guest commentary by David Potts
Editor’s note: David Potts is a certified public accountant with more than 33 years experience. Although every effort is made to provide you accurate and timely tax information, it is general in nature and not specific to your facts and circumstances. Consult a qualified tax professional to discuss your particular case. Feel free to e-mail topic suggestions or questions to firstname.lastname@example.org
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Almost every homeowner understands the concept of home equity. Home equity is the money you would expect to be left over after you sold your house and paid off the mortgage or loan.
Except in unusual times, with the passage of time, home values increase and mortgage principal amounts decrease providing the owner with stored wealth. Increasing home equity helps drive consumer confidence and economic growth because homeowners feel prosperous and spend this stored wealth because bankers beg you to borrow money and buy a new boat or motorcycle using your home as collateral.
Private business owners build equity in their business much the same way homeowners build equity in their homes. As their business grows it can increase in value and as business debt is paid down the equity in their business increases. Unlike real estate, the equity of a going concern business can be difficult to determine. Since banks are adverse to uncertainty, business owners generally are unable to borrow on the equity of their business.
Banks will loan on inventory. They will loan on accounts receivable. They will loan on equipment and real property. But ask your loan officer to loan you money secured by your company’s goodwill and see what he says. Yet for many companies, goodwill comprises a large, if not the largest, part of its value. So why is a bank adverse to loan a business owner money based on a company’s goodwill?
Let’s define goodwill in context of our discussion. Goodwill is a business asset. The International Glossary of Business Valuation Terms defines goodwill as “that intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified.”
Goodwill is intangible and therefore makes lousy collateral for a bank to secure a loan. You can’t repossess goodwill. But when a business owner decides to sell the company, goodwill is converted to a tangible asset: cash. Goodwill represents the premium price a buyer will pay for a profitable company with a future. It is the price a buyer will pay for a business that exceeds the value of the tangible assets, i.e., the building, the equipment, the inventory, signage, and such.
It is unusual to find a small or medium size business managing with the primary objective of increasing the value of their company. With most owners, business value is treated as a byproduct created by the business making a profit. But it’s not profit alone that determines the value of a business. As the definition implies, there are intangible aspects that drive a company’s value.
One aspect of business goodwill is repeat patronage. This should be the goal of every business. Every business exists to satisfy their customers. However monitoring sales totals doesn’t give a complete picture of the value of your customer base. Other indicators include client retention rates, gross profit per customer and whether or not you are the customer’s preferred vendor. If a new competitor came on the scene, how easily could they convince your customer to buy from them?
When trained sufficiently, a company’s workforce can also be a competitive advantage over its competitors. Companies that invest in their employees and companies that retain their employees accumulating years of experience add to a company’s value. This value is intangible, part of a company’s goodwill.
Documented systems and processes, marketing systems and brand development, a culture of innovation, efficient workflows ... all these and more add to a company’s goodwill. It is this creation and management of intangible assets that make a company more valuable.
In the end, a company’s value is dependent on and evidenced by a sustained, year after year generation of profits and strong cash flows that can be transferred to a buyer. Add in a history of growth with the expectation of continued growth and a company’s value climbs even higher.
Hard assets are generally necessary to generate a business’s goods and services, but it’s the intangible assets your company creates that ultimately determines how much cash you can leave the business with when your execute your exit plan.