Small Business Valuation - Intangibles and Creating Value (Part 4)

A business’ value is created in the intangibles, what is above and beyond hard assets.

Buying good assets can value but does not create it. Any other business can buy the same machines, office space, or inputs/supplies. Aside from real estate, tangible assets are unlikely to appreciate. Entrepreneurs and small business owners need to focus on the intangibles to create wealth. The intangibles are what is hard to recreate and replace.

A business should strive for an EST. Achieving one of these is enough to create value – and if more than one applies, even better. Simple examples of EST are the fastEST, cheapEST, safEST, smartEST, highEST quality, or the all-around BEST. This EST identity can be known as reputation, brand, and awareness - but they are all connected to the intangibles of the business. Reputation matters to all stakeholders - customers, suppliers, partners, employees, and creditors/investors.

Albert Einstein once described the power of compounding as the eighth wonder of the world. It is an astounding result when one has the advantage of a long-time horizon. Intangible assets drive the compounding benefit in a business, whether it be from repeat customers, charging a premium based on reputation, having protected IP, or an efficient infrastructure that is used to keep costs down year after year.

Let me describe in detail how various intangible assets of a business create value.

Customers and contracts (if applicable). This is absolutely number 1! It proves validation in the product and service. Repeat customers are even better, as are long-term contracts. Acquiring customers takes more than a smile. It takes reputation, understanding what customers want, and resources for presence, sales, and marketing. Customers are the difference between having a product and a business. This simple and obvious statement does serve to focus an entrepreneur and remind us that business is connecting products/services and customers. Everything else in business supports that connection.

Employees. This can often be overlooked by acquirors and in succession planning. In a small business, there may only be 5, 15, 50, even a couple of hundred workers; just a couple of challenging employees or position turnovers makes a noticeable difference. Employee mobility is the highest in history. Finding and training employees takes resources. When planning a transaction, it is essential to have a plan to retain employees, keep morale high, and convey certainty and stability. Not having a retention plan in place can result in a quick erosion of value and put a new owner/manager in an unenviable position when they are just getting started. Employee retention is among the top reasons for having a succession plan, a transition period, and wanting a seller to retain an equity interest.

Capital and intelligence. Do not overlook two primary business resources: capital and intelligence. These will matter to varying degrees over the course of a company lifecycle. It can be hard to “get in the game” without capital. Capital can prove to be a value creator by allowing for acquisitions, beating the competition by getting more favorable supply terms, or to weather challenging periods. A lack of intelligence could easily convert dedicated capital dollars into cents. Intelligence is an all-encompassing term and will foster process efficiency. Intelligence can be institutional knowledge not to make the same mistake twice. I tie capital and intelligence together because each dollar invested will become worth a lot more with smart decisions and a whole lot less with poor ones.

Process efficiency. Experience within a similar business and industry could be the most valuable for a company and entrepreneur. The first time a repetitive process is completed will not be the most efficient way possible. People become better through repetition. Even simple things can take time to sort out. Examples of improvements and efficiencies a business can develop over time include the configuration and layout of a processing facility, established forms and IT that speeds up repetitive tasks, and a clear division of responsibilities.

Additionally, office and management infrastructure fall within process efficiency. Well-run sales and marketing, accounting, purchasing, inventory management, and administration functions can make a huge difference in creating value. I equate the stability of these areas to jumping up from concrete or wet sand. You will reach higher from that stable basepoint instead of having to sink a little each time you try to jump and will never getting as high.

Intellectual Property (IP). IP can encompass a broad array of assets, and be tougher to understand and value. IP includes commercial software, pharmaceutical formulas, product designs, or manufacturing techniques – as well as internally developed systems. In the case of the company’s product - how good is the technology, drug, or media content? What is the potential to monetize it? The protection of patents, copyrights, and trademarks are valuable, if approved. Strong internal IP should be apparent in the process efficiency category.

Entities, permits, licenses, and certifications. The more there are- the higher the value. Many businesses could be organized for a few hundred dollars thanks to LegalZoom and a state department of licenses website. Others are much more complicated. Permits, registrations, accreditations, applications, and qualification periods can take months, even years, for approval. There is value in having these requirements completed. Desirable certifications include ISO 9000+, LEEDs, Veteran Minority or Women-owned for SBA and government contracting purposes, or Hub-zone, to name a few. Be sure to understand their transferability in the case of succession or sale/acquisition.

The more difficult an asset is to replace - the more value it has.

While offering this framework and list of intangible assets to develop makes it sound easy to create value - it isn’t. Developing intangibles is incredibly hard. Be self-aware and understand the strengths and deficiencies of the organization. Focus on the advantages first, then figure out changes to bolster the weaknesses – whether it be new personnel, different spending priorities, or an acquisition.

Thank you for reading this multi-part series.