To make your business worth a lot of money (and therefore to make you worth a lot of money) you need to work at developing goodwill. Here’s how to make your business valuable.
The development of the goodwill of a business is the fastest and surest way to become rich. Goodwill is wonderful because it is basically wealth that comes out of thin air. Goodwill is not a tangible ‘real’ asset that has to be purchased from retained profits.
The glory of goodwill
Goodwill is something that can be developed in the normal course of business without any additional investment being required. Goodwill is a reflection of the fact that you have chosen a good business to get into (one with high barriers to entry) and run it well. Most service businesses (plumbers, builders, consultants, etc) have very little goodwill because such businesses can be started up easily.
Goodwill is a premium; it is the extra money you are paid when you sell your business, above and beyond what the tangible assets are worth.
When someone buys a business, they buy two things;
These are things like plant, equipment, machinery, motor vehicles, stock, etc. They are the hard, real assets that are necessary for the running of the business. They have been purchased with the owner’s cash either at the start of the business or out of profits during the life of the business.
These are things like goodwill, brands, licenses and concessions and restraint of trade (the person selling the business promising not to go back into that type of business for a number of years). The intangible assets have been developed seemingly out of thin air, but have a value because of, and based on, the ongoing profitability of the business.
People going into a business have the choice of buying the tangible assets they need and going into business from scratch as a start- up, or buying an existing business that is already up and running.
Goodwill is the premium that the buyer pays to get a ready-made business. Its amount is calculated largely by the profitability of the business. As a general principle, a business will be worth somewhere between three and eight times its annual profit after the owner’s salary. (There are lots of exceptions to this, but the basic idea applies to the sale of most businesses).
Therefore, if a business is making $100,000 p.a. net profit after tax and after a salary for the owner, and a multiple of four is used, its total value would be $400,000.
If a buyer resists the temptation to start up from scratch, and buys the existing business for $400,000, ($150,000 of tangible assets and $250,000 for goodwill), they have paid $250,000 more for ownership, but they have also bought some considerable advantages:
- The systems are all developed
- The markets and customers know that the business exists and are used to buying from it
- Suppliers will continue to supply their goods and services
- Staff are in place and trained
- The sellers of the business will not compete against the new buyers.
All these things (and more) add up to one very important point: from the day the new owners pay their $400,000 and take over the business it will be profitable. Right from the first day, there will be an income. The new owners will not have to spend time in developing business systems, training staff, finding customers and so on. The business simply continues under the new owners as it had under the old ones.
That is why people pay goodwill – for the continuation of the business and its profitability, so that the stream of earnings and profitability is uninterrupted.
What makes a business valuable?
Goodwill is your reward for running the right business in the right way, the premium that a buyer will pay over and above the value of the assets because the business uses those assets efficiently and well to make good profits.
To make a business worth a lot of money (and therefore to make you worth a lot of money) you need to work at developing goodwill. A high goodwill value is how people become rich through their businesses. However, only some businesses attract a high goodwill figure; in certain industries businesses will only ever sell for a little goodwill, and these are, of course, industries to avoid if possible. Many forms of consultancy are like this, as most of the goodwill from customers accrues personally to the consultant rather than to the business. Even though the consultancy maybe quite profitable, it will not be able to be sold with a lot of goodwill as it walks out the door with the consultant.
Businesses that are valuable:
Have good sustainable profits
No-one will pay a lot for a business if they think the profits that have been made are not going to be ongoing. A buyer will want to be confident that the profits and therefore the return on investment are gong to continue.
Have growing profits
Most buyers will want to be able to improve and enhance the business to make better profits. A smart business buyer knows that if the profits can be increased the value of the business will increase in proportion. The example above showed a business with profits of $100,000 a year being worth $400,000. If the profits can be increased to $150,000, then, all else being equal, it will continue to be worth four times its annual profits, and so be worth $600,000.
Are not dependent on any one person
The business should be independent of you not only in a process or technical sense (others should easily be able to do the work or sell the product), but also in a marketing sense. It is not a good idea to have your name attached to the business (John Smith Printing Ltd). This makes it harder to pass on the goodwill to someone else; it is far better to have a generic name, like Ace Printing Ltd.
Have good systems and processes.
The business can be easily managed and run without your minute-by-minute intervention (McDonald’s has such good systems that the business can be run by teenagers).
Are not easy to copy
Perhaps this is because of location, strong branding, a special recipe, distribution network, exclusive stock or agencies or some other special factor. Some sort of barrier to entry stops (or at least slows) others from setting up a similar business.
Have a likely end-buyer
It is good to know what sort of person (or company) is likely to be the eventual buyer of your business. You may think that your engineering business would be ideal for a farmer who is retiring to town, your chain of four shops valuable to a large retailer who is in competition with you, or your fruit juice company valuable to a large corporate already in the food business. It does happen that people develop good businesses that do not have a natural buyer. This can be especially so when the value gets too high for most individuals to contemplate (over $2 million is too high for even most retiring farmers) but is not high enough for a corporate to think worthwhile (as it is less than $5 million).
You need to find a business that you can get passionate about, something which is a good fit with who you are. However, run checks on your choice; will it be something that can be built up and sold? Will people want to buy it and pay for the privilege? Can you build a business that is so good in your market that no-one will want to take you on from scratch? These are really important questions, ones that need thinking through before you start to create an even bigger enterprise.
Reprinted from ‘Get Rich, Stay Rich,’ by Martin Hawes and Joan Barker with kind permission.