Small town auditors play an important role in the social fabric that holds rural society together. They act as counsellors, advisors and representatives of the law, telling their clients what they can and can’t do, and advising what they should and shouldn’t do.
My friend Dan operates his practice in a lovely country town. His clients are the petrol station, the pub, the hairdressing salon, grocery and food franchises, engineering and repair shops, seed merchants, bed-and-breakfasts, and local farmers.
City folk tired of the rat race dream of moving to Dan’s town and buying a small business. It also happens from time to time that local people want to sell their businesses, move to a larger town, retire, or just do something else. Professional people and service industries want to realise value for their client base. Buyers and sellers go to Dan for advice and a valuation. And to talk about the little bit extra they want over and above the value of the balance sheet assets, which in these parts is generally called goodwill
Now the question arises, why should anyone pay more for anything than the fair value of what you can see and touch? Buyers may be persuaded to pay a little extra if they can understand what it is for. They may be prepared to pay for a company's good reputation, a solid customer or client base, a strong and recognisable brand, an especially gifted workforce, proprietary technology, and anything else that creates advantage over competitors.
Goodwill shouldn’t be confused with these other assets that are intangible but identifiable. Formulations, designs, trademarks, proprietary technology and patents are also intangible assets. However, since they can be attributed to specific items, they are identifiable assets and have a value which can be separately negotiated. But goodwill is the secret sauce or magic ingredient that binds these tangible and intangible assets together and turns them into a business that makes money. An essential ingredient in this sauce is - customers.
Goodwill is worth nothing unless it has power to attract customers. Goodwill only has value if it helps to grow and retain customers and sales.
Dan explains that goodwill in a small business is driven by the kind of customers a business attracts. He likes to illustrate the four main groups of customers in zoological terms - as dogs, cats, rats and rabbits. These animals represent the personal preferences and characteristics of the customers who patronise any small business.
PERSONAL GOODWILL - DOGS
A dog develops a fondness for its owner, rather than the place where the owner lives. A faithful dog follows its master. The owner-managers, leaders and gifted individuals in a business are the creators and custodians of dog goodwill. This personal goodwill attaches to the proprietor of the business and reflects her skills and personality. The bad news - it can’t be sold either with the business or separately, unless a cast-iron employment contract exists.
Dog customers see the value in the company because of the people running the show, and so are most likely to change their preferences if the company leaders relocate. Gourmet diners tend to follow a particular chef when he or she moves to a new restaurant venue.
Some customers are attached to the owner of the business due to her exceptional skill, personality, and honesty. This thinking applies to professionals like accountants, doctors, lawyers, and personal service businesses like hairdressers. Dog goodwill is unique to an individual and shouldn’t be paid if the individual isn’t part of the deal. These customers emotionally invest in personal goodwill which is not transferable.
When Sharon decided to sell her thriving hair salon and move to the coast, she was distressed when Dan explained that she wouldn’t be able to get much for her business. Sharon with her outgoing personality and vast energy reserves is the driving force behind her operation, doing the work of three people, managing operations, sales, customer relations, procurement and human resources. But the big dog is moving on, and what is left for the new buyer?
Warren Buffet is the heart and soul of Berkshire Hathaway. The share value will fall through the floor if Buffet decides to step down or move. Many people would choose to re-invest their funds at Buffet’s new address.
LOCALITY GOODWILL - CATS
Cats are attached to a home rather than to the owner of the house. If the owner leaves the house and somebody else moves in, many cats choose to return to the old home. Cats represent those territorial customers who go to the same shop or hairdressing salon whoever owns the shop. Just as cats prefer the old home, cat customers give rise to locality goodwill.
Cat goodwill isn’t inevitable. It depends on the design, location and furnishing of the premises and it doesn’t change when there is a change in ownership. This type of goodwill has stability and therefore its value is usually high. In some industries a premium called key money is paid to a landlord, or a current tenant, to secure a lease on a well-sited rental property.
In today’s technology companies, where location isn’t important, cat goodwill also applies to customers who are loyal to a brand or the company name and reputation. They are highly invested in the brand equity – the virtual premises - of the product and will hardly ever switch their preference. The management and leadership team of the entity is less important.
Apple customers are a good example of cat goodwill. They are so highly drawn to the brand that no amount of better deals, price cuts or fancy features can lure them away. Steve Jobs and Steve Wozniak may come and go, but Apple users cling to their i-phones and Macs.
FUGITIVE GOODWILL - RATS
Rats are indifferent to who is putting out the cheese or where is it coming from. The characteristic of a rat is that it has no attachments and moves from place to place. Rat consumers don’t have their favourite manager, hairdresser or brand. For this reason, rat goodwill is also known as fugitive goodwill and is valueless. It is fickle and vulnerable and cannot be translated to generate any value. While the custom of rats is always welcome, they can’t be relied upon as a material basis for goodwill.
For example, many consumers of basic FMCG products like toothpaste and shaving cream don’t demonstrate any loyalties. They think that all the offerings from the competing companies serve the same purpose and the rat customer buys when the product is needed and chooses based on availability, price, mood and preference at the time. Rat households buy food products based on price. Rats stay at Backpackers and campsites.
LOCATION GOODWILL - RABBITS
Rabbits spend their lives in and around a spinach patch and don’t like to venture too far away from home. The rabbit shops by convenience and ease of access rather than by quality or price. Rabbit consumers will only buy a product if it is available within an acceptable radius from home or work.
When my local filling station added a convenience store, it began to be patronised by children on the way home from the neighbouring school, and by pensioners who would walk to the store from the old age homes and retirement villages in the area.
Rabbits won’t go the extra mile to buy better quality or cheaper fruits, vegetables, or groceries. A true rabbit won’t go further than the nearest convenience or department store to make a purchase. Rabbit goodwill is thus based on location. The value of a prime location and venue is reflected in the commercial land value and rental and does not add to the value of goodwill in a retail business.
What is goodwill? It is the attractive force which brings in and keeps clients. It is a composite and subconscious psychological set of individual preferences based on locality, the way business is conducted, the personality of those who conduct it, and in part to the availability of competition.
Many of us behave as dogs, cats, rats or rabbits for different products and services, in different circumstances and at different times. The faithful dog is attached to a person, rather than to a place. The cat has no attachments beyond the premises. Rats are indifferent where and what they eat as long as food is available. Rabbits are attracted because they live close by and it would be more trouble to go elsewhere.
As for the monetary value of goodwill, accountants are taught simple and complex formulas for valuation, and many industries have developed their own rules of thumb (three times turnover for a filling station, R10,000 per hectare for a maize farm). Like many other accountants, Dan provides his clients a range of values based on the four animals. His life experience tells him that inexperienced people sometimes pay good money for turnover that has no enduring value.
Today we define customer capital as the value of a company’s relationship with the people and other companies that it does business with. Companies have begun to take their customer capital seriously, and manage it as the asset it is. The value of relationships that a firm builds with its customers, and which is reflected in their loyalty to the firm and its products, is one of the three kinds of intellectual capital of a firm (the other two are human capital and structural capital) that are not reflected in a balance sheet.
What does this mean for a young entrepreneurial start up or the owner of a small business with an eye on retirement in 5 years’ time? It’s a useful exercise to consider the percentage of customers in each animal category and plan accordingly.
If you’re a dog, it may be a good idea to bring in one or two puppies and train them up. Who knows, one may even buy you out one day. Another strategy is to take the bones left over at the end of the month and bury them in a portfolio of local and overseas unit trusts.
Good dogs can start a business, create value for customers and others, and earn a living. But many dogs never grow or become very rich because they find it difficult to translate their talent, energy and knowledge into processes which other animals can follow. Things seem to go better and faster when they do it themselves.
For a dog to build a really successful business – as opposed to a one-man band with a few helpers - the dog’s intuitive knowledge needs to be turned into a system that others can follow every day at work.
Any dog that can teach others how to innovate, design, make great products, deliver services, follow business processes, and develop a strong organisation culture, builds a formidable pack that can attack even large species of prey. A system enables things to work in a repeatable way. Structural capital is more than the knowledge and habits in the minds of the pack members. It includes any tool, process or information that helps a firm keep and grow its knowledge, and use it to achieve its goals.
Big dogs create systems that make it possible for their company to handle larger volumes of business in a structured way, and be less vulnerable to loss of staff and customers. By sharing learning and experience, and recording this knowledge, managers and staff together create a support system of formulas, routines, information systems, databases, policies, competitive intelligence, and processes. The knowledge gained from the products and the systems the firm has created over time, makes up its structural capital, the organised knowledge stays behind when employees go home for the night. Structural capital is stored in documents, media, processes, systems, databases, brands, patents, trade-marks and trade secrets. Some structural capitals - patents, trademarks, copyrights and trade secrets - enjoy legal protection. Structural capital is owned by an organization, remains with an organization when people leave, and includes the value of licences, agencies and other rights.
For investors and lenders, information about structural capital is important in assessing a company. Most structural capital can be used and re-used without diminishing its value. In fact, most structural capital improves with re-use. A database or a process or a design can be improved over time and the more often it is used, the greater is the potential for improvement. The marginal cost of re-using a process is almost zero, which is why structural capital is one of the best investments big dogs can make.