Creating Business Value
Wait a minute there is a huge difference. Assume for instance you are a famous
scientist that just made a machine that would make pure gold and the cost of
the machine was $20,000. How much would someone pay for this machine. I am willing to bet it would be more than
$20,000. But how much more, is the Appraisers dilemma. Well the first thing to decide is how much
production is it capable of and secondly how long will the machines run. All
machines need maintenance and surely as sophisticated as this one is, what will
Where will we get the parts, are they available and how
expensive would they be? Who is qualified to repair this machine? Is the
inventor the only one who could fix it? How long will this genius be around and
what will he charge for consulting or repair?
Oh no, what if this ability to make pure gold is illegal and if not
how long before Uncle Sam decides you are ruining the economy
and passes laws to stop your production? But wait, maybe they would want to buy
it. Oh my God, how much more would Exxon pay? Forget Exxon, what about Germany,
no wait, the Chinese or Russians? However, the Saudi's have all the cash.
I wonder what the value of this machine is now. I would bet
millions or even billions. What do we call this increase in value? Is this blue
sky? Is this increase in value really
real? Surely not, since the SBA is only
willing to loan $20,000 plus one half of this so called blue sky, and not to
exceed $250,000. Maybe with this
thinking a buyer should forget this machine as it is obviously risky with all
that goodwill and purchase another machine that only has cash flow that will
support a loan of $40,000.
I think you can see by this silly scenario that there is goodwill. A business should be looked at the same as a money machine. The appraiser needs to study the company to find its strengths and weaknesses and calculate risk. Based on its current operation what does the future hold for this business? Will future government regulation slow down or end the cash flow? What about the company’s suppliers, is cost going to increase; is there other suppliers the company can buy from or are is the company at the mercy of a single supplier. As stated above, all machines need repair, so what kind of condition is the equipment in and how old is it. Does the seller have a good reason for selling his or her business? How hard will it be for a new owner to fill his shoes? It’s good to hear that the workforce has been with the company for years with hardly no turnover and that these excellent employees and managers made the company grow throughout the years, but what is the age of the employees and management? Are they all going to retire soon? When was their last raise?
Just who are the company’s customers? Is that one big account that represents over 50% of their business going to buy from the company through ownership change; and are they under contract to buy; or is the customer’s CEO a long time college buddy of our retiring seller?
Another factor in calculating risk is the economy and the company’s trade area. Based on the foreseeable future, is the company’s product or service going to be negatively affected?
Salaries and wages are usually the second largest expense after cost of goods. Considering the nature of the business and the degree of technical expertise needed to make the company’s products; is the new owner likely to find new people to replace retiring employees and management; and what will they have to pay them? A shortage of talent is like everything else, the more scarce, the more you have to pay. Being the second largest expense, and not able to project future costs, means any projections are guesswork, and as we all know, anticipated future earnings is the foundation of all valuation models.
Value has a lot to do with the size of the buyer pool. Is this company such that the technical expertise needed to manufacture, improve, market, and upgrade its product such that only a handful of buyers are qualified; or would it be a perfect fit for the thousands of unemployed managers from corporate downsizing.
Ease of entry plays a big part in value. How hard is it to start up and compete with this company? If you are successful, one certainty in business you can count on is your neighbor will be selling a close substitute product or worse; one of the huge companies with millions to spend on advertising and marketing will shut you out of the market completely. If a buyer can open up across the street from the business and make as much money in six months to a year, why would the buyer pay 4 or 5 years of earnings. However, if the buyer was looking at a substantial upfront investment in assets and a 5 hard years to get where the owner is now; knowing he would be constantly shelling out his personal capital to keep his new start up business afloat and receiving no salary during those 5 years, would realize he would be way ahead by paying the 5, 6 or maybe 7 years of earnings because he would start making money the first month, receiving a salary and does not have to compete with the company.
Every question in this article must be assigned a degree of risk. The compilation of these risk factors determines the capitalization rate or multiple of earnings used to establish the value of the company and determine its goodwill.
The Small Business Administration (SBA) defines goodwill as:
“Goodwill” is created when an existing business is acquired
and the acquiring entity pays more for the business than the book value of the
business’s assets. Simply put, “goodwill”
is the premium the seller is requiring as part of the purchase price (and the
buyer is willing to pay) for an established business in the marketplace as
compared to that same buyer starting a new business. By paying a premium for an established business,
the buyer is relying on the existing business’s established market share to
continue due to such reasons as an established customer base, a premium
location, etc. (Customer lists and
non-compete agreements are documents that the seller may provide to support the
goodwill the seller is requesting.)
Therefore, simply stated, it is the difference between what
a company will sell for and it’s hard assets.
To get to the price the company will sell for, the appraiser has
researched, analyzed, compared prior sales and analyzed a myriad of factors
that would contribute to or decrease value.
In the Excess Earnings method, each asset of the business is analyzed as
to the return it should earn. The amount
of earnings after this is considered excess and is capitalized to calculate
In summary, there is a huge difference between goodwill, blue sky, and pie in the sky, because goodwill is painstakingly analyzed, researched, compared to comparable sales and calculated. Blue Sky and Pie in the Sky are values that are guessed at or just pulled out of thin air so the next time you hear someone using them interchangeably I hope you will correct them.
Article written by George Abraham, CEO, Business Evaluation Systems