Don’t Forget Goodwill When Valuing Your Business
When engaging in the sale of your business it is important to consider all of the factors that will help you receive the maximum value. One area a seller should not forget to examine is goodwill. In a nutshell, goodwill is the value of intangible assets that don’t have an easily defined valuation. It is easier for a buyer and seller to determine the valuation for a piece of machinery or a fleet of vehicles. How do you go about valuing your client list? Trademarks? Brand name? These are more difficult figures to pin down.
Goodwill can be further divided into personal and transferable goodwill. If all the goodwill is tied to the owner, so that if s/he leaves the goodwill goes as well, this is considered personal goodwill. A buyer won’t be willing to pay a premium in this instance. It would be considered a negative if the buyer perceives that the owner is the business, and the business is the owner. The other type of goodwill, transferable goodwill, is more valuable. This is the goodwill that a buyer should be willing to pay a premium for as it can be transferred. Think about your client lists, customer and supplier relationships, brand name and image, and trademarks and other IP that the buyer will acquire with the tangible assets in a sale.
How important is goodwill in an acquisition? That depends. A 2015 study by Houlihan Lokey that examined the purchase consideration from 563 transaction closed in 2015 found that the median percentage of the purchase consideration attributed to goodwill was 38%[1]. This figure varied by industry. The median percentage in the financial institutions industry was only 6%. However, the median value for the technology industry was 52%. As you can see, the amount that goodwill will impact the purchase price changes depending on the industry you operate in as well as the specifics of your company.
Why Goodwill is Important
Business owners know that value cannot be defined only by tangible assets. An auto manufacturer cannot be valued by finding the sum of the values of machinery, raw materials, plants, and property. Intangibles also contribute to profitability and should be considered in an acquisition.
Goodwill is important because it helps to minimize the risk that a business will stumble after a change of ownership. Certainly, some changes take place after an M&A transaction, but a business with a solid customer list, IP, and other intangibles should continue to operate as it has done historically.
A variety of factors can be considered goodwill including, but not limited to:
- Copyrights, trademarks, patents
- Brand name
- Reputation
- Customer and supplier lists and relationships
- Contracts
- Proprietary software and know-how
- Trade secrets and recipes
- Customized databases
Let’s look at a few of the above to better understand how they play into goodwill.
Customer/Supplier Lists and Reputation
Any prospective buyer is going to want to see that the business can be maintained after the transaction. If a situation arises where the owner exiting would tank the business, many buyers aren’t going to take a second look. Ideally, you would be able to show that your business has a customer list that will allow the buyer to forecast recurring revenues. For example, if I’m selling a pool cleaning business and I can demonstrate that I have a book of business with clients who have been loyal over several years, a buyer can project what types of revenues to expect in the future.
A positive reputation is also important. Combining a good reputation, say for doing quality pool cleaning, with a loyal customer list is extremely valuable to a buyer. The buyer will be able to comfortably predict future cash flows and will have an opportunity to expand the business leveraging the positive reputation.
Brand name, trade secrets, trademarks, and patents
A strong brand name can be very attractive to a would-be buyer. This is because a strong brand name will attract customers. If consumers recognize the brand as being high quality, fun, or providing reasonably priced products/services a buyer will want to be sure they can continue to use the name. Think about Apple, Inc. Just say “Apple” and people will start to have an image of a specific type of product and experience. If you were to consider a purchase of Apple, Inc., but the name wasn’t included, would you be willing to go through with the purchase? Likely not.
Let’s turn to trade secrets and recipes. If I offered to sell you a world-famous energy drink company, but with one catch: the drink recipe isn’t included in the sale, would that be attractive? Again, likely not. The recipe is a critical part of the company’s success. Without the original recipe that made the drink famous a buyer runs a huge risk of losing customers and their investment.
Intangibles such as a brand name, trade secrets, and trademarks are all assets that cannot be touched, but most certainly create real value for a company.
Databases and Proprietary Software
Let’s examine the pool cleaning business mentioned above. The business likely has a database with customer data. As many of us know, knowledge is power and data is a stepping stone to knowledge. Leveraging the data in the database, a buyer could identify customers who may be good targets for additional services. If the database includes email addresses the buyer could initiate an e-mail marketing campaign when running promotions or deliver useful messages on pool care in various seasons.
Just like a database is valuable, so too is proprietary software. If your company has developed software used to operate the business this is a source of value to a buyer. The software may be used to manage internal processes, streamline communication with customers, or a variety of other functions. If it is a process that cannot be easily duplicated and can translate into future profits it can add to the goodwill value of your company.
Great Valuations Include Goodwill
The above examples are not an exhaustive list of areas in your business that may contain goodwill. Each business is different and may have various sources of goodwill. As a seller, it’s important to remember that you shouldn’t let a buyer discount, or ignore, your goodwill. One objection a buyer may raise is that goodwill cannot be touched, like a tangible asset. This is true, but it is worth your time and effort to explain, in detail, why your business deserves a premium based on goodwill.
If you’ve built a successful business and are ready to exit, working with an experienced investment banker who understands goodwill can help you achieve the valuation that your business deserves.
Sources
[1] Giffin, M., Miles, K., Stefanowski, T., & De Simone, M. (2016, October). 2015 Purchase Price Allocation Study (Rep.). Retrieved November 4, 2018, from Houlihan Lokey website: https://www.hl.com/uploadedFiles/12_Insights_and_Ideas/Articles/2015-Purchase-Price-Allocation-Study-HL.pdf
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