Let’s say that you’ve been offered to purchase a small business as a going concern—a turnkey operation— and the asking price is $1 million. It’s obvious to you that the net tangible asset value, that is to say the tangible assets such as equipment, receivables, and cash less the liabilities such as payables, doesn’t even come close to $1 million. In fact, in your opinion, the net tangible asset value cannot be more than, say, $500,000.
So, presumably, the additional $500,000 of the asking price represents what is referred to as intangible assets. 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.
In a business sense, goodwill 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 a business’s success. If the valuation for this going concern—typically a capitalised sustainable earnings calculation—indicates $500,000 in goodwill, that would be quite normal.
But simply knowing goodwill is indicated shouldn’t be enough for an astute, well-advised acquirer like you. You are going to want to know what actually constitutes the indicated goodwill value. While it’s legitimate to pay for goodwill if it’s expected to continue after the business changes ownership, that doesn’t hold if any elements of the goodwill disappear when the business changes hands; that’s a different matter. 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 as much as all of it. Personal goodwill describes the portion of goodwill attached to the presence of a particular individual or individuals, usually the owner. That is, the business’s success depends directly on the owner’s presence. This might be because of a particular skill set, personality, or some other unique factor that attracts customers. In such circumstances, when the seller leaves, the goodwill leaves with them. You would obviously be foolish to pay for the portion of the goodwill deemed to be personal.
So, this is not only an important consideration when purchasing a business, but also a warning that, as an owner, if you plan to eventually sell your business as a going concern at a value that includes goodwill, you must avoid confusing your identity with your business’s. You don’t want the success of the business to be associated with your persona—that’s creating personal goodwill for which a buyer should not be willing to pay.
Then there’s the issue of “potential” owners raise when they claim their business has a lot of it and should therefore attract a good price. It’s often true that a business has good “potential”—we’ve all visited a business and speculated on how we’d realise its full potential. But why would a buyer pay for the “potential”?
Continuing with this example, if you’re the potential buyer and the potential hasn’t been realised, and you have to do the work to realise it, why would you pay the seller for it? It’s a bit like a house seller expecting the buyer to pay a premium because the house could look fabulous with new windows and a coat of exterior paint. Why would the buyer pay a premium for potential if they have to spend time, effort, and money realising it? This isn’t to say buyers never pay for “potential”; barring unusual circumstances or some compelling reason, I can’t see why anyone would.
The bottom line, therefore, in a business buy-sell situation is that if the price includes a goodwill element, it has to be identifiable and transferable to have value. And “potential” only has paid-for value in extraordinary circumstances.
