PROTECTING THE VALUE OF YOUR BUSINESS
Businesses can be started in many ways. They can start as a hobby that grows into a business. They can develop from someone that has a technical ability, such as a doctor starting a medical practice or a carpenter that becomes a registered builder, or they can be purchased.
It doesn’t matter how a business starts, the major defining factor that separates businesses from an income source, is the ability to develop a value for the business called goodwill. Successive federal governments have recognised that small business owners often work for less than what they pay their employees, and to encourage small businesses have introduced valuable capital gains tax concessions for small business owners.
Goodwill can relate to the name of a business, a product, or a location. If you want to protect a business name or product name this can be done by registering a trademark or a copyright. This however can be costly. An interim step is to incorporate a company with the name of the business.
Where the value of the goodwill relates to a location this must be protected. The ultimate protection comes from owning the property. If this is not an option long term leases need to be signed. These can be leases for a 3 year term that have several options to renew. If the business is not protected by a lease it’s goodwill value can be lost or diminished because a landlord does not renew the lease.
When buying an established business, where goodwill is included in the price, the terms of the lease for the business location should be checked. This will include establishing what the lease terms are, in other words a three-year, five- year or longer lease term, and the landlord should be contacted to make sure the lease can be transferred or a new lease entered into.
When a business is purchased as a going concern it is important to break down the purchase price into its component parts, which can include trading stock, plant and machinery, trademarks or copyrights, and goodwill.
Where goodwill is included in the purchase price of the business it is important to ensure it actually has any goodwill. As a rough rule of thumb the price you pay for goodwill should be 3 to 5 times the sustainable net profit of a business. In some cases less risky businesses can be sold a lot higher multiples of the sustainable net profit.
Sustainable net profit is calculated by increasing the net profit of a business for expenses that relate to ownership, such as interest, private motor vehicle expenses and large superannuation contributions, and decreased where working owners have not been paid a wage or operate from a location they own that will need to be leased. The sustainable net profit figure is the amount of money that the business should produce if purchased as an investor that does not plan to work in it.
To make sure that the value placed on the goodwill of the business you are buying actually exists, you should have an accountant review the financial statements for the last three years.
Unfortunately over the years I have had a number of clients tell me about a business they have purchased, rather than having contacted me as a part of assessing whether to buy the business. In some cases these clients had not really purchased a business, they had paid a large sum of money for what was really a job.
Upon reviewing the financial statements for the business, and taking into account the net profit for the business included wages for everyone except the owners, there was no real profitability to base a value for goodwill on.
For those clients that contacted me as a part of assessing whether to buy a business, and after establishing that the sellers were working more than 50 hours a week and not receiving a wage, the possibility of working for less money per hour than they were currently receiving as employees, did not appeal!
In addition to proving that a business actually has a goodwill value, it is also important to make sure that other valuable assets being purchased are owned by the people or entity selling the business.
These can include trademarks, patents, business names, copyrights, etc. Do not fall into the trap that VW did when they bought the Rolls Royce Car Company. After the purchase they found that the company they bought owned the naming rights for a Bentley. It transpired that BMW had bought the naming rights to Rolls Royce when they bought the Rolls Royce jet engine Company. Once you have protected the value of the business that you are starting or purchasing, the next step is to start working on the business, as well as working in it, to make sure that you maximise its goodwill value; but that is another story.
