How do you value a business?

Is your business worth as much as you think?

Many business owners who have been closely involved with their company’s daily operations are surprised to discover their business is worth less than anticipated when selling due to the existence of personal goodwill. In order to understand what personal goodwill is, we must first understand how value is generated.

Fair market value

The fair market value of a company is directly related to the future cash flows the company is expected to generate and the risks associated with the company’s ability to continue generating those cash flows subsequent to a sale.

Types of Goodwill

In general terms, “goodwill” exists as a result of a company’s ability to generate an above-average return on its operating assets. The more profitable a business is, the more likely the existence of goodwill. Goodwill is comprised of a number of so-called “intangible” assets, such as a business’s reputation, customer relationships, brand, location, and workforce. The various components of goodwill fall into one of two categories – personal goodwill and commercial goodwill:

  • Personal GoodwillPersonal goodwill attaches to the shareholder and relates to items such as the shareholder’s reputation, skill or personal client relationships. Unlike commercial goodwill, personal goodwill walks out the door along with the old owner.
  • Commercial GoodwillCommercial goodwill consists of components transferrable to a new owner, such as location and brand that are attached to the business. Since these items will remain with the business after a sale, there’s little risk associated with new ownership obtaining the future returns generated by these intangible assets.

An example

Consider two owner-operated sports therapy clinics with identical profits. Clinic A is known for its competent, friendly and knowledgeable staff, many of whom have developed long-term relationships with their patients. Although Shareholder A plays an active role in the clinic’s daily operations, it is a behind-the-scenes role with limited patient interaction.

Contrast this to Clinic B’s clientele who specifically request the services of Shareholder B and who are indifferent to the services provided by Clinic B’s staff. In the above example, Clinic A’s business will continue to be profitable subsequent to its sale and the departure of Shareholder A.

This illustrates the existence of commercial goodwill rather than the personal goodwill that exists in Clinic B, whose profits will dramatically decline subsequent to the departure of Shareholder B.

Conclusion

With this knowledge in mind, owners should endeavour to convert their personal goodwill into commercial goodwill that will remain with the company – well in advance of the sale of the business. This is done through the transfer of the shareholder’s knowledge, relationships and skills to the employees that will remain behind. A holistic approach to succession planning involves proactively converting the shareholder’s personal goodwill (i.e., business contacts and relationships) to commercial goodwill to the greatest extent possible, as well as developing an effective tax strategy, thus helping to ensure they obtain the greatest financial reward for the time and effort spent developing their successful business.