Businesses Have Tangible and Intangible Assets
Businesses have either tangible or intangible assets. Tangible assets include current assets (such as cash or accounts receivables) and long-term capital assets such as physical equipment, vehicles, and land. Conversely, intangible assets are non-physical in nature and include a company’s goodwill, brand, name recognition, customer base, employee relationships, leasehold rights, and intellectual property. Intangible assets may be indefinite (such as a brand that stays forever with a business) or definite (such as a non-compete agreement given to the business by an individual for a certain period of time).
Intangible Assets Drive Business Sales
When one is selling a business, the primary factor in determining the value of the business is its intangible assets. A business that is not profitable is sold as an ‘asset sale’ with no value assigned to its intangible assets. An ‘asset sale’ is simply the best estimate of a company’s tangible assets. No value is given to its intangible assets because the business is not generating profits. Intangible assets represent the value given to a business above and beyond its mere physical value.
Buyers Want Free Cash Flow
Ultimately, a business buyer wants to know how much free cash flow they can expect to earn from the business during their ownership period. Free cash flow is defined as the reported profits of a business (not including depreciation as an expense) after regular capital expenditures and changes in working capital. Buyers will typically pay a multiple of 2-4x a business’s annual free cash flow. Tangible assets may help a business generate sales and ultimately free cash flow, but they cannot do so independently. A business must use its intangible assets to actually generate customers, sales, and ultimately free cash flow.
In Business Sales, the Goodwill Represents Premium Paid Above Tangible Assets
Goodwill is the portion of the purchase price of a business that represents the premium paid above and beyond the net asset value of the business. The net asset value is simply the fair value of the company’s current or tangible assets (including cash and accounts receivables) minus its liabilities. If the purchase price paid is less than the net asset value of the acquired company, then the purchaser pays negative goodwill for the business. If the purchase price paid is in excess of the net asset value of the acquired company, then the acquiring company is paying for the goodwill of the business. The acquiring company then records the resulting goodwill on its balance sheet as a long-term asset.
Goodwill Must Be Reviewed Annually
When a company has goodwill on its balance sheet, it must annually test this intangible asset in order to see if the goodwill has been impaired. The goodwill may be impaired when the current value from the future cash flow of the acquired intangible asset is less than its carrying value on the balance sheet. An impairment loss (if taken) is reflected as an expense item in the income statement. There are many components to goodwill such as customer relationships, supplier relationships, employee relationships, patent rights, brand name, and reputation. A problem with any of these components may result in the impairment of a company’s goodwill.
Example of Valuing Intangible Assets
- Jim has owned and operated Jim’s Pool Builders for over 30 years.
- During that time, Jim’s company has grown to 20 employees and generates about $1M/year in free cash flow from building pools for customers throughout South Florida.
- The company has about $500K of physical assets including equipment, vehicles, and inventory.
- The company also has about $100K of accounts receivables.
- Jim’s business broker assigns a value of $3M to the business, which is roughly 3x the annual free cash flow or owner benefit of the business.
- The company’s valuation thus consists of $600K of tangible assets ($500K of physical assets and $100K of accounts receivables), and $2.4M of intangible assets.
- The intangible asset value (2.4m) is 2.4x the annual free cash flow or owner benefit of $1M/year.
- The intangible assets include the customer list, brand name, reputation, relationships with employees and suppliers, proprietary technology, business model, and any other contractual relationship or competitive advantage the business may possess that allows it to generate sales and profits.
- Jim successfully sells his business for $3M to Dale of Dale’s Pool Builders.
Example of Impairment of Goodwill
- Let us assume that a year after the acquisition, Dale’s accountant assesses the value of goodwill on the balance sheet.
- The acquisition of Jim’s Pool Builders created $2.4M of goodwill on Dale’s balance sheet.
- Dale’s accountant explores whether the future cash flow from the acquisition of Jim’s Pool Builders is the same as when the intangible asset was acquired.
- Because of the loss of a few key contractors who served as the company’s main referral sources, the accountant forecasts that the business will only generate $750K/year of free cash flow in the upcoming year.
- This compares unfavorably to the $1M/year of annual free cash flow when the business was purchased.
- As a result, Dale’s Pool Builders must take an impairment charge on the value of the intangible asset.
- The impairment charge may be calculated by determining the value of the intangible asset today and then subtracting the carrying value (or original valuation) of the same intangible asset.
- Using the previous 2.4x multiple of free cash flow in order to derive the intangible asset of the business, the accountant calculates the present intangible asset value to be $1.8M ($750K of projected free cash flow x 2.4).
- Dale’s accountant realizes the company must take a $600K impairment charge ($2.4M minus $1.8M).
- This impairment charge is taken as an expense on the income statement by Dale’s Pool Builders.
Intangible assets are the true ‘value-creators’ of a business and are reflected as such in the premium paid by a buyer above and beyond a company’s mere net asset value. Understanding and properly valuing a company’s intangible assets greatly helps a business seller realize fair value for their business.
Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.
