Monetize your Goodwill – your hidden goldmine

by Mark Wardell

To maximize its value, every company should be set up and operated so that it can be readily sold. When or if you choose to sell it is immaterial, because sooner or later every business owner must face the reality of this inevitability.

In order to maximize the sale value of your business, it must become an entity in and of itself. In other words, you need to think of your entire business as if it were an enormous, complex entity, separate from you, the owner. Only then can you systematically go about increasing its value.

What is value?
The real value of every business is found in its inherent intellectual capital, not in the size of its inventory. That’s because products don’t have value, benefits have value, and benefits are intangible. For example, you don’t go to the store to buy a drill bit, you go to the store to buy a solution for making a hole. If someone gave you a better option than a drill bit for making a hole, you’d take it instead, wouldn’t you? Because the product itself holds no value to you. It’s the solution you’re interested in. It’s the solution you’re willing to pay money for. The same is true for your business.

So how do you increase your intellectual capital? By capturing and maximizing it, in a way that is sustainable. In the majority of businesses, most of this value is stored inside the heads of a few key people. Without them, the business would rapidly get into trouble. So the challenge is to capture this individually stored knowledge for the ongoing benefit of the business.

Goodwill
To understand the value of your intellectual capital in a measurable way, you’ll need to understand the value of your goodwill, described as the value of your business, over and above its liquidation value.

There are two kinds of goodwill. Sellable goodwill, referred to as “business goodwill”, represents the potential profit from the sale of your business. Unfortunately, if you’re like the majority of business owners, much of your goodwill is un-sellable. This is referred to as “personal goodwill”. It has value to you, but has little or no value to a prospective buyer, because if you leave, you take it with you.

How to increase your value
Because goodwill typically has minimal liquidity (i.e. can’t easily be turned into cash), it represents the greatest risk factor to a potential buyer. One of the chief concerns a buyer has is how long it will take them to earn back the goodwill they purchased, using discretionary earnings (dollars available after normal business expenses) from the company.

Consequently, when all is said and done, the value of your business is based on two primary variables. The amount of its discretionary earnings and the length of time those earnings are likely to continue, once the business has changed hands.

The length of time a business can sustain its earnings directly impacts on what we call its “earnings multiple”. This is the multiple a purchaser applies to the discretionary earnings to arrive at the price they are willing to pay for the business. Simply put, if the business is able to sustain itself for a longer period of time, then its earnings multiple will be larger. Of course, the reverse is also true.

As with all investments, a buyer will typically look for a greater “return on investment”, that is purchased at a lower price, when the risk is perceived to be higher. Conversely, all other factors being equal, a buyer will typically be willing to pay more for a business when the risk is perceived to be lower. Therefore, an owner can expect to receive a higher earnings multiple for their business if the perceived risk of failure is reduced.

How much growth in value is possible?
The answer to this question is typically impacted by a number of external factors. However, all things being equal, it is possible to systematically double the value of most private businesses within three years. Consider the following simplified example.

At Wardell, a typical client experiences an earnings growth rate of 20% per year, but for our example below, we’ll assume an annual growth rate of only 10%. Assuming $500,000 in annual discretional earnings and a starting multiple of 2.5 times earnings (i.e. 2.5 years worth of earnings), the following chart demonstrates the impact on value of a multiple increase of 1.5 times, over a 3 year period. As you can see, the estimated value of the business has more than doubled, from $1,250,000 to $2,662,000.

Even more interesting, however, is the relationship of this growth to a company’s goodwill value. In the above example, if we assume that the tangible assets of the business totalled $750,000 at the benchmark stage, then at that point the estimated goodwill value of the business was $500,000 ($1,250,000 - $750,000). Assuming the tangible assets grew to $1,000,000 over the following 3 years, all other things being equal, the goodwill value of this business would have grown from $500,000 to $1,662,000 ($2,662,000-$1,000,000). That’s a 3 year increase in goodwill value of 332%, or an additional $1,162,000 (%1,662,000 - $500,000). 

As you can see, while most people focus their efforts on increasing earnings alone, exponential results can be achieved by increasing both your earnings and your earnings multiple simultaneously. Or to put it another way, the best way to achieve real growth is to focus on value.

The financial benefits of a solid infrastructure are undeniable. But there is yet another benefit to building your company properly. Time. While every business owner must eventually face the reality of succession, not everyone is on the same timetable. But by properly developing their business, one can gain a tremendous amount of time-freedom from it while still functioning as its owner. When you sell your business is up to you, of course, but there is beautiful irony in the fact that the more your business is worth, the less you may feel the need to sell it.

Click here to learn more about Wardell-powered Business Valuations