In many cases, small businesses rely on key management; typically the founder and CEO. The founder and CEO will have developed the IP, maintain trade secrets in his/her head, manage client relationships and sometimes relies on personal trust as opposed to written contracts in client and supplier relationships.
Goodwill is that intangible asset that contributes to earnings as a result of name, reputation, customer and employee loyalty, location, products, etc. When goodwill is attributable to the individual it is called personal goodwill, when it is attributable to the entity it is called enterprise goodwill. Enterprise goodwill is created by adopting formal processes, systems and documentation which reduce the dependence on individual talent. Items such as Service Level Agreements (“SLAs”), marketing plans, job descriptions, employment contracts, confidentiality agreements, professional codes of conduct, organization charts, etc. institutionalize a business. If a key employee leaves and a replacement can be trained quickly to fill the position, then the business will be more stable, less risky and more valuable. Goodwill must be attached to the enterprise to realize value in a business transition.
Personal Goodwill Characteristics
The following characteristics would be indicative of personal goodwill:
• Small business highly dependent on owner’s personal skills and relationships
• No non-compete or employment agreements
• Personal services provided by the owner(s) an important feature in the company’s products or services
• Sales largely dependent on owner’s personal relationship with customers
• Product and/or services know-how and supplier relationships rest primarily with the owner(s)
Enterprise Goodwill Characteristics
The following characteristics would be indicative of enterprise goodwill:
• Company has written contracts with major customers and suppliers
• Company has written employment and/or non-compete agreements with key employees
• Formalized organizational structure, systems, and controls
• Company has formalized production methods, business processes and business systems
• Business is not heavily dependent on personal service performed by the owner(s)
• Company sales result from company name recognition and/or sales force
Enterprise goodwill must also be sustainable. Sustainability refers to the ability of the company to maintain the incremental cash flow over the medium to longer-term. Sustainability may require ongoing investment in R&D, promotional costs, and other expenses that have to be taken into account when assessing the value of goodwill.
To realize full value in the sale of a business, the owner-entrepreneur must make him/herself redundant by transferring personal goodwill to the business. This is done by putting formal systems and procedures in place. If a potential buyer feels that a business is largely owner dependent, they will either not buy it, reduce the price they are willing to pay, or make a portion of the price contingent upon the seller successfully transferring personal goodwill to the business.