How to Treat Goodwill in an M&A Transaction

Mike Harvath  00:03

Hello, and welcome to this week’s Shoot the Moon podcast broadcasting live and direct from revenue rocket world headquarters in Bloomington, Minnesota. With me today is my partner Ryan Barnett. For those that you tune into the podcast regularly, or even those of you that don’t, revenue rocket is world’s premier growth strategy, and m&a advisor to tech enabled services companies. Ryan, what the heck are we talking about today?

Ryan Barnett  00:35

Hey, Mike, and thanks for having us. And thanks to everyone who’s who’s been listening to our series. It oftentimes we we’d like to dig into things that we’re seeing currently, in deals and things that are, might be a little bit of a niche, but help people understand some of the complexity and demystify the things that we see in m&a transactions for IP services companies. And one of the things we’re seeing in a deal today has a little bit of customer under a buyer looking at the implications of an asset or a sock deal. And part of that of the implications of goodwill within m&a transactions. And not something I’m not familiar with. But Mike is much more familiar with and wanted to, to dig in and understand what what is goodwill, and why it’s important and what it should be considered. And then some, some thoughts and opinions about how it can be used for buyers and sellers in the marketplace, is a fair, friendly reminder, you know, we are not tax consultants. Well, we have a number of tax considerations that are always done in m&a transactions. We defer official opinions over to your your tax accountants and tax accounting teams who can too can give more detail. But we are again, we deal with this in an everyday sense. So Mike just helped the cook, kick us off here. You know, what is goodwill? And what’s goodwill in terms of an IT services company?

Mike Harvath  02:13

Yeah, so, you know, goodwill, a couple of things to think about, you know, goodwill on your balance sheet is essentially a filler is one way to think about it to the true valuation of the business. In in low asset businesses. Like, you know, tech services companies where we don’t have a lot of manufacturing or plant or equipment type things that you might have, in other types of, you know, more physical asset businesses, the goodwill allocation really have to do with your, what we’ll call your soft intellectual property or your operating experience, that’s probably another way to put it. It has to do with the knowledge in the business. It’s it’s the cornerstone of a knowledge based business. And in some ways, you can think of it as a plug to sort of the value of the business associated with that knowledge. And that that goodwill, if you will. So when we think about tech enabled services, businesses, and you’re going to do a transaction, if you will, you have to allocate the purchase price to something, right. And so if someone’s going to, you know, you would never just sell your business as a tech enabled services business for the value of the assets. Most people wouldn’t do that, regardless of the kind of business it is. But let’s just assume in this case, you don’t really have any physical assets, you have a few desks and maybe some computers and you know, a few things and you certainly wouldn’t sell it just for the value of your, of your physical assets or not the value of whatever those are. So then the delta between that in your purchase price has to be allocated somewhere and it’s typically allocated to Goodwill. Now, there’s good news with that Goodwill’s a tends to there’s good news and bad news, I guess. Goodwill tends to be where the lion’s share of the value is on a business. And it is a kind of a long term asset from an amortization perspective. And what I mean by that is, it can’t it’s not susceptible to accelerated depreciation like some physical asset classes could be. Also, you know, I’ll get into your bit, you know, sort of the difference between an asset transaction from a legal perspective and a stock transaction, because there are impacts to a buyer or seller, although in the context of a tech enabled services businesses, those are fairly minimal. And the reason why those differences are minimal, is because of the lion’s share of the purchase price is allocated to goodwill in both cases. And in some businesses, that’s not the case. So I know it’s kind of a complex topic, but we’ll unpack it a little further in a minute.

Ryan Barnett  05:26

Yeah, that’s a great start. Mike, so, I decided to to repeat here that that goodwill can be things like a customer list or a customer relationship. It could be the knowledge of technology or service offering, it could be the, the brand or the logo that is that fair?

Mike Harvath  05:47

Yeah, absolutely. Right. It’s sort of everything that surrounds a business that allows that business to operate and make money that isn’t physical, or might be a tangible asset. Okay.

Ryan Barnett  05:59

Okay. And just goodwill? Is this, is this just simply an accounting thing? Mike, is this to fill that hole in the balance sheet? Or is there? Is there a reason why a company would want goodwill? Other than what you explained a revolving customer relationship, or good customer relationships or good employees? Is there anything when you’re buying a company that you would look at that, that goodwill is anything different than this accounting terminology?

Mike Harvath  06:31

Well, I mean, you’re gonna want to depreciate all the assets that you acquire in a business. So the good news is that, you know, if you’re gonna pay, let’s just be with nice round numbers, you’re gonna pay that million dollars for a business, you’re gonna want to be able to depreciate that purchase, just like you would anything, like, if you bought a vehicle for your business, or maybe you expanded your office and you bought new furniture, you get to depreciate that asset over a period of time and, and, you know, certainly that will help your financial, your financials, right to be able to deppreciate those assets. So, your, your, from a tax perspective, or reduce your, your tax, right, so you’re gonna want to be able to depreciate those assets. Goodwill is a depreciable asset, so it does count. And, depending on your tax situation, you know, oftentimes as a tenure asset could be a 15 year asset sort of depends. But you’re, you’re able to depreciate those assets. As you continue to operate your business, physical assets can be depreciate a little more quickly, in and this is probably a good segue into, you know, why someone might want to do an asset, legal transaction versus a stock transaction, or what what’s, you know, often people use the term sort of in a confused stock transaction term with equity, those are different things. But, you know, an asset deal essentially says, Hey, we’re buying the assets of your business, including your goodwill, and we’re going to value each of those asset classes discreetly. So if we’re going to spend 10 million for the business, we’re going to pay 8 million for the, for the goodwill, we’re going to spend a million dollars on, on physical assets. And you know, maybe there’s another asset class that you may allocate purchase price to. And, you know, you’ll be able to segregate those asset classes based on the IRS’ rules around how fast you can depreciate that goodwill. In a stock deal, there’s a much larger percentage that has to be allocated. I shouldn’t say much larger, there’s a larger percentage that has to be allocated to Goodwill and typically the assets of physical assets, you don’t get what’s called a step up depreciation advantage. There’s some accounting rules that you can apply to step up or accelerate the depreciation of certain physical assets in an asset, ideally, you can’t in a stock deal. And so now, I say that with a little bit of a caution, because there is a way to do that, within the IRS called called a section 338 H 10. Where you get essentially, a stock deal with the benefits of an asset deal from a buyer’s perspective. It is fairly complex and there’s some rules around what types of transactions qualify and you know what types of legal entities that can companies have to be in order to call FYI for them, you know, so I would caution you to, you know, certainly talk to your tax advisor if you’re contemplating a stock transaction with a section 338 H 10. election. But, in short, there are some some workarounds there. But in general, it’s safe to say that, you know, a stock transaction will most likely be a longer amortization of the purchase price. But it’s only slightly so because it would be only appropriate based on what would be applicable to the stepped up depreciation schedule, which typically has physical assets. Now, if physical assets have been already depreciated, then there’s no further depreciation really available. So I think to you can’t depreciate assets twice, you may be able to, you know, you can certainly the safest way to do it is to allocate the non depreciable value of those physical assets. There’s other ways to look at it too, there’s sort of fair market value of those assets, even if they’ve already been depreciated, that may be applicable. But again, these are all add the caveat that we’re not tax advisers, and you should be talking to your tax advisor about the most efficient way to amortize the purchase price. But hopefully, that gives us some guidelines and some details here, Ryan to talk about, you know, the different types of business entity and, and you know, why, frankly, there’s not that big a difference between an asset deal and a stock deal when it relates to tax efficiency in our industry.

Ryan Barnett  11:44

It’s a great question, is there? Can you help me understand what would happen if goodwill wasn’t in place? And IT services would simply the value of the the enterprise value of the deal would just be that of the assets or book value? Or is that even a fair question?

Mike Harvath  12:05

Yeah, no, not really, because, you know, the, you have to be able to account for me, it would be catastrophic. On a rational level, you’d either only a business would only be worth its physical assets or book value, which, you know, we don’t isn’t appropriate in our world, but But beyond that, it would also mean that the acquire, you know, if they spent more than that to acquire the business, because remember, when you get to purchase prices of a business, you have to get to a willing buyer and a willing seller coming together on price. Certainly, there’s some guidelines around, you know, fair value and multiples of EBITA, and comps and all these things that impact value, but, but when when you think about that, there would just be this big hole of purchase price value that would be paid, that wouldn’t be depreciable, by the buyer, certainly would take a huge bite out of the tax efficiency of the deal. And as a result, you know, I think a lot fewer deals will get done.

Ryan Barnett  13:05

Okay, okay. And then in general, it’s a Is there anything a seller can do to increase the goodwill of the company? From what I’m hearing? It sounds like having a well run profitable business with repeat customers, and then a strong brand and a knowledgeable employee based on all that it would be essentially all dedicated to Goodwill. There, is there anything specific associated with goodwill that the seller should consider? Or focus on perhaps a year before transaction?

Mike Harvath  13:42

Well, that’s a good question. And the way to think about that, I think is just, you know, it’s directly correlated to the overall value of the business, right? So I think, you know, goodwill, in its own right, has value in that it sort of fills the gap between whatever the other asset classes you have, and their book value, and the price that’s paid for the business. So you would want to make sure that you’re running the business efficiently that you’re, you know, you know, it’s you have significant profitability that you’re sort of in the top, quartile of some of your peers kind of cover off all of the things that we normally talk about, about what builds value in a business over the long term. And, you know, and then obviously, by doing that your value of your business is going to be higher than if you don’t do that. So it’s sort of a direct correlation to you know, run a great business that is growing and profitable and and meets the needs of your customers and clients well, and in that you’ll have interest by you know, suitors and you know, You’ll always have the option to sell the business and optimize the purchase price and thus, sort of optimize the goodwill per se. But but those two are directly correlated, as it sort of fills the gap between your book value and the price paid for the business is kind of what’s made up of the goodwill, or the goodwill makes that up.

Ryan Barnett  15:20

Sure, sure. And then if you think about a company who perhaps does several acquisitions, and then goes through its own process to sell, is additional goodwill created and every acquisition, is that something that? Is goodwill just created or destroyed? In a transaction? And how does that how does that have like a longer term impact? If you’re buying a business, and you’ve got goodwill that’s on your balance sheet, you ultimately sell yourself for that business? Is there any implications to having a large amount of of this goodwill?

Mike Harvath  15:59

Well, it certainly is a depreciable asset as it relates to tax. So you know, how you roll that forward? In your situation? Should your business sell? Or it really becomes the benefit of the buyer, right, and how they treat the goodwill? And that’s a tax question that has a lot to do with the the type of entity that’s doing the acquisition, you know, and, and how they apply that goodwill in the next transaction. And you know, and there may be other things that impact, not necessarily goodwill in the situation, but certainly impact value. We’re just speaking about one of those earlier today, which is a loss carry forward tax credit, that can add value to a business beyond the goodwill, that maybe have been inherited as part of an m&a transaction that you had done on your behalf your own business, but still has value because it hasn’t been fully realized. And if someone were to acquire you, that also could be realized. And that impacts not only the value of the business, but also, you know, how you might treat any goodwill that you’re carrying or ammortizing on your balance sheet pursuant to previous m&a transactions. I guess that’s why we all hopefully have very good tax counsel. Because these these quickly become complex as to how you treat them. And if you sprinkle in other things like, you know, section 330, at age 10 elections on stock deals, and you know how you do step up depreciation on physical assets in that situation, assuming it’s not all allocated to Goodwill. And I mean, there’s a variety of things that can become pretty complex pretty quickly. So the our advice is always that, you know, particularly as it relates to amortization of assets pursuant to m&a and or whether that be on buy side or sell side and tax efficiency, that you have someone who is very experienced in merger and acquisition tax, providing you advice and counsel, early on before you would ever do a transaction either at acquire a business, or sell your business because tax efficiencies certainly can play a huge role in sort of how you get return on an investment if you’re a buyer and how you ultimately treat that. And ultimately, you know, your your purchase price sort of realization, if you’re a seller.

Ryan Barnett  18:41

Absolutely, that’s where this is one of those daunting things, if you don’t have the right people by your side, it’s hard to get the deal done. And having the right experts in A having a an m&a advisor who understands the implications on both sides of the table, be having your tax accountant there and see having the legal agreements that that are able to incorporate this, it sometimes may not be as easy as flipping a switch from, you know, ask them to a stock deal or or vice versa. So having some of the flexibility understanding when you’re looking at a deal that they you have the ability to to maneuver correctly is critically important to these decisions. So yeah. Mike, that’s about all the questions. I have any any closing thoughts as we talk about this in depth? Goodwill discussion?

Mike Harvath  19:37

Yeah, I guess, you know, the advice I give to the audience is that, you know, there’s a lot of consternation around whether a deal should be an asset or stock deal in our industry. And I think those are, are not, it’s not really necessary. In both transactions, you know, the lion’s share of the allocation will be goodwill. There’s only very small very specific and small situations is very specific situations in which it would have a different impact to you as a buyer from a tax perspective, and oftentimes there’s no impact. And so I wouldn’t overthink it. Now, there’s other reasons, where, you know, sometimes depending on the situation and how a particular deal is authored, a stock deal could come with additional liability for a buyer. But generally, your legal counsel can can take care of neutering that and managing it accordingly, based on the documentation associated with the purchase agreement. So I, you know, again, it kind of comes back to, don’t get overly concerned on whether it’s positioned as an asset dealer or a stock deal. There’s ways to do a stock deal and then convert it to an asset deal, as well, that, that that are oftentimes used by buyers post transaction and call an F reorg. And that can be certainly an approach as well, in the event that there would be a need to do that based on the legal entities that are doing their, the acquiring, or if there’s specific, you know, sort of litigation or legal reasons to shield the assets. But, you know, it probably all comes back to this recommendation, which is, you know, you need, you need three real competent advisors on your side, if you’re gonna go do deals, you need a m&a adviser who knows how to navigate these waters, you need a great legal adviser who’s experienced in m&a. And you need a great tax advisor who also knows her way around, you know, m&a, and related tax matters.

Ryan Barnett  22:02

That makes sense. I appreciate the all the insight here, Mike, and I’ll turn it back later to wrap it up.

Mike Harvath  22:10

Sounds great. Thanks, Ryan. Without going to tie revenue on it, for this week’s Shoot the Moon podcast. Please tune in and join us next week. When we will continue our broadcast and what finally has become summer here it seems at least spring and looking a lot more like summer in the Midwest, and talking about more relevant topics around growth strategy and m&a for tech enabled services companies. So that makes it a great day a great week, and we look forward to having you tune in next time, so long