By far the biggest part of the purchase price of a small family business is goodwill. So it is vitally important to a buyer to have knowledge and understanding of just what goodwill is and how to place a value on it.

This is the second in a series of articles on valuing goodwill and explains that the first step is to break down the goodwill into components.

The first of these is “Factors That Change Future Expected Profits”.

Goodwill is usually defined as “the value an interested but prudent purchaser would pay for the expected future profits of the business.”

So how much should this prudent investor pay for these expected future profits? “Well, it depends” you reply. “Depends on what?” I ask. “It depends on the circumstances of the business”.

Absolutely correct. The key words here are “future” and “circumstances”. A buyer wants to know as much as possible about what is going to happen in the future, not what happened yesterday or last year.

And the buyer wants to know what circumstances exist that may increase or decrease their risk or alter their bargaining position.

After many years of valuing small businesses of this size (defined here as businesses with profits up to $200,000 per annum), I have broken down these “circumstances” down into five major groupings – I call them “The Components of Goodwill”.

They are:-

Factors that Change Future Expected Profits

Factors that Affect the Risk Level of the Business

Factors that Affect Your Bargaining Position

Other Factors

Buying in Times of Recession

The very first step in valuing goodwill is to calculate what is usually called the “Sellers Discretionary Earnings”, or SDE. This becomes the “base goodwill”.

In valuing goodwill this base figure is adjusted up or down according to how much the above factors affect the business. Let’s look at each in turn. The first one is:

Factors that Change Future Expected Profits

Sales and Profit Trends

If you are a property investor you will be familiar with capital growth. You buy a rental property for so much and a few years later it’s worth a lot more when the rent increases.

It’s the same with a small business. If the sales and profits are increasing and the business is expanding, then obviously it’s value will increase accordingly. The reverse is also true.

Profitability Trends

This is different from profit trends caused purely by increased sales. Something is happening in the industry that will increase or decrease the margin you can add to your prices.

This could be caused by your products or services becoming more fashionable and in demand and so able to command higher prices. Or there is a coming shortage of supply, or buying prices are dropping due to mass production. Or production costs are dropping due to new technology.

It could also be the reverse. Margins are tighter due to increased competition or your products or services are becoming obsolete.

To be clear, I am only talking about profitability trends that are already in train. The vendor will tell you all about them.

You should not have to pay for improvements of any kind that you know you can make after you take over. These could be from better management, more professional marketing, improved efficiencies, sourcing of cheaper purchases etc.

Known Future Cost Increases

A good example of this would be an upcoming market rent review where you know the cost is going to increase significantly.  Find out or estimate what the annual increase is going to be to the best of your ability, and deduct it from the base goodwill.

Utility, waste disposal and insurance price increases are other examples

This article was written by Brian K Fitzgibbon CPA.

Brian is an experienced accountant and small business consultant. He runs his own business, lectures extensively on small business topics and has checked out and valued many hundreds of small businesses for buyers.

Brian is also the author of the highly acclaimed and invaluable
"How To Value A Business And Buy It Without Fear"
A do-it-yourself guide for first-time and experienced buyers alike.

To download a FREE Chapter from Brian's book please follow this link: "HowToValueBusiness.com"

August 20th, 2009 | Tags: business valuations, buying a business, buying a job, checking out a business, components of goodwill, definition of goodwill, diy business valuations, due diligence on a small business, future expected profits, goodwill valuation, how to buy a business, how to value a business, tips on buying a business, valuing franchises, valuing goodwill in a small business | Category: articles | Subscribe to comments | Leave a comment | Trackback URL  |