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How to Calculate Goodwill in M&A Deals and Merger Models (17:33)

In this tutorial, you’ll learn why Goodwill exists and how to calculate Goodwill in M&A deals and merger models – in both simple and more complex/realistic scenarios.

Table of Contents:

  • 1:21: Goodwill – Why It Exists and Simple Calculation
  • 6:59: More Realistic Goodwill Calculation
  • 11:47: How to Determine the Percentages in Real Life and Added Complexities
  • 16:07: Recap and Summary

In this tutorial, you’ll learn why Goodwill exists and how to calculate Goodwill in M&A deals and merger models – in both simple and more complex/realistic scenarios.

This topic matters because you’ll often have to complete this exercise on the job and answer questions about it in interviews.

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First, What Is Goodwill?

Goodwill is an accounting construct that exists because Buyers often pay more than the Common Shareholders’ Equity on Seller’s Balance Sheets when acquiring them in M&A deals, which causes the Combined Balance Sheet to go out of balance.

Click here to get the slides and explanation in PowerPoint, and here to get the Excel file.

By creating Goodwill, we ensure that Assets = Liabilities + Equity, i.e., that the Balance Sheet remains in balance.

For example, if a Buyer pays $1000 for a Seller, and the Seller has $1500 in Assets, $600 in Liabilities, and $900 in Equity, the Balance Sheet will go out of balance immediately after the deal closes.

If the Buyer spends $1000 in Cash, its Assets side will increase by $500 total ($1500 increase in Assets from the Seller, and $1000 decrease from the Cash usage), and its L&E side will increase by $600 due to the Seller’s Liabilities.

Therefore, the Balance Sheet goes out of balance by $100, as shown below:

How to Calculate Goodwill - Why It Exists

We fix this problem by creating $100 of Goodwill on the Assets side.

The basic calculation is:

Goodwill = Equity Purchase Price – Seller’s Common Shareholders’ Equity + Seller’s Existing Goodwill +/- Other Adjustments to Seller’s Balance Sheet

Here’s the Balance Sheet from the example above, with $100 of Goodwill added to fix this problem:

How to Calculate Goodwill - Balance Sheet Fix

In real life, we normally create two Assets to deal with this problem:

1) Other Intangible Assets for specific, identifiable items that have value, such as patents, trademarks, and customer relationships; and

2) Goodwill, which is the “plug” for everything else that ensures balancing.

How to Calculate Goodwill in More Detail

In all M&A deals, under both IFRS and U.S. GAAP, Buyers are required to re-value everything on Sellers’ Balance Sheets.

So, if a Seller’s factories, land, inventory, etc. are worth more or less than their Balance Sheet values, they must be adjusted – and those adjustments will also factor into the Goodwill calculation.

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.

Finally, new Deferred Tax Liabilities in M&A often get created because of the write-ups of PP&E and other Fixed Assets as well as Other Intangible Assets.

So, if you want to know how to calculate Goodwill in real life, the calculation might look 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

You can see an example of a “real” Goodwill calculation with some of these additional items below:

How to Calculate Goodwill - More Complex Example

If an item increases Assets or reduces L&E, that means less Goodwill is needed to boost Assets – so we subtract that item. This explains why we subtract Asset Write-Ups as well as Liability Write-Downs such as the DTLs that get eliminated.

Here’s the Balance Sheet with these additional items included:

How to Calculate Goodwill - Full Balance Sheet

To determine the percentages for these write-ups, you could look at the percentages allocated to similar companies that were acquired in this market recently.

For example, if you’re acquiring a high-growth software company, you might look at a deal like Atlassian’s $384 million acquisition of Trello and use the percentages allocated to Other Intangibles and the other line items there as a reference.

In that deal, Other Intangibles represented ~33% of the Equity Purchase Price, so you might use that as a reference in your Goodwill calculation as well.

Goodwill represented ~75% of the Equity Purchase Price, and there was no PP&E Write-Up, so you might aim for similar percentages if you’re completing the purchase price allocation process for a similar deal.

How to Calculate Goodwill: Added Complexities in Real-Life

The Goodwill calculation in real life gets even more complex because you must deal with items such as Deferred Rent and Deferred Revenue and their possible elimination or write-down, as well as inter-company receivables and payables.

Also, the Deferred Tax line items work differently in different deal types (Stock vs. Asset vs. 338(h)(10)).

There are different categories of Intangibles, such as Definite vs. Indefinite-Lived ones, and there are also industry-specific items such as In-Place Lease Value and Above/Below-Market Leases in real estate.

And don’t forget about Earn-Outs and other Contingent Payments – they show up on the Balance Sheet and also affect Goodwill.

All these items follow the same rules; it’s just that you calculate them a bit differently for use in the Goodwill calculation itself.

About Brian DeChesare

Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys lifting weights, running, traveling, obsessively watching TV shows, and defeating Sauron.