The term “goodwill” is often used in conversation as a subjective description of how much your customers like your business.
However, in valuing a business, there is nothing subjective about the definition of goodwill. It is the difference between what someone is willing to pay for your company minus the value of your hard assets.
Let’s imagine you own a contracting company and the main physical assets in your company are the five vans you own and some tools with a total value of around $100,000. If you sold this business company for $1,000,000, the acquirer would have paid $900,000 in goodwill ($1,000,000 – $100,000).
If a company sells for the value of its fixed assets, it is often a business in distress or one step away from closing. One way to think about your job as an owner is to maximize the difference between what your business is worth to a buyer and the value of your fixed assets.
Marriott Buys More than Bricks and Mortar
As an example of the difference between valuing a business for its hard assets vs. its goodwill, look at the recent acquisition of Starwood Hotels & Resorts Worldwide by Marriott. Neither hotel chain owns many of the hotels that bear their name. Instead, they license the name to operators, franchisees and building owners.
So why would Marriott pay $13 billion for Starwood if they don’t even own the hotels they run? In part, Marriott wanted to get its hands on the Starwood Preferred Guest program, a loyalty scheme which has proven more popular than Marriott’s program for frequent travellers.
Similarly, Uber is worth something north of $50 billion because more than one million people per day hail a ride using Uber, not because they own a whole bunch of cars.
Building Hard Assets at the Expense of Goodwill
Many owners focus on building their stockpile of hard assets, not understanding the concept of goodwill.
Acquiring hard assets like land and machines and equipment is fine, but the savvy owner, looking to maximize his value, focuses less on the tangible assets and more on what those assets allow him to create for customers. There is nothing wrong with accumulating hard assets unless they take away from capital you could be investing in creating goodwill. Then the opportunity cost may exceed the value of owning all the things.
It is quite possible both Uber and Starwood would be a shadow of the companies they are today had they pursued a strategy of accumulating hard assets. Would Uber ever have made it out of San Francisco if they had to buy a Lincoln Town Car every time they wanted to add a driver to their network?
If you focus on what creates value for customers, you will maximize the value of your business far beyond the value of your hard assets.