Tag Archives: goodwill

Revenue Quality: What Does it Really Mean?

High quality revenue companies are valued higher than low quality revenue companies.  But what does this really mean and why is this? It is simply a question of risk. High quality revenues reduce risk and therefore result in a higher valuation. What are high quality revenues?  Primarily it is about revenue continuity but also diversity and profitability.

Revenue Continuity
Long term customer contracts provide future revenue predictability.  In many cases capital projects will not get financed without long term customer contracts.  But what if you don’t have long term contracts, what else can give an investor or financier comfort that revenues will stick around? Questions that get at this answer include: How much of an “annuity” does your business model have?  What percentage of revenues can be counted on to recur every year?  Is the product/solution mission critical?  Is it embedded in your customers’ businesses?  Are switching costs high?

As an example, cloud based Software as a Service (“SaaS”) solutions such as Salesforce, Workday or NetSuite are often sold on a per seat, monthly subscription basis.  In some cases upfront customization is required and in all cases customers have to learn how to use the new software.  Once customers have adopted such a solution, they will not switch very quickly.  The solution becomes embedded in another business’ processes which results in high switching costs.  As a result, its recurring revenues are usually quite stable.

There are a number of ways to grow recurring revenues; license or lease your product or technology instead of selling it outright, sell products that need periodic supplies or maintenance, sell service or maintenance agreements, franchise, etc.

Revenue Diversity
The greater the customer concentration the greater the risk.  The opportunity to supply a major retailer (i.e. Wal-Mart or Home Depot) or a major manufacturer (Ford or GE) can be a tremendous opportunity for a small company but it can also drain a lot of resources and result in pressure on margins and tremendous customer concentration.  While the growth that it drives will increase value, the associated risk of these revenues will reduce value.

Early-stage companies tend to have only a few customers that make up a large portion of revenues but, over time, they must strive to build a diverse revenue base.   Ideally no customer generates more than 10% of revenues.

If you operate in a low barrier to entry, fragmented market then it will be hard to increase prices and produce sustainably strong margins.  Of course different business models generate different margins.  For example, a grocery business will have a lower gross margin than a cloud based SaaS business which can generate gross margins of over 70%.  Over time, competition will put pressure on margins but under certain circumstances, such as first-to-market solutions, proprietary products and processes or patents, companies can sustain high margins for a considerable period of time.

Most entrepreneurs will say they have excellent customer relationships and that certain customers would not leave them no matter what.  But stuff happens.  Maybe this belief is based on personal relationships which cannot be sold with the business.  There are always opportunities to improve revenue quality, whether it is to extend revenue continuity, increase revenue diversity or to improve margin.  Improving revenue quality should be an ongoing priority for business owners as it is a strong contributor to company value.

Goodwill Transferability is Critical for a Successful Business Sale

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.