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 article, the first in a series on goodwill, explains that it really represents the future profits of the business, that it really does exist despite what some people think, and that “buying a job” is not such a bad thing.

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.

For instance brothels are legal businesses in some countries and banned in others. Let’s say you know of a legal one for sale that makes a profit of  $1million a year. But you also know that a new Government has just been elected and they are going to close down all brothels. How much would you pay for it?

On the other hand I once valued a travel agency that had started from nothing about two years before and had never made a profit. But they had made very good advance sales to groups of retirees going on world trips in the next year and expected more through tie-ups they had made.

When the commissions on these sales came in they would be in the black. A buyer paid out good money for their business.

There is No Such Thing as Goodwill

I have clients say to me “Brian, I don’t believe in goodwill and I would never pay for it. As far as I’m concerned there is no such thing as goodwill. I would sooner start my own business from scratch”.

OK, let’s imagine you do that. You select a site, outlay a months rent in advance, pay legals and utility connection fees, fit out the shop, do the signage, employ some clerks, pay in advance for training and take out some advertising.

And you have not even opened yet. When you do, it might take 12 months for the business to break even (if it ever does), so you are subsidizing the business until then. And probably using borrowed money to do it.

How much does all that cost? About the same as the goodwill you would pay for the same business down the road that started 12 months ago and is now in profit.

This is not an argument to say that it is always better to buy a business rather than start your own. Sometimes it is and other times it isn’t. It’s just pointing out that goodwill really does exist and is to some extent a reward for the owner who took the risk in starting the business in the first place.

To my stubborn clients who still insist that goodwill does not exist, my final word is to say, “Fine, go and make an offer for the business down the road and say you only want to pay for the plant and equipment and the inventory. See how far you get.”

The starting point for valuing goodwill in a small business with annual profits of less than $200,000 is one years net profit after various adjustments.

Simple, isn’t it? Why one year’s net profit? For businesses of this size and average risk this is a rough rule that has been accepted for many years by brokers, sellers and buyers alike. Most rules of thumb used by brokers for these types of businesses – usually so many weeks sales or a certain % of annual sales  – when analysed

end up with the goodwill portion of the price being around one years true net profit.

Buying a Job

There is another reason as well for the one year standard. And that is that many buyers of this size business are “buying a job”. This is a term that is used contemptuously by some accountants and advisors, especially if the business has profits below the $100,000 mark. They say if you buy a business like that you are “only buying a job”.

In their view buyers should approach the purchase of a small business just like any other investment. Look at the risk and then add a loading to what you would get if you invested in, say, Government Bonds – a guaranteed, ultra-safe investment.

So if you got a 5% return from the bonds, you might add a loading of 20% for the risks of a small business. So you should expect a 25% return on your investment.

So far so good. However the other thing they say is, to make a fair comparison you should imagine you were a “passive investor”, just like you would be if you invested in the bonds. A passive investor means you don’t have to do anything to earn the money. You just buy the bonds and that’s it.

In other words, you should pretend you are still in a fulltime job elsewhere and that you employed a manager for your small business at a commercial salary.

On that basis many small businesses would never sell. Imagine a small corner store earning $50,000 profits before the owner takes anything. Given the hours that the owner works they would probably have to pay a manager $60,000 to do the same work.

This would make the business look like it is running at a loss and mean that it is showing a nil return on investment and is worth nothing.

But in reality it is worth something as these types of businesses change hands every day for good money – and usually around the “one year’s profit” mark.

People buy businesses like that for two reasons – independence and security. Independence because they are fed up with bosses telling them what to do. And security because nobody can sack them, no matter how tough the times.

They may not make much money and they won’t get a company pension, but

they can work past normal retirement age if they want to. And, who knows, one day they may sell out for a lot more than they bought for.

If that’s buying a job, personally I’m all in favour of it!

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 18th, 2009 | Tags: business valuations, buying a business, buying a job, checking out a business, definition of goodwill, diy business valuations, due diligence on a small business, 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  |