Sondra Stewart, CA, CBV, is president of Stewart Business Valuations Inc.
The single most significant asset for most business owners is their business. I’m often asked how business valuators determine a valuation approach for private operating companies. In other words, how is the decision made to either use an asset-based approach (a balance sheet approach) or a multiple-of-earnings approach?
The difference lies in the absence (or presence) of commercial goodwill. Commercial goodwill refers to goodwill that is transferable to a new owner, unlike personal goodwill which is generated directly by the owner’s skills and involvement in the business.
Businesses have two types of assets—tangible and intangible. Tangible assets are those assets that you can touch, like working capital, fixed assets, etc. Intangible assets refer to customer and supplier relationships, technology, business reputation, assembled workforce, management team, etc.
When looking at the overall value of a business, these intangible assets form part of the commercial goodwill—in other words, their presence supports the conclusion that the business value is greater than the tangible asset value.
To build commercial goodwill, owners need to build a company that will be transferable, consistently profitable and that can (eventually) function independently of them. A telling question for business owners is, ‘What happened the last time you tried to take a few weeks of vacation?’ Answers can range from, ‘I’ve never done that,’ to ‘nothing,’ to ‘there was an attempted management coup.’
A business needs to be nurtured with time and capital. Time is needed to build a reliable management team to reduce, over time, the business’ dependence on the owner’s personal efforts. The business needs sufficient capital to pay (and train if needed) a solid management team, fund capital maintenance and expansion, meet the business’ cash operating requirements and deal with unforeseen cash demands like the sudden bankruptcy of a customer.
Companies should investigate options in their customer and supplier relationships. If a key supplier provides 90% of a company’s inputs, it is critical to understand the nature of the supplier’s business. Particularly if the supplier is a smaller company that is vulnerable to succession issues, it can be prudent to have alternate solutions in place in the event of an emergency.
If a key customer represents the majority of a company’s sales, that customer’s business risks are now shared by the company. This riskier operating style can reduce value. That said, sometimes purchasers will be interested in acquiring a certain large customer to flow their own product through, which can increase the sale price.
Diversifying a client base is a daunting task. Sometimes just contemplating it can be a useful exercise that highlights the need for new team members. The management team should be industry experts in that they understand their competition and changes in the marketplace and are able to plan—as opposed to simply react.
For example, a common response from savvy businesses competing with smaller shops (with much less overhead and lower fees) is to develop creative strategies to define their particular niche. This usually involves leveraging their financial resources by brand building and by investing in assets (technology, staffing, additional locations, purchase of company providing complimentary services, etc.) that will provide an obvious value-for-fee advantage to their clients.
Management needs to document key business relationships, systems and processes in writing, to the extent possible. Proprietary works should be documented and where appropriate, protected by legal means. While some of this paperwork can seem tedious, it’s part of the framework that helps enable the future transition of the business.
A shareholder agreement, prepared by a lawyer experienced in this area, often will set out normal day-to-day expectations from the owners (such as duties and weekly hours devoted to the company) as well as help the owner group deal with unusual circumstances such as the addition or departure of a shareholder.
When building a business, reliable financial information received in a timely fashion is needed to monitor the business and make changes where needed. It is helpful to have a financial reporting system with some interim (monthly or quarterly) reporting capacity and an annual review performed by a qualified accountant.
Most business owners would benefit from some professional feedback on the various options regarding how to eventually get paid for the value of the business, be it through a sale to third parties or management or through an estate freeze. This is where a team approach (lawyers, accountants, financial planners, valuators) can really help map out what the business owner needs, and how to achieve it.
Owners need to discuss their plans and intentions with family members, who may have their own surprising assumptions about the future of the business. It can build a significantly different mindset within a family-run enterprise when the next generation realizes that the owner’s plan is not necessarily to gift them the future growth in the company, but rather, that the company’s focus is on maximizing the saleable value and that the CEO title will be earned, not awarded.
The ways to build business value are as diverse as the Canadian marketplace itself. What remains consistent is a need to build the business in a way that develops transferable goodwill, to ensure that when the time comes, the business builders are likely to be properly compensated for their years of effort.