brandarticles sales Business legacy: chance or strategy?
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If you are anything like me, then there is something inside you that wants to leave something of value behind when we leave. How many of us would love to have been a Dickens or Tolstoy, an Einstein or a Picasso, or even a Pelé or a Fangio?
On a slightly smaller scale perhaps is that we leave a good name and fond memories. True it could be many years even before you retire, but there will be a time when either choice or circumstance will lead to a point where the business you founded has to be passed on, sold, or simply let go for no financial reward.
There are two options. One is to wait until just a few years before the event. In this scenario, you work hard at building the business through the years and hope that when the time comes you will be in a position to gain something from the disposal. The second is that you think about the future now and strategise to maximise return for all your hard work.
Unfortunately, there are no guarantees. Everything could be going just fine, your management team are in place for a buy-out, and then BOOM! something occurs that scuppers all your plans. It could be that the biggest customer leaves you, or that you are unable to continue to work, or your potential investor decides not to buy-in. For whatever reason, the business you thought would be easily saleable, suddenly isn’t.
So why bother to strategise? Well the value of any business is in its reputation, not your reputation. A business reputation rests on two things: experiences and perceptions.
Customer experiences are the product of your delivery culture – you should be in control of these at every level. The way the phones are answered, the way your staff solve customer challenges, the way you cope openly and honestly with suppliers, and the way you treat your staff are all trigger points for experiences. There are many opportunities to give either a good or bad experience on a daily basis.
Perceptions are formed from personal experiences communicated to others. These can be good or bad. Company websites, advertising, and press releases vie for customer attention alongside the information about the company on internet blogs, forums, and social media sites. Add the opinions of friends and relatives as well, and there is a potent cocktail all ready to form a perception of any organisation, or even personalities within an organisation.
For sale purposes, the sum total value of a business is made up of both its tangible assets (buildings, equipment and so on), and the intangible value, traditionally known as ‘goodwill’. In modern parlance this is also called ‘brand equity’. So the key is to understand what ‘brand equity’ is, what the criteria are for maximising return, and to strategise now how that can be achieved. Leaving it to nearer the time is rather like having no pension plan until two years before retirement!
The long-term benefit of ‘brand equity’
Brand equity is seen by accountants as an intangible element. Over and above assets, a company can build ‘goodwill’ into a business sale. However, goodwill is not straightforward because it is nebulous.
Dictionary definitions of goodwill in an accounting sense state: Goodwill: ‘an intangible asset valued according to the advantage or reputation a business has acquired (over and above its tangible assets).’
Another definition states: ‘the value of a business that is beyond the market value of any tangible assets. It includes reputation, prestige, and company name.’
Way back in 1901, on 20 May in the House of Lords, a senior judge, Lord MacNaghten answered this question: ‘What is goodwill? It is a thing very easy to describe, very difficult to define. It is the benefit and advantage of the good name, reputation and connection of a business. It is the attractive force which brings in custom. It is the one thing which distinguishes an old-established business from a new business at its first start.’1
These early attempts to clarify what makes goodwill led to a definition in a court case in 1934. The case of Whiteman Smith Motor Co. Ltd. v Chaplin, led the court to define goodwill, and the relationship between location and customer loyalty. The court found that customers have different habits and characteristics, and that an analogy could be drawn from the habits and behaviours of animals. This definition has become known as the Zoological classification, and we will explain this a bit later.
There are some recognised industries (such as the farming industry and not-for-profit organisations) where goodwill is not relevant because there is no need of the traditional customer loyalty definitions. For the vast majority of companies, however, at the end of the day, a business is only worth what someone is prepared to pay for it.
The sale of assets without goodwill brings very little return – we all know that second-hand equipment isn’t worth a lot! This is why goodwill is so important in a sale. It is the intangible element that produces the real value for the seller and real benefits for the acquirer. So it seems unwise to leave this element of a business sale as open to opinion and negotiation.
Generally, goodwill is seen as just one item, but not by accountants. In order to asses the value of goodwill, and what factors are important, accountants divide the goodwill into three components:- Locational (or inherent) goodwill
- Personal goodwill
- Company (or free) goodwill
Locational goodwill obviously refers to where a company is situated. So for a hotel sited next to a motorway junction, or a restaurant set on the beach front, locational goodwill would play a major part in defining what the goodwill element of a sale could be. This calculation would be based both on regular customer base and there would also be some element included to allow for passing customer traffic. If, on the other hand, the company is manufacturing products which sell worldwide, and are distributed from some industrial estate, then location would play only a very small part in the calculations. Locational goodwill determines whether the customers are loyal because of the location, or stay because of the reputation or products of the company. If the business were to be relocated, would it retain its customer base or have to find a new set of customers? What would the value be when the cost to replace customers that leave has been taken into consideration?
Personal goodwill is based on the personality, reputation and abilities of an individual (or individuals). For example, where most of the customer contacts are generated through a personal network (particularly that of the owner) then again the question arises of where the customer loyalty lies – in the owner or the business? Would customers leave because the owner is no longer around? Another factor is that, as well as key customer contacts, very often the technical competencies and skill sets also lie with key personnel. Acquirers need to assess the likelihood of key personnel departing on change of ownership and the ramifications of such departures. So personal goodwill provides yet another imponderable in exit calculations.
Company goodwill lies in a customer’s trust in the company. This is obviously much more in the area of brand reputation and brand loyalty. It is affected more by products and services offered, and the perception of quality surrounding such offerings. The customer is attracted primarily to the name of the company or product, not to the owner or the location, which are unimportant factors. However, this is seen only as one factor to be included and balanced against the other goodwill factors.
All these three elements of goodwill are based on the traditional model of customers dictating the price, as well as the reputation of a company, and therefore playing major part of the profitability of a business. It was therefore necessary to define the types of customer that a business has, in order to fit them into one or more parts of the above goodwill components.
Returning to the Whiteman Smith Motor Co. Ltd. v Chaplin case of 1934, the court gave these definitions of customers and their loyalty patterns:
- the dog, who stays faithful to the person and not the location
- the cat, who stays faithful to the location and not the person
- the rabbit, who comes because it is close and for no other reason
- the rat, who is casual and is attracted to neither person nor location
The first type of customer, the dog, applies especially to small businesses such as photographers or the building trades such as plasterers, tilers, etc., where much of the skill and expertise is vested in one person. Customers like the person’s style, their work ethics and their reputation. This definition concerns not necessarily just one-man-bands, but also businesses where the name of the company includes the name of the owner (for example, Paul Pipe Plumbers Ltd.) where the service or product remains highly connected to a personality.
The second type of customer, the cat, is not based on loyalty to one personality. This type of customer is drawn to the location, for example, a restaurant. They are a customer of the business because its location suits their lifestyle choices or business requirements. This is much more apparent in the B2C sector because it is often reliant on a specific location (as smaller high street retailers, for example). Move a shop, lose the passing trade. Move a plumbers merchant (B2B) anywhere in the area and the customer base is hardly affected.
The third type, the rabbit, uses the business only because it is convenient. If the business changed hands they would still be a customer. If the business changed in nature, then they would find the nearest business that replicated the offering of the original company. An example of this could be customers of a hire outlet of some kind who need to hire a piece of equipment, so nearest is probably one of the major factors why they choose to be a customer.
Finally, we have the rat. These customers have no loyalty. They often sniff around, smell out the best deal and buy on price rather than on personality, reputation or location. This puts them much more clearly in the B2B sector (local stationery suppliers are a good example where customers primarily buy on price alone). Rats are not the type of customer you can easily retain after the first sale.
Obviously there are overlaps between the definitions. The challenge for accountants is to successfully leverage the most important factors to achieve the sale, whilst minimising the other factors that could reduce the value. This balancing act is subject to a whole host of opinions and counter-opinions, with both sides trying to do the best on behalf of their clients. The fact that all these calculations are based on customer loyalty (or lack of), therefore leaves much room for interpretation. It engenders no confidence for either the seller or the acquirer because the valuation is eventually agreed by what they believe the customer base may or may not do. The difference between the goodwill method of valuation and a brand equity valuation is stark.
The key lies in eliminating the variables so that a much clearer picture of the future is available to the acquirer. Essentially, by building a holistic brand over a period of time you can control the types of customers that an organisation attracts – and more importantly, retains. You will be able to demonstrate a continuity of earnings pattern that is sustainable after exit. You can prove that the business will retain its customer base because of the way the organisation behaves, interacts and influences the market.
Reducing the number of uncertainties involved with goodwill valuations involves influencing customers: those who are loyal because of location (cats), customers who were attracted to an individual personality (dogs), and the customers who are only attracted by convenience (rabbits). Some rats will continue to be rats!
Building loyal customers based on the brand, not on a single personality or a few key individuals, puts that loyalty where most value can be gained. Perhaps a new analogy needs to be added to the Zoological classification – the horse!
Horse and rider
The horse is able to be ridden and therefore requires a degree of influence by the rider. It was also one of the first animals to be branded by its owner! Although a horse can react particularly to its owner, it is not solely loyal to that owner, and can be ridden by any other rider. It is, therefore, unlike the dog, which does not reliably respond to the directions of anyone other than its owner (or trainer).
When ridden correctly there is a ‘oneness’ between horse and rider where the horse instinctively responds to the lightest of signals. Such is the rapport that the experience is great for both the rider and the horse. The horse is not loyal to a location (like the cat is), nor comes just because you are close (like the rabbit) – ever tried catching a horse when it doesn’t want to be bridled? Lastly, horses do not scavenge (like rats). No, they like to be free, but also love to be ridden and controlled.
Strong brands control the experiences and perceptions of their customers by implementing a holistic brand strategy, thus creating a horse and rider synergy that brings benefits to both. Dog-like customers therefore become horses, cat customers become horses, rabbits become horses, and even some rats become horses!
Where you only have horses, you have controlled customer loyalty. When you control customer loyalty you have a valuable, tangible brand that is well positioned for future growth. That’s brand equity!
How to assess brand equity
A number of efforts have been made to recognise brand equity as a separate entity within the report and accounts, particularly during the internet boom period a few years ago. Many companies were sold on the speculative premise that the customer base would be sustainable in the future.
Inadvisably these companies were then valued on the strength of their brand name without any financial certainty to back up the prospect of future growth through customer loyalty. The internet bubble burst, and this has led many accountants to believe that this method of calculating the value of a business does not work.
However, it is possible to identify brand equity. This can be demonstrated quite clearly with major global B2C brands such as Intel, Kodak, Marks & Spencer and many others. For example, a company such as Amazon continues to flourish in the internet arena. Do customers care who runs the company? Do they want to visit because it’s close? Do they care where the headquarters are?
No. All they care about is the customer care they receive – whether the books arrive in good time and in good condition. The true value of Amazon is therefore entirely in its reputation – not in a location or a personality. The brand equity can, therefore, be quite clearly demonstrated as a tangible asset because the value of the company is not in its physical assets, but in its reputation and customer loyalty.
If Amazon was ever to be valued for disposal or acquisition, future sales patterns would not be affected (provided that the same levels of customer care continued). The ability to sustain future turnover through customer loyalty is the key factor – this is what makes brand equity.
So we need to apply some measurements in order to arrive at a brand equity figure that can be used as a hard factor in the valuation of a business:
- Sound financial data
- Brand strength against competitors
- Influence on customers and markets
Firstly, there has to be sound financial data over a period of, say, 5 years in order to form a base on which to separate the intangible earnings (patents, management expertise, etc.) of the organisation from the tangible assets (equipment and materials, etc.). The value of the business must not be in a personality or a location, but have been deliberately and consistently embedded into the very core of the organisation.
Secondly, we need to look at how strong the brand is against its competitors. Is the brand at risk (for example, by competitor product innovation) or has it gained an advantage (for instance, by introducing new products or by delivering better customer experiences)? The stronger the brand, the more accurately future earnings can be predicted, because the risk of not achieving those figures is minimised. A weaker brand may have more difficulty in achieving the same growth because it has a harder job persuading customers to remain loyal.
Lastly, we have to assess how much the brand is influencing its customer base – is retention strong and sustainable? How much is the brand influencing customer demand? Strong brands use marketing to find customer needs and fill the gap, therefore creating greater demand. Weak brands just jump on a bandwagon. If you can see the bandwagon then you’re already too late to market and you’re playing catch up (me too businesses). Of course, if you can exploit a gap in the market so much the better! So customer and market influence is another key factor when estimating future revenue.
This is why holistic branding brings such a competitive edge. If every area of an organisation is viewed as affecting the whole brand, then there will be clear evidence that all three criteria are measurable. Where this is possible, then you can easily assess what the financial value of the brand is, not affected by personalities, locations, or even product price!
So brand equity can be assessed, and is more clear-cut than the traditional ‘goodwill’ model. Accountants may still want to call that goodwill (because they understand the terminology), but if you can take out the uncertainties in predicting future earnings, then actually you can demonstrate real brand equity!
The more immediate benefits
You may not be thinking of an exit strategy in the immediate future, but that should not stop you beginning to build for that event now. There are numerous tangible benefits to be gained along the way by putting a holistic brand strategy together and implementing it daily.
In fact, banks are much more willing to be co-operative when the going gets rough, if they know there is:
- a viable strategy in place to improve the business
- a management team committed to do what it says it will
- a defined set of targets that are being achieved
- a positive culture emerging
- a differentiated business with clear potential
So there is a better method of leaving a legacy of a great reputation, reaping rewards and satisfaction along the way, and finally maximising the financial reward of your long-term strategy through the intangible benefit of brand equity.
Too many company owners leave it far too late before thinking of an exit route - don’t be one of them. If you haven’t already put the foundations of a holistic brand strategy in place, then we suggest you look at our practical ‘How To’ guide, ‘Define your brand,’ which will help to get you started.
Footnotes
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