How to Calculate Goodwill in M&A Deals and Merger Models [Tutorial]

[Music] [Music] hello and welcome to another tutorial video as you can see this time around we're going to go over how to calculate goodwill in M&A deals and merger models why it exists and show you a few simple examples of how this works now this one does not actually come directly from a reader or watcher question but it comes from the fact that I was looking at this channel the other day and I realized that we had videos on topics like negative goodwill and bargain purchases and also topics like purchase price allocation for non controlling interests but we don't have anything specifically on a forum or basic topic which is how to calculate goodwill in the first place also even though it's a fairly basic topic we actually get a surprising number of questions about it despite the fact that there's detailed coverage in our guides and courses there are lots of articles online on investopedia Wikipedia other sources like that it still seems to cause a fair amount of confusion so here goes our explanation starting with why goodwill exists and a simple example once we go through that then we'll look at a slightly more complex example and some added complexities that can come up in this calculation in real life with more advanced models so why does goodwill exist the short answer is that goodwill is an accounting construct that exists because in M&A deals buyers almost always pay more than what the sellers balance sheets are worth so if you look at roughly assets minus liabilities and say that's the value of a seller's balance sheet to acquire the sellers equity a buyer is almost always going to pay more than that number now the buyer gets all the sellers assets and liabilities so when this happens when it pays more than what the sellers balance sheet is worth that makes its balance sheet go out of balance when a deal closes we create goodwill to fix this imbalance and ensure that assets equals liabilities plus equity on the combined balance sheet the basic calculation for goodwill is that it equal is the equity purchase price in the deal minus the sellers common shareholders equity that's what goes away in the deal plus the sellers existing good well that also goes away and then you add or subtract other adjustments to the sellers balance sheet let's go through a very simple example in Excel so you can see what this looks like visually we're going to say here that a buyer pays $1,000 in cash for the seller and the seller has fifteen hundred dollars in assets 600 and liabilities and common shareholders equity of nine hundred so let's go into Excel and see what this looks like here is our target company right here we have cash of two hundred accounts receivable of 300 PPE of 1000 and so total assets equals one thousand five hundred and then on the liability side they have debt of four hundred accounts payable of two hundred equity of nine hundred and so liabilities plus equity equals one thousand five hundred and our balance sheet for the seller balances now the buyer is going to pay a thousand dollars for the equity purchase price for the seller right here and if we look at the acquirers balance sheet which is similar to the targets just a whole lot bigger because the buyer is a bigger entity and we simply combine the acquire and targets and balance sheets as is so we just go in and literally add up each item cash accounts receivable PPE accounts payable debt and so on if we just do this the balance sheets actually balance but of course that's not what happens in an M&A deal in M&A deal we have to reflect the fact that the sellers common shareholders equity is written down and the fact that we spend cash or debt or stock to acquire the seller so here we'll keep it simple and just say that we are spending $1,000 in cash to acquire the seller and I'll link to that 1000 up there now in our combined column over here we take the acquirers numbers plus the target's numbers plus these transaction adjustments and so we end up with 700 of cash right here now what also happens is that on the other side we need to wipe out the sellers shareholders equity so we can just link to that and reverse it directly and so you can see the problem right here our balance sheet goes out of balance because our assets side here goes up by 500 but then our liabilities and equity side goes up by 600 now if we had paid exactly 900 for target instead so exactly matching it's common shareholders equity then we would not have gotten this problem because in that scenario the asset side would go up to seven thousand six hundred and the liabilities and equity side would go up to seven thousand six hundred and so to fix this issue I'll change it back to one thousand four now to fix this issue we create something called goodwill and it follows that exact same formula that I showed you before we take our equity purchase price the one thousand right there and then we subtract the sellers common shareholders equity because that gets written down in the deal that reduces the liabilities and equity side and so it's going to reduce the amount of goodwill we need the liabilities and equity side goes down so the asset side does not need to be as high to balance it and then we're also going to add in in the sellers existing goodwill because this is written down and reallocated in the deal so in this case we simply get one thousand minus that nine hundred and we don't have anything else for these other items so we can just say for now that the goodwill created is equal to the one hundred right here and then when we go and fill that in on the balance sheet we go under transaction adjustments here and let's write down the sellers goodwill so we'll put a negative sign in front of that and then we'll add the new goodwill that gets created now we can see that our balance sheet balances our total assets is seven thousand six hundred and our total liabilities equity is seven thousand six hundred and our balance check says okay so that is the short five-minute version of why we need goodwill and how it works so as I say here we get this imbalance because liabilities are up by six hundred assets are up by five hundred if we don't have good well we create goodwill and also another asset called other intangible assets to balance it to fix this problem typically other intangible assets are for specific identifiable items that have value like trademarks patents and customer relationships goodwill is for everything else it's really the plug that makes the balance sheet balance so the simple calculation like I just showed you equity purchase price minus sellers common shareholders equity plus sellers existing goodwill the sellers existing goodwill is also written down in the deal because it's fair market value is zero so the new goodwill that you create includes effectively the entire of goodwill plus whatever incremental new portion you have now this calculation ignores that other component other intangible assets but will show you their impact in the next example here so on that note let's go into more detail on this calculation and look at some other things that could come up in the goodwill allocation process so in all M&A deals under both IFRS and US GAAP buyers must revalue everything on sellers balance sheets so if the seller has factories or land or inventory and the fair market value of those is different from what's on the balance sheet which is highly likely especially for items like real estate and land then the values must be adjusted when the deal closes and the balance sheets are combined many items that represent timing differences like deferred rent deferred tax liabilities deferred tax assets also go away because these types of temporary differences are reversed and then reconciled in M&A deals so any remaining owed taxes or owed rent or other items like that are paid out when the deal closes everything is reconciled and these items go away for the most part and you will also often get a new deferred tax liability and sometimes some other new items in the deal we covered this in a separate video on why deferred tax liabilities get created in M&A deals so please refer to that if you want some more details on why this happens and some excel demonstrations of the mechanics here so in reality a real goodwill calculation might look a little bit more like the following goodwill equals equity purchase price minus sellers common shareholders equity plus sellers existing goodwill minus asset right UPS plus asset writedowns minus liability right downs plus liability right ups the rule here is that if an item increases assets or reduces liabilities in equity that means that less goodwill is needed a boost asset step balance the balance sheet therefore we can subtract any item that increases assets or reduces the liabilities and equity side this is why we subtract items like the PPE and inventory write-ups so why we subtract liability write down such as the deferred tax liabilities that go away in the deal so to show you an example of this now let's go back to the same example unex tend it and let's say that we now have a PPT write-up of 5 percent so this company's plants property and equipment buildings real-estate and so on are actually worth 5% more on the market than they are on its balance sheet so let's take this 5% and then go up to the PPE balance right here we have that and then for the intangible asset right up we will say here that we are going to be allocating this out of the 100 allocable purchase premium which is a standard approach here and let's just say that 20% of this goes to the companies intangible assets so items like customer relationships trademarks patents other things like that that may not show up directly on the balance sheet initially but which have value to the acquirer and then we'll take our purchase price allocate and multiply by the 20% and then the deferred tax liability here is going to be based on the write up of both these items the PPT write up and the other intangible write up or creation times the buyers tax rate again we get into this in a separate video suffice to say that the depreciation and amortization on these write-ups will not be deductible for cash tax purposes therefore we're going to get a deferred tax liability that represents that difference between book and cash taxes in future years and when that difference goes away the deferred tax liability will also go away so for the write up of PPE let's link to it up here and use a negative sign and then for the write up of intangibles let's link to it right here and use negative sign and then for the new deferred tax liability this will have a positive sign because we're adding this we're increasing the liabilities and equity side so therefore we must create more goodwill for this to bring the asset side up more by contrast with the write up of PPE we're increasing the asset side so it means we need less good well and with the intangibles we are also increasing the asset side so it means we need less and good well so let's go in and fill out everything here and see what happens now accounts receivable we're not going to have any adjustments here so I'll just enter 0 for the plant property and equipment adjustment will link down to where we have it in our schedule right here other intangible assets same idea and then moving down new adjustments for Accounts Payable no adjustments for the debt because this is an all-cash deal and then for the deferred tax liability will link down and get it right here and so now we have a couple additional adjustments and our balance sheet still balances the main difference here really is that we just get less in goodwill because now we've written up more of the other assets so we're not just plugging the entire gap with goodwill we're only plugging part of the gap with goodwill so this example just represents something more similar to what you might actually see in real life in this type of scenario let's go into some more detail now a common follow-up question we get on this topic is okay but how do you determine the exact amount of PPV and intangibles to write up what about the new deferred tax liability how do you figure out all these numbers the short answer is that you don't have enough information to do it the real way if you only have access to the sellers public filings because they do it the real way you need market data for the real estate and the land for the intangibles you need some way to project the revenues and cash flows that come from them and then some type of discount rate and you have to value them using a mini DCF you don't have the required data to do this but you can make some approximations based on recent deals for similar acquired companies in this market for example if we want to create goodwill for the potential acquisition of a high-growth software company we might look at something like alaskans 384 million dollar acquisition of Trello and use some of the percentages right there so I've brought up here Atlassian filing which lists the purchase price allocation for this Trello acquisition goodwill was about two hundred and eighty nine million of the three hundred eighty four million equity purchase price and intangible assets was about 127 million of that three hundred eighty-four million dollar purchase price so if you want to do the quick math here other intangibles are about 33 percent of the equity purchase price goodwill is about seventy five percent they had no write up or a minimal write up for PPE any other items and pretty much just brought them in as is now the newly created deferred tax liability here 46 or 47 million is roughly 37 percent of the intangible assets here that get nup were created in this deal now that doesn't necessarily mean anything for us because 37% is probably not the tax rate exactly for our buyer but that is useful as a reference just to show where this number might be coming from so in our deal if we believe that this company is similar to Trello we might create other intangibles such that they represent 33 percent of the equity purchase price record the other items as is and then create a new DTL based on the buyers tax rate now of course in our scenario here this is clearly not a technology company because the PP&E balance is very high they have no other intangibles right now it just doesn't seem to be a high-growth software company so we probably wouldn't do it but if we did have a software company we might tweak some of these numbers and try to make this percent allocated to other intangible assets much higher we'd also check at the end to make sure that goodwill is actually a significant portion of the equity purchase price so maybe something in the sixty to eighty percent range rather than only five to ten percent for example and finally in the last topic here I want to cover a few more added complexities that come up in real life first off you can have a lot of different items here beyond just the ones we mentioned you can have deferred rent deferred revenue intercompany accounts receivable and accounts payable add that have to be eliminated in a deal so here for example and another one of these schedules we have the write down of deferred rent this is for a retail company where deferred rent is very common we have a write down of their existing deferred tax liabilities in different deal types that deferred tax loud items work differently in the schedule you might write down the entire deferred tax assets in some cases but only part of it in other cases depending on whether it's a stock asset or 338 H 10 deal so in another example model I have right here we actually do a check and we calculate the deferred tax liability slightly differently depending on the deal type because some of the amortization and depreciation from these write-ups may be deductible or not abductive all depending on what type of deal it is we can have more types of intangibles you can have definite versus indefinite lived ones and then there are industry specific items like in place lease value and above and below market leases in the real estate or real estate investment trust industry for example and we can see it right here in this purchase price allocation and Goodwell calculation for a REIT M&A deal we eliminate the furred rent we create new assets and liabilities for above and below market leases and also something called acquired and place lease value and don't forget about earn outs and other contingency payments even though those are not paid out directly they are still put on the balance sheet and so they'll have to factor into this goodwill calculation we're at the end so let's do a recap and summary now goodwill exists to plug the gap when a buyer pays more than the sellers common shareholders equity in an M&A deal and it has to combine the balance sheets and get everything to balance goodwill equals the equity purchase price minus the sellers common shareholders equity plus the sellers existing goodwill which is written down plus or minus all the other adjustments to the sellers balance sheets depending on which side you're on these could be pluses or minuses and depending on whether you're dealing with write ups or write downs they could be pluses or minuses the main added complexity complexities here are that you will almost always see some type of write ups for intangibles PP&E and other fixed assets you'll also see right on breakdowns and write-ups of many of the deferred tax line items which are quite common among all companies and then to make things even more complex you'll see deferred rent and deferred revenue and different treatment of that intercompany receivables and payables you will see different treatment of the deferred tax liability depending on the deal type different types of matanza bowls and then also different industry specific items and earn outs and contingent payments as well we get into all those in our full courses and guides on our breaking into Wall Street site that's it for this tutorial you should now have a better idea of how to calculate goodwill why it exists the simple way to do it and then some of the added nuances that can come up in real life

Channel: Mergers & Inquisitions / Breaking Into Wall Street

Views: 28,532

Keywords: merger models, M&A deals, Goodwill, purchase price allocation, deferred taxes, asset write-ups, deferred tax liabilities, other intangible assets, balance sheet combination, Shareholders' Equity, Goodwill calculation, mergers and acquisitions, mergers and inquisitions, goodwill accounting, m&a deals, merger model, how to calculate goodwill, goodwill calculation, calculation of goodwill, goodwill valuation

Id: m5p0D3kV72g

Length: 17min 33sec (1053 seconds)

Published: Thu Jan 24 2019