EBITDA is an acronym for Earnings Before (deduction of) Interest, Taxes, Depreciation and Amortization.It’s a way of evaluating a company’s operating performance without considering financing or accounting decisions, or the tax environment.
From time to time, I receive a call from someone who wants me to tell them the value of a business that they want to buy or sell. They provide a few items of information, such as last year’s sales or net income and expect that I will apply a multiple to quickly and easily come up with a value*.
What they are asking me to do is apply a rule of thumb.
Continue reading “Using Rules of Thumb in Valuing a Business”
According to the American Institute of Certified Public Accountants’ Statement on Standards for Valuation Services, goodwill is “that intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified.”
The Internal Revenue Service defines it as “The value of a trade or business attributable to the expectancy of continued customer patronage. This expectancy may be due to the name or reputation of a trade or business or any other factor, and in the final analysis, goodwill is based upon earning capacity. The presence of goodwill and its value, therefore, rests upon the excess of net earnings over and above a fair return on the net tangible assets.”
What does this mean in English? Goodwill is the value of a business, over and above the value of its identifiable tangible assets. It is the expectancy of future earnings. As a simple example, assume a distribution business’s only asset is inventory with a value of $100, but someone is willing to purchase that business for $500. The $400 paid over and above the value of the inventory is payment for goodwill.
Why would someone pay more for a business than the value of the tangible assets? Because they expect to use those assets to earn a profit. In the distribution business or any business, goodwill may include customer relationships, supplier relationships, reputation, location, trade secrets, or any other factor that causes the business to earn income above and beyond a fair return on tangible assets.
How can you create or increase the value of goodwill in your business?
If goodwill is based on customer relationships, is the goodwill owned by the business or the employees who maintain the relationships? This is an area of controversy because it has significant tax ramifications in the sale of some businesses, but the courts have generally held that goodwill is owned by the employee unless he or she has executed a restrictive covenant or employment agreement with the company. If no such agreement exists, and the employee is free to work for a competitor and bring the relationship there, then the company does not own the goodwill. However, if you are considering selling your business and do not have restricted covenants or employment agreements, consider very carefully whether or not they are necessary.
When is it necessary to have a business valued? There are many more reasons than you think!
