Let’s say that you’ve been offered the opportunity to purchase a small business as a going concern – a turnkey operation – and the asking price is $1 million. It’s apparent to you that the net tangible assets value – that is, the tangible assests such as equipment, receivables, and cash, less the liabilities such as payables – don’t come close to $1 million. In fact, in your estimation, the net tangible assest value is no more than, say, $600,000.
So, presumably, the remaining $400,000 of the asking price would represent what is referred to as intangible value. The owner will likely tell you that it is “goodwill” and may also mention “potential.” Let’s take these two items one at a time.
The term goodwill, in a business sense, is the aggregate of intangibles such as reputation, established customer relationships, convenience of location, special expertise, and brand familiarity – all of which can contribute to the success of a business. And if the valuation for this going concern – typically a capitalized sustainable earnings calculation – indicates $400,000 in goodwill, that would be quite normal.
But simply knowing that goodwill is indicated shouldn’t be enough for an astute or well-advised acquirer like you. You will want to know what actually constitutes that indicated goodwill value. While it’s legitimate to pay for goodwill expected to persist after change of ownership, that calculus changes if any elements of the goodwill disappear once the business changes hands – that’s a different matter entirely. You won’t want to pay for something you won’t have after the acquisition.
A common problem with small businesses is that some goodwill can be what’s known as “personal goodwill” – sometimes all of it. Personal goodwill describes the portion of goodwill tied to the presence of a particular individual, usually the owner. In other words, the success of the business depends directly on that person’s involvement – whether because of a particular skills set, personality, or some other quality that attracts customers. When the seller leaves, the source of the goodwill leaves with them. It would be foolish to pay for goodwill that is, in essence, personal.
This is not only an important consideration when buying a business – it’s also a warning to current owners. If you plan to eventually sell your business as a going concern at a price that includes goodwill, you must avoid letting the success of the business become indseparable from your personal identity. Once that happens, you’ve created personal goodwill, and a well-advised buyer won’t pay for it.
Then there’s the matter of “potential,” which owners often invoke to justify a higher asking price. It’s frequently true that a business does have genuine “potential” – we’ve all walked into a business and imagined what we’d do with it. But why should a buyer pay for that “potential”?
To return to our example: if the potential hasn’t been realized and you are the one who will have to do the work to realize it, why would you pay the seller for it? It’s a bit like a homeowner expecting a buyer to pay a premium because the house could look fabulous with new windows and a fresh coat of paint. Again, why pay a premium for potential when you’re the one who has to invest time, money, and effort to achieve it? This isn’t to say buyers never pay for “potential” – but barring unusual circumstances, there’s little reason they should.
The bottom line, in any business sale, is this: a goodwill element in the price must be identifiable and transfereable to have real value. And “potential” only justifies a premium in truly extraordinary circumstances.
