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
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 vs. Business Goodwill
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)
Business 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
Business goodwill must also be sustainable. You sometimes hear of goodwill write-offs or goodwill impairment. This occurs when accountants determine that the carrying value of goodwill on financial statements exceeds its fair value.
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.
Manage all Business Risks
Running a business requires taking risk. Managing risk in business creates value. Here we outline how to manage risk to drive value. If your revenues are project oriented with little opportunity for repeat business, or you operate in an industry with low barriers to entry, or a people dependent business such as consulting, advertising or staffing, then what can you do to realize as much value as possible?
Mitigate the risks inherent in the business model by focusing on the following:
Differentiate your Product or Service
While at first glance, it may seem hard to differentiate a business in a well established and competitive sector, keeping an eye on consumer trends combined with creative marketing can often carve out a new profitable niche and present a tremendous growth opportunity.
Grow and Strengthen Customer Relationships
Reduce the unpredictability of project revenues by nurturing customer relationships. If you can show that the same customers use your services several years in a row then you have an argument for revenue predictability. If that list of customers is more than twenty then you have an argument for revenue diversity. Length of customer relationships is also a good indicator of a high quality product/service.
Focus on Execution Excellence
In a service business, it comes down to attracting and keeping the best personnel in order to deliver service excellence. Human resources is a complex, multi-dimensional field and should include processes for recruiting, role definition and responsibility, position incentives and benefits, periodic feedback, and documentation and procedures to fill gaps in the case of unexpected departures.
Add Products and Markets
A one product company is riskier than a product line company. A local company is riskier than one with a multi-national presence. While it is easy to over-extend yourself, consider managed product and geographical growth to mitigate risk.
Cultivate Multiple Supplier Relationships
Don’t let your business become “captive” to a sole supplier of component parts. Cultivate multiple supplier relationships to reduce supplier power and dependence.
Analyze your profit margin to see where you want to drive your sales — to higher-margin areas. A trend of improving margins as a result of operational efficiencies and returns to scale will result in a higher valuation.
Protect Intellectual Property
IP can be patented, copyrighted or treated as a trade secret. Identify the IP in your business and make sure it is protected and properly owned.
Build Your Brand
Spend time on all of the above will build your reputation and your brand.
The following chart summarizes various characteristics that drive company value.
Business Risk Management Plan
Managing risk in business should be pursued by way of implementing formal processes. A business with formal processes, systems and documentation reduces the dependence on individual talent and can quickly respond to exogenous shocks. 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. Documented processes are transferable value. Capturing and transferring knowledge will make the business more sustainable and more valuable.
If potential buyers feel that a business has a high risk profile, they will either not buy it, reduce the price, or make a portion of the price contingent upon the business’s future performance. Managing operating risk will increase the sale-ability, even for small, niche and project oriented businesses.
Recommended Further Reading
For more on the right buyer for your business, see: Finding the Right Buyer
For more on how long an acquisition takes, see: How Long Does it Take to Sell a Business?