By: H. Warrick Jervis, Quist Senior Financial Analyst –
In the context of a Purchase Price Allocation, Goodwill represents the total consideration paid for an acquisition, less the value of the tangible and identifiable intangible assets. Essentially, it is a residual value – the leftover amount. Most auditors, however, find this textbook definition completely unsatisfying. And understandably so – I am hard-pressed to think of anyone willing to pay good money for leftovers. Obviously, there must be more to it…
A more relevant question is: “What does Goodwill represent?” As is typical in valuation, the answer depends on the facts and circumstances that are unique to each transaction. Following is a brief discussion of some of the more common components of Goodwill:
- Assembled Workforce is not amortized for financial reporting purposes, just like the other components of Goodwill. However, the assembled workforce is unique in that it is the only component of Goodwill that often is valued separately (usually under a replacement cost) so that it can be considered as a contributory asset under the excess earnings approach (a topic for another day). In human-capital intensive industries, or those requiring a very specialized skill-set, the Assembled Workforce can represent significant value.
- Competitor Elimination can be an important consideration in the “build” (organic growth) versus “buy” (acquisition) decision. In some cases, eliminating a would-be competitor in a target market can solely be a defensive maneuver, but more often than not there is an offensive aspect as well.
- Risk Reduction can be achieved through revenue or geographic diversification. There is also the potential to acquire operational redundancy and reduce operational risk.
- Time to Market encompasses the notion that purchasing a company may be a faster (and easier) way to grow or expand relative to organic growth.
- Sales Pipeline includes the sales leads and the prospect of converting potential customers to actual customers. Active customers and customer lists, meanwhile, are valued separately as an intangible asset.
- Going Concern Value embodies the fact that every Purchase Price Allocation is supported by a discounted cash flow valuation, and an acquirer is buying the present value of expected future cash flows.
While this list is certainly not exhaustive, it should be evident that Goodwill is a very important aspect of most transactions. Particularly in situations where there are few tangible assets, it is not uncommon to see 50.0 percent or more of the purchase price allocated to Goodwill.
Goodwill is perhaps the least examined of all the assets on the balance sheet. Just because Goodwill is comprised of intangible assets that are not valued separately does not mean Goodwill is not important. Here at Quist, we treat Goodwill with the same attention and care as the other assets involved in a transaction, and take the time to understand exactly what it represents. To us, Goodwill is more than just a residual – it often encompasses very important components of value that can be critical aspects of any transaction rationale.