What Goodwill can REALLY be worth

Our last article back in March in the Exceeding Expectations section of our Excellence Quartet blog was about “Goodwill”, the difficulties of putting a value on it and the consequences if you get this valuation wrong.

In July in our “Capitalism or … Commonsense” section we wrote about how if you can do all the right things and you do them really well one of the results will be superior profitability and returns for shareholders.

In this article we bring these two ideas together in a story about how one business discovered just how much the goodwill they had created through doing all the right things and doing them really well could be worth.

This is the story of Hotel Chocolat and its “Chocolate Bond”.

For those of you that don’t have a sweet tooth and may not have heard of Hotel Chocolat they are a producer and retailer of top quality, exclusive chocolate.

From the start the founders, Angus Thirwell and Peter Harris were determined to do the right things and to do them really well. For them this included being brazenly committed to producing only authentic chocolate using only authentic wholesome ingredients. It also included their policy of “engaged ethics”. This not only involves paying their cocoa farmer suppliers above the world market rate but also being directly involved in helping them improve their own, their families’ and communities’ lives and futures.

The result of all this is that over the 15 years since they were founded they have grown sales to £52m and have over 500 employees, a success story by any comparison.

Earlier this year they decided to raise some capital to invest in further growth. To find this investment they did not go to the banks, the stock markets, venture capitalists or even a rich Aunty … they went to their customers.

Hotel Chocolat has over 100,000 customers registered as members of their Tasting Club. So they not only know where to find them but they also know their taste in chocolate and have carefully nurtured their enthusiasm for their products and company. These customers were offered the opportunity to buy “Chocolate Bonds” redeemable in full in 3 years and paying interest in … chocolate! This was equivalent to an interest rate of over 6% if paid in cash.

The bond issue was approved by the FSA and raised £3.7m. This will be used to expand Hotel Chocolat’s UK factory and invest in facilities in their wholly owned cocoa plantation in St Lucia. They believe up to 250 new jobs will be created.

The Chocolate Bond was an innovative idea but without the goodwill that had been built through doing all the right things really well it would never have delivered any value.

If you would like to find out what doing the right things and doing them really well could do for the value of your business why not take some time to talk to us. Call Steve Goodman on 07802 385586 or Tony Ericson on 07973 138253.

Exceeding Expectations is brought to you by Steve Goodman and Tony Ericson. It is one of our "Excellence Quartet" of blogs promoting the concept of Excellence as the key to prosperity. Each article uses a recent business/financial topic to highlight different perspectives and conclusions from those obtained using conventional thinking and techniques.

Goodwill - What is it and what's it worth?

As reported in the Telegraph two weeks ago Fat Face the surfwear retailer reported losses of £225m in its accounts to end May 2009. The retailer has been forced to write off hundreds of millions of pounds of "goodwill". It conceded that its value has more than halved since it was bought by private equity firm Bridgepoint in 2007.

In general use "goodwill" is an accounting term used to reflect the portion of the value of a business entity not directly attributable to its assets and liabilities. It is an intangible asset that reflects the ability of the business to make a higher profit than would be derived from selling the value of the tangible assets. This value is often created and or crystallised at a point of acquisition or merger. However businesses have also been known to write "goodwill" valuations into their balance sheets to reflect what they believe is the true value of the business.

Actually valuing "goodwill" is much more of a challenge than simply accounting for it. In the case of Fat Face the explanation for the write down was "that it will take longer for the brand to achieve its full potential than ... previously believed". BC Partners recently wrote off the whole of its investment in Foxtons estate agents "... we made the wrong call". Frequently premiums paid for acquisitions are not reflected in subsequent financial performance.

Valuations of "goodwill" can get inflated to unrealistic and unsustainable levels. For example:

• A business may have traded during exceptionally benign economic and market conditions, achieving levels of profitability that cannot be sustained when more "normal" conditions are restored.
• A business may achieve a genuinely competitive advantage but then does not have the ability to sustain that in the face of greater competition and/or changes in market conditions.
• And of course - when greed overtakes fear as the main driver of judgement

In contrast we had an example of a client whose advisors were quite unable to understand why the business had superior ability to make profits compared to its competitors and the consequent superior value of the business. They failed to attract buyers for the business at anything like its true worth.

So valuing "goodwill" is not easy and there are no clear criteria or formulae for getting it right. However the consequences of getting it wrong, whether upside or downside, can be serious. If we apply our Competitive Strength perspective to this we can immediately see the fundamental problem. Valuing "goodwill" is about the future but all the data and dimensions used are from the past and present - what a business has shown it can do in economic and market conditions that have existed up to now, rather than what it will need to be able to do in conditions as they might be in the future. Every offer for investment carries the health warning - past performance is no guarantee of future returns!

What is really needed is 20:20 foresight, but is that possible? We believe it is. Whilst it is very difficult to forecast the future it is possible to make an objective assessment of a business' ability to cope with and even to thrive in whatever the future turns out to be.

The key is to be able to make an objective assessment of the Competitive Strength condition of a business entity. This is a new business measure and is made up of two components:

How capable a business is compared to those that want to beat it

and

How capable a business is of mitigating the impact of those forces out there that could cause it to be beaten.

Competitive Strength is the manifestation of the deep seated managerial and behavioural values and competences in a business that are the main determinant of whether, over time, it will substantially outperform its competitors and successfully withstand unpleasant surprises. The rock solid research which identified this linkage also established that there are massive differences between the financial performance and sustainability of an average Competitive Strength condition and the truly excellent - much greater than previously thought.

This is because the greater the Competitive Strength the higher the organisational level of Changeability. Changeability, quite literally the organisational "ability and capacity for change" is a key attribute for superior performance and sustainability. We first defined and publicised this new business culture criterion in our "Why Excellence" seminars in 2003. It has been good to see that research carried out by Dr. Michael Jarrett, adjunct professor of organisational behaviour at London Business School and published in his book "Changeability" in 2009 has confirmed our own work and experience.

Hence the Comparative Competitive Strength condition of a business is a reliable indicator of its ability to make a higher profit than would be derived from selling its tangible assets and the potential value of its "goodwill". You don't have to forecast the future, just objectively assess the business' ability to to cope with and thrive in whatever that future might be - 20:20 foresight achieved!

By combining the research with our own work on Changeability we developed the Competitive Strength Report to enable business leaders and managers to objectively measure the Comparative Competitive Strength condition of their organisation, to clearly understand the implications for it future financial performance and its survival and to decide quickly and clearly what they need to do about it. What is more the web based process is fast (3 weeks), requires a minimum of executive time and is very low cost, so is it accessible by a very wide range of types and size of business.

So if you are a business owner thinking about an exit, or you are considering an acquisition, or you an investor considering where to make your next investment, or an advisor to clients in any of these scenarios,go to our website for more information on Competitive Strength and how it can help you make that all important valuation of "goodwill".

Exceeding Expectations is brought to you by Steve Goodman and Tony Ericson. It is one of our "Excellence Quartet" of blogs promoting the concept of Excellence as the key to prosperity. Each article uses a recent business/financial topic to highlight different perspectives and conclusions from those obtained using conventional thinking and techniques.

Different thinking - Different results