If you’re making an acquisition, is there goodwill in the deal? What does that look like, and does it matter?
Consider this scenario: A buyer is acquiring or combining businesses, and is paying some excess above the derived fair market value of the assets. What should the buyer be concerned with? From an accounting standpoint, the buyer account is set up on the balance sheet under long-term assets called “goodwill.” It is an intangible asset that arises from an acquisition.
When you make an acquisition, the buyer and seller need to follow the rules of accounting and allocate the purchase price to the fair market value of the tangible assets working from a closing balance sheet. This becomes a snapshot in time and is only relevant when the buyer’s CPA firm decides it is time to review and audit the account. This is where it can become confusing and complicated for both parties.
Allocation of purchase price (at the closing) along with the goodwill calculation is important. Remember that these calculations are performed at the time of the transaction and are not really reviewed until the auditors decide it is important. What does this mean? What if there is an impairment? Is it fatal? Here are a few points to keep in mind:
- Goodwill is an intangible asset. Lenders will not allow buyers to borrow against it as it has no value.
- If there is an impairment, then it is a “non-cash” charge to the P&L. This means nothing material happens.
- Buyers will not penalize the seller if there is an impairment as it is treated as an extraordinary item and non-recurring.
- Goodwill does not generate any additional value or cash flow. It is intangible.
- The common valuation metrics are: Valuation to EBITDA, Price to EPS (if public), Valuation to Revenues, ROI, ROE, and total payback in after-tax dollars.
- Accountants are hard wired to focus on allocation purchase price to book value. They also tend to focus on valuation to book value as the key metric. It’s important to know this metric, but not to rely on it. Many companies that buyers may wish to purchase do not have a lot of hard assets to allocate money to.
In considering Goodwill, the buyer should remember what they are paying for, such as future earnings, revenues, customers, hard and soft synergies, people, and solutions-based offerings. Hard assets such as furniture, fixtures, inventory, receivables, code, and patents are important, but they are only valued at the time of the purchase until the auditors decide to revisit and revalue.
It’s the performance of the business combination that is important to the buyer, and the enhanced value for both the buyer and seller. Remember that goodwill is an intangible asset that does not independently generate cash flow. If it is written off, it is treated as a non-cash charge, and a non-recurring item for earnings calculation. Knowing the rules and proper metrics is essential to making sure you’re getting a good deal.
For more insights on goodwill and other issues in M&A, stay tuned.
Steve Pomeroy is the founder of Big Change Advisors, a Los Angeles M&A advisory firm of business advisors and capital sourcing advisors for startups and middle-market companies. Since 1992, Big Change leaders have completed over 38 transactions including M&A, Capital Sourcing, and Public Offerings representing over $800 million in total transaction value. Big Change Advisors donates a percentage of all fees to help serve the homeless through the Los Angeles Mission. To request a free consultant, contact us.