As a business owner, one of your long-term objectives is to build and grow the value of your business. The question often raised around that goal is “What will drive business value?” In my experience, the most significant driver to increasing value is the goodwill of the business.
Simply stated, goodwill is a business’s ability to generate more profits and cash flow than one would otherwise expect it to, given the business’s tangible assets.
There are many different types of goodwill. It is important to understand how each of them impacts the value of your business. You also need to be mindful of the potential “bad” goodwill of your business – which can significantly hinder the future value you are trying to create.
Generating the right kinds of goodwill
The following forms of goodwill will most likely drive the value of most business types across many industries. Note: Some may not be applicable to your particular business.
Goodwill driven by location
A business may accrue goodwill because of its physical location. For example, let’s say a business operates a specialty coffee and pastry shop located on a busy commuter route in an area made up of commercial offices and warehouse buildings. This specialty shop enjoys a high volume of drive-by and walk-in customers, either because of its proximity to their place of work or its convenient location on their route to work. For that reason, the business generates a superior return on its net tangible assets employed.
Goodwill driven by product sold
Some businesses accrue goodwill because they have a specific product identity and acceptance that appeal to its customers and potential customers.
An example would be an outdoor furniture manufacturing business that is nationally recognized in the marketplace for its high quality, durable rattan patio sets. By virtue of its ability to efficiently produce superior-made rattan furniture, the business has gained significant market share and realizes high-net profit margins.
Goodwill driven by service
For businesses in the service industry, their service delivery model is what drives their goodwill. Their high level of customer service drives the identity and acceptance of their service in the minds of customers and potential customers.
Here, an example would be a florist that supplies and delivers flower arrangements to the high-end major hotels in a city. Contracted by these hotels, the florist has developed a reputation for supplying quality arrangements on a consistent, timely basis. Moreover, the florist carefully monitors and oversees the flower displays for the hotels. They therefore provide a hassle-free service to their customers, ensuring high customer satisfaction and high rates of return.
Separating your business from “bad” goodwill
At first glance, the concept of “bad” goodwill seems counterintuitive. But indeed there is a type of goodwill that doesn’t drive business value: personal goodwill.
Personal goodwill arises from an individual’s particular abilities, good name, and reputation. All well and good, but personal goodwill is not transferable, either by contract or otherwise. Since this type of goodwill is intrinsically linked to a specific person, it will expire when that person loses interest in their business; retires as a result of personal choice, age or disability; or passes on.
And being non-transferable, personal goodwill has limited commercial value.
Consider a situation where a business is largely driven by the efforts, skills, and connections of its owner. This individual may have gained significant prominence, enjoyed high annual earnings, and have accumulated substantial economic wealth. Certainly, the specific skills of the owner have created economic value.
But the owner hasn’t trained others. Nor have they put systems and processes in place to replicate the business tasks they are currently responsible for, or to ensure their skills and contacts are passed along.
Don’t get me wrong. In many cases, the value of a business does include a significant portion of personal goodwill. However, it needs to complement the other, longer-lasting types of goodwill.
Through the use of employment contracts and non-compete agreements, sellers often try to convert some of their personal goodwill to saleable goodwill. But that may not always be possible. There is a strong probability that a future purchaser will not pay for this type of goodwill. And, since it isn’t transferable, why should they?
After all, you can’t transfer your reputation, skills, or abilities. And it is difficult to transfer the relationships you have built up over the years.
So, if your business is highly reliant on you being there in the day-to-day operations, you are likely limiting the value of your business. If you want to enhance and maximize the return on your business investment, you need to build up your business’s other, longer-lasting types of goodwill.
How do you do that? Think about implementing these four key strategies:
- Focus more attention to working on your business rather than in it
- Develop systems and processes that can be relied upon – not that rely on you
- Transfer, wherever possible, your unique skills and knowledge to your team
- Develop your team to the point where you can truly become redundant.
Focusing your attention on these four areas will give you the greatest chance of creating future business value – value that a prospective purchaser is prepared to pay for, because you have created a business that has continuity value.
Rick Gendemann, CPA, CA, is a partner with Manning Elliott LLP. Rick specializes in estate planning and business succession services for Canadian owner-managed businesses in a wide range of industries.
Originally published on Manning Elliott blog, July 2017.