rate is impacted by things such as:
- the size and diversity of the business’ customer base
- the value of the business’ brand
- the business’ credibility and reputation in the market
- the strength of agreements the business has with its suppliers and customers.
The market will value goodwill based on the strength of that run rate.
Good information key to goodwill value
There is a common view that ‘no one will pay for goodwill in today’s marketplace’ but that is not correct, as we have explained before in our eBooks.
The market is willing to pay for goodwill, but they’ll only pay when they have confidence in the information that suggests there is goodwill i.e. a future flow of earnings beyond the current owner. Credible, robust, transparent information is critical to allowing a purchaser the opportunity to assess the value of your business' goodwill.
Be prepared to negotiate
Goodwill is often a flashpoint in the negotiation process, both for vendors looking to maximise the return from their business when exiting, and for purchasers trying to place a value on a business opportunity.
People can argue about what a hard asset is worth, but there is usually a fluid and active market for hard assets, so it is not hard to determine what their value is.
Goodwill is intangible and therefore it is more debated regarding value.
Does ‘future potential’ cut it as goodwill?
From a business advisor and valuer’s perspective, I have to say that technically the market does not value future potential as part of the goodwill equation.
The explanation for this requires us to look again at business maintainable earnings (BME).
Goodwill is based on BME, and BME is about the current run rate of the business – what has been built up by you and is likely to be maintained if the business continues to be run in a similar manner, regardless of ownership.
The purchaser is unlikely to pay you for other opportunities they hope to create in the future, unless the business under consideration is highly sought after.
Here’s an example:
You own a business that manufactures leisure goods and also distributes to on-sellers. You have a client base of 100 customers.
A potential purchaser is looking at your business. This purchaser manufactures homewares and is attracted to your customer base because they feel there are potential synergies i.e. they may be able to sell their homewares, as well as your business’ leisure goods, to your customer base.
This potential complementarity is part of their motivation to buy your business.
In this situation, would your business’ goodwill be worth more to this buyer?
The potential complementarity may represent the main buyer motivation in this case, however, unfortunately for you, the answer is ‘no’ because, again, goodwill is valued on the current run rate of the current business.
In this case the purchaser has to take the risk of introducing their product range to your customer base. They are taking the risk, so they usually want to receive most, if not all, of the reward.
Goodwill and strategic value – what’s the difference?
In the example above there is a strategic advantage for that purchaser in acquiring your business and they may be willing to pay a ‘strategic premium’, particularly if it is a competitive process and the buyer really wants the opportunity.
Readers may say: “Who cares if they’re paying for goodwill or strategic value? It all ends up in the same figure.”
This is true, but it is important that as a seller you go into the process with your eyes open and understand the levers that purchasers and their advisors will use to determine your business opportunity’s value to them.
Remember, a buyer does not want to pay for opportunity that they have to create, so strategic value is often the cream on top of a deal that may or may not be achievable.
JPAbusiness provides a range of services to business buyers and sellers, including valuation, due diligence and negotiation support. Contact the JPAbusiness team on 02 6360 0360 (Orange) or 02 9893 1803 (Parramatta) to arrange an obligation-free consultation.
James Price has over 30 years' experience in providing strategic, commercial and financial advice to Australian and international business clients. James' blogs provide business advice for aspiring and current small to mid-sized business owners, operators and managers.