How to Calculate Goodwill and Why It Exists. Would You Like a Write-Up with Your Plug?

Transcription

1 How to Calculate Goodwill and Why It Exists Would You Like a Write-Up with Your Plug?

2 This Video: We Haven t Covered This Before?!! I was looking at this channel the other day and realized that we had videos on Negative Goodwill and Purchase Price Allocation for Noncontrolling Interests But nothing on a far more basic topic: how to calculate Goodwill in the first place!

3 This Video: We Haven t Covered This Before?!! Also, we get a surprising number of questions about this topic, even though there s detailed coverage of it in our guides and courses and lots of articles online! So, here goes, starting with why Goodwill exists and a simple example:

4 Why Goodwill Exists SHORT ANSWER: Goodwill is an accounting construct that exists because in M&A deals, Buyers almost always pay more than what Sellers Balance Sheets are worth (i.e., Assets Liabilities) The Buyer gets all the Seller s Assets and Liabilities, so that makes its Balance Sheet go out of balance when a deal closes We create Goodwill to fix this imbalance and ensure that Assets = Liabilities + Equity on the Combined Balance Sheet Basic Calculation: Goodwill = Equity Purchase Price Seller s Common Shareholders Equity + Seller s Existing Goodwill +/- Other Adjustments to Seller s Balance Sheet

5 Why Goodwill Exists Simple Example EX: Buyer pays $1000 in Cash for the Seller, and the Seller has $1500 in Assets, $600 in Liabilities, and Common Equity of $900 Next: Seller s Common Equity is written down in the deal, and the Buyer s Assets go down by $1000, then up by $1500, for a net increase of $500 but its Liabilities go up by $600! Imbalance! To fix this imbalance, we create 2 new Assets in M&A deals: Goodwill and Other Intangible Assets Other Intangible Assets are for specific, identifiable items that have value, such as trademarks, patents, and customer relationships these do not always get created, and we ll cover them later

6 Why Goodwill Exists Simple Example Goodwill is for everything else the plug to make the BS balance Simple Calculation: Equity Purchase Price Seller s Common Shareholders Equity + Seller s Existing Goodwill Why: Seller s Existing Goodwill is also written down in the deal! So, the new Goodwill must include the entire old amount of Goodwill plus the incremental new portion This ignores Other Intangible Assets we ll show their impact in the next example

7 How to Calculate Goodwill More Detail In all M&A deals, under both IFRS and U.S. GAAP, Buyers are required to re-value everything on the Seller s Balance Sheet So, if the Seller s factories, land, inventory, etc. are worth more or less than their Balance Sheet values, they must be adjusted Many items that represent timing differences Deferred Rent, Deferred Tax Liabilities/Assets, etc. also go away because these temporary differences are reversed and reconciled in M&A deals And: A new Deferred Tax Liability (and sometimes other new items) often gets created in the deal (see our separate video on this one)

8 How to Calculate Goodwill More Detail So a real Goodwill calculation might look more like this: Goodwill = Equity Purchase Price Seller s Common Shareholders Equity + Seller s Existing Goodwill Asset Write-Ups + Asset Write- Downs Liability Write-Downs + Liability Write-Ups Rule: If an item increases Assets or reduces L&E, that means less Goodwill is needed to boost Assets so we subtract that item This is why we subtract items such as PP&E and Inventory Write-Ups, and why we also subtract Liability Write-Downs such as DTLs that go away in the deal

9 How to Calculate Goodwill Even More Detail QUESTION: OK, but how do you determine the exact amount of PP&E and Intangibles to write up? What about the new DTL? ANSWER: You don t have enough information to do this the real way if you only have access to the Seller s public filings But you can make some approximations based on recent deals for similar acquired companies in this market Example: If we want to create Goodwill for a potential acquisition of a high-growth software company, we can look at Atlassian s $384 million acquisition of Trello and use those % s

10 How to Calculate Goodwill Even More Detail Results: Other Intangibles are ~33% of the Equity Purchase Price, and Goodwill is ~75%; no write-up for PP&E Newly Created DTL is ~37% of the new Intangible Assets but that ~37% is not necessarily the tax rate for our Buyer Our Deal: We might create Other Intangibles such that they represent ~33% of the Equity Purchase Price, record the other items as is, and create the new DTL based on the Buyer s tax rate And: We d check that the Goodwill is a significant portion of the Equity Purchase Price (e.g., 60-80% range rather than 5-10%)

11 Last Note: Even More Complexities Other Items: Deferred Rent, Deferred Revenue, Inter-Company AR/AP, and more Different Deal Types: Deferred Tax line items work differently depending on whether it s a Stock, Asset, or 338(h)(10) deal More Intangibles: Definite vs. Indefinite-Lived, etc. Industry-Specific Items: In-Place Lease Value and Above/Below- Market Leases in Real Estate And: Don t forget about Earn-Outs and other Contingent Payments

12 Recap and Summary Goodwill: Exists to plug the gap when a Buyer pays more than the Seller s Common Shareholders Equity in an M&A deal Goodwill = Equity Purchase Price Seller s Common Shareholders Equity + Seller s Existing Goodwill +/- Other Adjustments to Seller s Balance Sheet Added Complexities: PP&E and Intangible Write-Ups and Write-Downs and Write-Ups of Deferred Tax line items And Even More: Deferred Rent/Revenue, Inter-Company Items, Different Deal Types, Different Intangibles, Industry-Specific Items and Earn-Outs