What You’re Really Buying When You Buy a Small Business

If you are thinking about buying a business, you may have asked yourself the question…”what, exactly am I buying?”

And it’s a great question.

I remember being at a chamber of commerce function a year or so back and I had just met a local real estate agent who asked me this question. He used his real estate practice as an example, telling me that he had less than $10,000 in hard assets to run his business. How could his business be worth much more than that? He was animated about this topic, going on to say that if a small business has no contracts with clients, what are you really buying?

His understanding was that if there are no contracts, the business isn’t worth any more than the hard assets because it has no income guarantees. When he finished with his mini-rant, I replied by asking him this simple question; “do you know what a McDonald’s franchise is worth?”

Think about it. McDonald’s has no contracts with its customers, no income guarantees at all. They just open the store everyday – that is if they even close it the night before.Most McDonald’s are now operating around the clock and cars line up in the drive-thru and customers fill the dining room everyday.
So how is it that a single McDonald’s store can sell for millions of dollars?

The answer is this one simple word: goodwill.

When you buy a small business, what you are buying is the goodwill of that business. Dictionary.com defines goodwill as an “intangible, salable asset arising from the reputation of a business and its relations with its customers, distinct from the value of its stock and other tangible assets”.
In other words, you’re buying the reputation the business has established.
Goodwill can be a little tough to wrap your mind around because it is an intangible asset. It’s air. You can’t capture it and look at it, but it is the lifeblood of a profitable business – and it is the main reason a McDonald’s store is so crazy expensive!

McDonald’s Hypothetical Example
Assets: $100,000
Goodwill: $400,000
Total Price: $500,000

You are going to be buying the hard assets as well, but depending on the type of business it is, the value of those assets may be minimal compared to the goodwill value.
The hard assets vary from business to business, but I define them as anything that the business uses to generate their sales volume. Everything from computers and websites to filing cabinets and store shelving. If the current owner uses it to run the business, then you will need to have it as well.

So not only are you buying the assets of a small business, but you are buying the goodwill – the reputation of the business as well. And the reputation you buy is where the real earning potential is!