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.

[@antoninlapresle4807]

There is genius in the clarity of your videos. Thanks a lot!

[@financialmodeling]

Thanks for watching!

[@zquan877]

Best video for goodwill calculation ever, thanks Brian

[@financialmodeling]

Thanks for watching!

[@quant-trader-010]

Thank you so much! This lecture complement well with the deferred tax liabilities lecture, where I was puzzled how the balance sheet stay balanced after creating DTL. It turns out that extra goodwill is also created in the same amount. That makes sense.

[@azamatayazbekov740]

I was just wondering why we are adding existing goodwill? Shouldn’t we subtract it?

[@financialmodeling]

Existing Goodwill is written down in a deal, so we *add* it in this calculation because it means we'll need more new Goodwill after the deal closes to bring up the Assets side and make the Balance Sheet balance. Asset write-downs are added and Liability write-downs are subtracted (and vice versa).

[@sonerguney3225]

Good presentation. Can we have the excel files for this? Thank you

[@financialmodeling]

Click "Show More" and scroll to the links.

[@sonerguney3225]

Many thanks for your prompt answer

[@sonerguney3225]

Good

[@financialmodeling]

Thanks for watching!

[@KaiHakai]

may I have excel files from your presentation? ❤😊😊

[@financialmodeling]

Click "Show More" and scroll to the links below the description.

[@LukeIlijevski]

Hey, I’m a 25yr CPA that’s worked in audit for a big 4 public accounting firm for the past 3 years. A pivot to IB as an analyst is currently my goal, as I’ve had in interest for a while but thought it to be a pipe dream. I’m currently studying finance topics such that I can try to hold my own in the interview phase (assuming I get some looks), but do you think I’m at a major deficit compared to people with previous IB internship experience? I’d hope that 3 years of professional maturation and my accounting background would count for something, but realistically speaking my thought is that the previous internship experience will likely win out

[@LukeIlijevski]

Great channel by the way. Very high quality stuff that is great for people preparing for entering into the industry

[@financialmodeling]

The issue is that it gets harder to win full-time offers at banks the more work experience you have because they won't know where to put you. And banks focus on hiring undergrads and MBAs, with a few recent grads as well ("recent" = graduated less than 1 year ago). You can still get in, but you'll probably need some type of valuation/transaction-related role first. See: www.mergersandinquisitions.com/breaking-into-investment-banking-accountant/

[@airstrike5062]

My suggestion from someone who's in the field is that you get an MBA at a Top 10 (or Top 5) school and then recruit on campus. Good luck!

[@alyab8880]

Yes, THANK YOU!

[@VerticLol]

Is there any place where the excel sheet can be found?

[@financialmodeling]

breakingintowallstreet.com/biws/kb/ma-and-merger-models/how-to-calculate-goodwill/

[@lokeshpathak780]

@@financialmodeling link is not working sir

[@gaurav2019]

Great video. Do you plan on making more videos relating to valuation of other intangibles as well or are they already there in your full course?

[@financialmodeling]

Thanks. Nothing planned at the moment, as it's not really a core focus for the industries we cover (more of a topic for Big 4 firms or independent valuation firms that provide this service).

[@mmmmm7376]

Thanks for sharing Brian.

[@financialmodeling]

Thanks for watching!

[@benjaminsutton9042]

Just a point of clarification here, this first deal appears to assume the buyer is acquiring the seller's cash and debt. Most deals I have seen (which have been smaller $200m or less private businesses) are on a "cash-free, debt-free basis". Therefore goodwill is simply purchase price less non-cash identifiable assets (assuming the seller has no goodwill). This can be all of the assets or in an asset deal could be the majority based on what was negotiated (some assets were retained by seller). In terms of journal entries from the buyer's point of view, the buyer is crediting cash for the purchase price (assuming cash consideration), and debiting acquiried assets and goodwill (with amount of acquired assets vs goodwill depending on write-up's from the seller's book value of those assets and negotiations around purchase price allocation). Would love any context if you have seen differently.

[@financialmodeling]

We cover CF/DF deals in separate tutorials. It's beyond the scope of this lesson, which explains the basic concepts that are tested in interviews. Yes, sometimes there are variations in the Goodwill calculation, but they are not important for understanding the fundamentals. Also, in most interviews at large banks, they tend to assume that transactions involve large/public companies, where CF/DF terms are much less common.

[@benjaminsutton9042]

@@financialmodelingYeah that makes sense and my context is mostly from corp dev buying smaller businesses (and always CF/DF deals). Something I think would be helpful is dive in deal structure (merger, stock purchase, membership interest, asset acquisition, etc.) and tax component. Particularly how tax liability for buyer and seller depending on the purchase price allocation and structure. Do you have a video on that?

[@financialmodeling]

@@benjaminsutton9042 Our channel focuses on helping students and career changers with interviews and cases studies, so we don't currently cover these topics, as they will not come up in entry-level interviews. We cover some of these more advanced topics in our courses, such as the Advanced Modeling course (breakingintowallstreet.com/advanced-financial-modeling/), e.g., for partial-stake acquisitions, spin-offs, stock vs. asset vs. 338(h)(10) deals, and so on.

[@cedricglasper2217]

How do I get a copy of your Goodwill spreadsheet?

[@financialmodeling]

Click "Show More" and click the links.