Goodwill vs. Blue Sky

By Scott Balfour

Don’t overpay for a business!

Goodwill is a definite, measurable, valuable asset of a business. Goodwill is often the result of good systems in place, being in business for years, a good reputation, loyal customers, steady predictable sales and cash flow, records, institutional knowledge, patterns, favorable leases terms, market share, perhaps franchise or dealer territories and many other intangible factors.

Blue Sky by my definition is an immeasurable and perhaps unsupported value above that of assets and goodwill. I caution any buyer not to place much value on Blue Sky. Blue sky is often ‘hidden’ in seller’s offerings. It’s often referred to as ‘potential’. I simply ask the seller if the potential is so easy to achieve …why haven’t you done it? Failing a good answer, I’d say consider that answer as the same thing as the first letter(s) in the word Blue Sky,…. BS.

Some sellers will tell you how much is skimmed off the top. It may be, but equally plausible, it may not be. You certainly can’t verify it nor sue for it down the road. If it’s not represented on paper, specifically the tax returns, don’t count on it.

It is true that business owners try to minimize their tax liability. The classic way of doing this is underreporting income and over-reporting expenses. Be careful though. There are times when this just isn’t so. Consider the restaurant that has dishwashers come and go every couple of weeks. The paperwork is horrendous and these workers are often paid ‘under the table’. This paying under the table doesn’t show up as an expense of operating the business and thus over reports cash flow. The contribution of owners and family members to the business should always be checked out and placed against fair market value for their efforts.

Conducting proper Due diligence is important in all transactions. All records and accounting should be verified.

Blue sky is not always the result of mean-spirited unscrupulous sellers. It sometimes happens inadvertently given that they are pricing the business ‘emotionally’ base on the blood, sweat, and tears they have put into it. There are also some brokers/marketing companies that place huge unsupported values on businesses. The worst typically have large upfront fees and are not local. They simply tell the seller a number that is so large and too good to be true that the seller eagerly signs up, and pays a large upfront fee. A fee that initially appears low based on the hope and dream of untold fortune. Rarely is it ever realized… our buyers are just too smart for that.

It is true that a business is often valued based on the anticipation of future earnings. A purchaser should always project these earnings themselves. Relying on someone else’s projections could create too much Blue Sky and too high of a price. I’ve seen too often where these ‘projected incomes’ just never materialize.

I do want to point out that not all businesses have blue sky built into their price. In fact, you will find that the most serious sellers and brokers alike have taken caution to assure against it.

So, how as a buyer do you determine value? How do you avoid paying for Blue Sky? First, a business value should be based on what it is worth to you. Are you going to run it as is, merge it with another entity, expand product or service, consolidate it to its most profitable units, or simply tweak it to have it reflect your personality? Secondly, conduct due diligence and verify the numbers.

Then given the numbers determine if the resulting numbers can fulfill your goals. Can it pay you a fair market salary, pay for the debt, provide you with some growth opportunities, a profit perhaps?

Also, consider what skill sets you bring to the business. Adjust the numbers accordingly, and you should have a well-priced business opportunity in front of you.

Yes there is risk in buying a business….but for many this reward is far outweighed by the risk. Taking no action could include the risks of staying in dead-end careers, frustration from making someone else all the money, having no opportunity to build equity (retirement) beyond a salary, provide no outlet for your creativity and individual effort.

The risks in buying a business can also be minimized by adding some talented accountants, lawyers, or other business advisers to your team.

Yes, don’t pay for blue sky … but don’t sit on the sidelines either.