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

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

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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

Lesson Outline:

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.

By creating Goodwill, we ensure that Assets = Liabilities + Equity.
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.

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 is out of balance by $100, and we fix it 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

We normally create two Assets to deal with this problem – Other Intangible Assets for specific, identifiable items that have value, such as patents, trademarks, and customer relationships – and 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 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 – 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, a new Deferred Tax Liability (and sometimes other new items) often gets created in the deal (see our separate video on
this one).

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

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 DTLs that get eliminated).

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 we’re acquiring a high-growth software company, we 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.

We could use the percentage allocated to Goodwill to check our work at the end as well.

Added Complexities in Real-Life

Calculating Goodwill 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.