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Written by: Rick Gendemann, CPA, CA
As a business owner, one of your long-term objectives is to build and grow the value of your business. The question often raised around that goal is: What are the things that potentially drive business value? In my experience, the most significant driver to increasing value is the goodwill of the business.
In general terms, a business’s goodwill is based on the ability of the business to generate above-average returns on the tangible assets employed. Simply stated, goodwill is the ability to generate more profits and cash flow than one would otherwise expect to, given the asset make-up of the business.
There are many different types of goodwill. It is important to understand how each of them impacts the value of your business. You also need to be mindful of the potential “bad” goodwill elements of your business – these can significantly hinder the future value you are trying to create.
The following forms of goodwill will most likely drive the type of business you operate and the industry you are in. Note: Some may not be applicable to your particular business.
Goodwill driven by location
Goodwill may accrue to a business because of its physical location. For example, a business operates a specialty coffee and pastry shop on a busy route used by folks going to and from work every day. It is also in an area of commercial offices and warehouse buildings. This specialty shop enjoys a high volume of drive-by and walk-in customers, either because of its proximity to their place of work or its convenient location on their route to work. For that reason, the business generates a superior return on its net tangible assets employed.
Goodwill driven by product sold
This will be a business with specific product identity and acceptance that appeal to its customers and potential customers.
An example would be a business that manufactures rattan outdoor furniture nationally recognized in the marketplace for its high quality and durability. By virtue of its ability to efficiently produce superior-made rattan furniture, the business has gained significant market share and realizes high-net profit margins.
Goodwill driven by service
For businesses in the service industry, their service delivery model is what drives their goodwill. Their high level of customer service drives the identity and acceptance of their service in the minds of customers and potential customers.
Here, an example would be a florist that offers delivery and supply of flower arrangements to the high-end major hotels in a city. Contracted by these hotels, the florist has developed a reputation for supplying quality arrangements on a consistent, timely basis. Moreover, the florist carefully monitors and oversees the flower displays for the hotels. It therefore provides a hassle-free service to its customers, ensuring high customer satisfaction and high rates of return.
"Bad" Goodwill Is One that Does Not Drive Business Value
At first glance the concept of “bad” goodwill seems counterintuitive. But indeed there is a type of goodwill that doesn’t drive business value: personal goodwill.
Personal goodwill arises from an individual’s particular abilities, good name and reputation. All well and good, but these are not transferable, either by contract or otherwise. Since this type of goodwill is intrinsically linked to a person, it will expire when the person: loses interest in their business; retires as a result of personal choice, age or disability; or passes on.
And, not being transferable, personal goodwill has limited commercial value.
Consider a situation where a business is largely driven by the efforts, skills and connections of the owner. This individual may have gained significant prominence, enjoy high annual earnings and have accumulated substantial economic wealth. Certainly, the specific skills of the owner create economic value.
But the owner hasn’t trained others. Nor have they put systems and processes in place to replicate the business tasks they are currently responsible for, or to ensure their skills and contacts are passed along.
Don’t get me wrong. In many cases the value of a business does include a significant portion of personal goodwill. It complements the other, longer-lasting types of goodwill.
Through the use of employment contracts and non-compete agreements, sellers often try to convert some of their personal goodwill to saleable goodwill. But that may not always be possible. There is a strong probability that a future purchaser will not pay for this type of goodwill. And, since it isn’t transferable, why should they?
After all, you can’t transfer your reputation, skills or abilities. And it is difficult to transfer the relationships you have built up over the years.
So, if your business is highly reliant on you being there in the day-to-day operations, you are likely limiting the value of your business. If you want to enhance and maximize the return on your business investment, you need to build up your business’s other, longer-lasting types of goodwill.
How do you do that? Think about implementing these four key strategies:
Focusing your attention on these four areas will give you the greatest chance of creating future business value – value that a prospective purchaser is prepared to pay for, because you have created a business that has continuity value.
Rick Gendemann, CPA, CA, focuses mainly on Estate Planning and Business Succession services for Canadian owner-managed businesses in a wide range of Industries. Rick can be reached at 604-557-5760 or by email at email@example.com.
The above content is believed to be accurate as of the date of posting. Tax laws are complex and are subject to frequent changes. Professional advice should be sought before implementing any tax planning. Manning Elliott LLP cannot accept any liability for the tax consequences that may result from acting based on the information contained therein.