How to bridge the personal-corporate goodwill gap
Finally some good economic news! Economic activity in the service sector (also defined as the non-manufacturing sector) grew in August for the 21st consecutive monthly, according to the nation's purchasing and supply executives in the latest Report on Business®.
For the most recent period studied (August), the non-manufacturing index (NMI) registered 53.3 percent, indicating expansion in the services sector. To understand this number, a reading above 50 percent indicates that the non-manufacturing sector is expanding; while below 50 percent states that the sector is contracting. (So maybe I had to dig hard to find this... at least it's something positive.)
Today, the service-based economy is a higher percentage of U.S. GDP than it's ever been. A quick run through the Fortune 1000 finds more and more services businesses and fewer manufacturers than the prior 40 years. With the number of services based businesses increasing (particularly relative to manufacturing), the issue of goodwill becomes even more significant when dealing with mergers and acquisitions.
We were presenting to a group of business owners in California recently and the president and owner of a widely respected engineering firm asked the question: "Is a manufacturing business worth more than a services business, because services-based businesses are mostly valued on goodwill?" The answer is both yes and no, and it often hinges on how dependent on the owner the business is.
The connotation of goodwill includes the value of customer lists, distinct and documented unique processes, brand value, and other similarly intangible assets. In particular and for most services businesses, the value of intangible assets (such as goodwill) far exceeds the value of the tangible assets. Since the value of goodwill in a privately held services business can be tough to identify, it is often only estimated when a buyer wishes to acquire a company. This is not the time to understand what kind of goodwill you have in your business. From our experience, there are two types of goodwill; corporate (or industrial) goodwill and personal (or professional) goodwill.
Corporate goodwill is the goodwill associated with a particular institution or organization. For example, the goodwill of a company such as Pepsi may include the value of its brand, as well as its formulas - both excellent examples of corporate goodwill. Neither of these intangible assets for Pepsi is dependent on a single person. To understand personal goodwill, look no further than your dentist.
Perhaps another differentiating factor can be addressed in one simple question: Are the customers buying from the company (Pepsi or the local dentist, in the aforementioned examples) because they like the company or the individual? We probably select our dentist not by the impression of his or her company or by the cool logo, but by the quality of service that the individual (dentist) provides.
Most services-based businesses start by building personal goodwill. As entrepreneurs, our job is to convince prospects that we are good people to be working with and that we can help them with some need they have. As the business grows, however, it is important that the goodwill transition from personal to corporate. Failure to make this transition often results in a lower valuation come time to sell and a deal structure that shifts deal risk to from the buyer to the seller.
One way to transition to corporate goodwill when starting with personal goodwill is to build depth at key positions within the business. For example, if current key customer relationships are managed by the owner, adding an experienced sales manager and ultimately transitioning the key relationships to that individual can solve that issue.
Another strategy for building corporate goodwill involves the business owner stepping away from the business. We often ask our business owner clients if they were to leave their business for six months and not report back or check in during that time period; what would the business look like upon their return? This question highlights risk not just with key relationships of the business, but also risks around company leadership and documented business processes that are critical to the organization.
Issues of goodwill are best identified well in advance of a potential sale. By asking questions about the importance of the owner to the business well in advance of a potential transaction, the business, and the business owner, can prepare to maximize business value. The less important the owner is to the business, the more likely the business is to have corporate goodwill. And where there is corporate goodwill as opposed to personal goodwill, there is generally, higher value and a more attractive deal for the seller.