What is goodwill? You’ve probably heard the term; you might’ve even used it. Depending upon the speaker and their industry, you might get different jargon-sometimes we hear it as an “air ball” or “blue sky.”
In accounting, goodwill is an intangible asset, included in the balance sheet like intellectual property. The concept of goodwill arises when a buyer is willing to acquire a company at a price over the fair market value of the company’s net assets. Under Generally Accepted Accounting Principles (GAAP) goodwill is an intangible asset with an indefinite life, and thus does not need to be amortized, though private companies, and only private companies, may elect to amortize goodwill over a ten-year period. However, goodwill must be evaluated for “impairment” annually.
Goodwill is often “created” before the sale by the company’s brand, reputation, customer and vendor bases, talented workforce, technology, or processes. These items are typically not reflected anywhere on the balance sheet of a company but are nonetheless valuable assets of the company and will generate a future cash flow value. However, they are neither tangible (physical) assets nor can their value be precisely quantified.
Goodwill-Yay or Nay?
Goodwill, from my perspective, is an amazing thing. In the abstract, the best companies are those companies that can, through whatever combination of the goodwill elements above, like their workforce or their relationships in the community, create future value that exceeds the value of the tangible assets. In contrast for us, when the reverse is true, and we see a company for whom the value of their tangible assets exceeds the value of the future cash flows, we usually can expect a more challenging sale.
However, for all those benefits, goodwill can still present serious challenges in a deal.
When is Goodwill a challenge?
Putting on my old banker hat, goodwill can also cause some heartburn. While goodwill signals strong cash flow for a company, it is difficult to collateralize, i.e. the “air ball” comment source. While the bank is more than happy to accept your equipment or building as collateral for a loan, they are understandably less willing to accept your pledge of your goodwill-you cannot repossess a company’s skilled workforce or strong vendor relationships for example.
As a banker, when I had a strong cash flow transaction, but with limited assets to pledge against that value, I would often look for credit enhancements, i.e. assets out of the business, a personal financial statement, or other credit enhancements such as an SBA guarantee. Another option is to look for non-bank lenders to be the source of financing for these types of transactions heavy in goodwill. Examples of non-bank financing we’ve been able to use in these sorts of deals include seller financing, earnouts or more equity infusion by a buyer. None of that makes goodwill bad, it just presents challenges in structuring a transaction.
Goodwill can also present challenges after the sale. One of my great fears when I was a bank CEO was having to explain to my shareholders why we had “goodwill impairment”. Goodwill impairment happens when there is a deterioration of the capabilities of the acquired assets to generate cash flows, and the fair value of goodwill dips below its book value. This is potentially a nightmare for a CFO or CEO, especially with a publicly traded company.
What is the impact of Goodwill in a transaction?
We believe it is best to address the goodwill issue prior to going to market, typically when we are doing the valuation on the company. At the end of that process, we can usually estimate the expected goodwill in the transaction, the scope or size of goodwill in relationship to the entire value of the company, and what the value drivers are creating that goodwill asset.
Knowing that helps us and our clients review the value drivers for the business, what the risks are for those value drivers, and whether the underlying factors which give rise to goodwill in the transaction are transferable to a new owner.
Another key reason for addressing goodwill in a transaction is it will help define the potential buyer universe, and how the transaction will be financed. For instance, assume there is a $40 million valuation on a company which has $20 million in tangible assets, with the remainder of the purchase price allocated to goodwill. As mentioned above, that goodwill would be difficult for a bank to collateralize, and with goodwill amounting to half of the deal here, it means that bank financing will be extremely difficult to acquire. Thus, that goodwill number really says the buyer needs to be a very large, strategic buyer already in the industry, with strong balance sheet that would be willing and able to put $20 million of goodwill on their balance sheet, or the buyer must be a private equity firm that has alternative capital and funding sources.
Making the transaction work:
Now that we know that goodwill is a positive, but may be a challenge in a deal, what can we, i.e. sellers, buyers, and advisors, do to help create goodwill in a future deal, or prevent the impairment of what is already on the books?
Ultimately, the answer is to focus on some fundamental items, like diversifying the source of cash flows, i.e. a diverse customer base, diversify reliance on salespeople, contractual relationships with customers, particularly recurring revenue contracts, a strong employee base that will stay with the company post-closing, barriers to competitor entry, and proprietary processes to name a few. Further, some prep work for a seller can be helpful, such as a quality of earnings report by a good CPA firm or having your customer and vendor agreements reviewed by an attorney prior to going to market. Additionally, early steps in de-risking the company for potential losses of key employees, vendors, customers or intellectual property can pay dividends when it comes time to sell, because the buyer can be confident that the company will be able to continue to generate cash flows going forward.
Conclusion:
Goodwill in a transaction usually means, if valued properly, you have a company where the new owner is acquiring long term future cash flow value, beyond the tangible assets in a deal. That’s an unqualified good thing if you are buying or selling a business. However, wearing my old banker hat, goodwill is a challenge to finance and as such as advisors it is critical for our clients that we recognize that and plan ahead.
