What is Goodwill?

OK class, its back-to-school time! Today’s blog is about goodwill.

groans

No, not Goodwill – but goodwill.  That thing that makes your company tick. Corporate culture, but more than that. It’s that feeling your employees get when they come to the office or log on every morning. It’s how they feel on Sunday night when they think about the upcoming week. It’s how your customers, vendors and other stakeholders think about you.

That doesn’t mean the two things aren’t related.  There is accounting Goodwill, and then there’s good old-fashioned goodwill (small g). Let’s talk about both, how they might be related, and maybe how they should be related.

So let’s start with the accounting concept of Goodwill. Under IFRS 3, it is defined as “an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized”. In simple terms:  Excess Purchase Price.  The consideration paid in excess of the fair market value (FMV) of the assets acquired.

[for more in-depth reading and an all-around good time, here’s a link to the ACCA study section on Business Combinations Business Combinations – IFRS 3 (Revised) | ACCA Global ]

Let’s unpack a few things here:

1. What’s a business combination?  An acquisition, merger, sale – essentially when the control of a business changes

2. So why does Goodwill only exist when there is a business combination? Because some sort of outside transaction is necessary to establish the purchase price or value of the company.  This is especially important with private (non-publicly traded) companies, as their shares may not have an easily identifiable value. But when one party purchases the shares of another company, as long as those parties are unrelated and a competitive process was followed, the purchase price is usually viewed the best estimate of market value.  Without a 3rd party transaction, it is extremely difficult (though not impossible!) to determine the value of a private company.

3. Why would anyone pay more than the FMV of the assets being acquired?  Aha! (It’s like that question was planted to set up the rest of this discussion……) Because sometimes, the whole is greater than the sum of the parts.

And this is where goodwill and Goodwill can intersect.  Now strictly speaking, company culture and all of those other things that go along with it are not an "official" Asset (accounting definition) of a company.  But they may indeed be one of the most important assets (not the accounting definition) that a company has.  More often than not it is undervalued, especially in a transaction (“business combination”).

When valuing a company for purposes of an acquisition or similar transaction, people use a variety of models.  The most common that I’ve seen is some variant of “Discounted Cash Flows”. That’s the value in today’s dollars of the expected future cash the company will generate. There are number of other methods as well.  And for the most part, they are extremely analytical, and numbers driven. As they should be. Shareholders on both sides of the transaction want to make sure the target is valued properly.

And often that valuation method leads to a higher number than if one simply valued each asset on the balance sheet individually. Why? Because you are buying an enterprise. A functioning company. There is value in that.

Forecasted future cash flows are just that – forecasts. But you also have to assess: how good are these forecasts? Can we do better? What changes might we have to make to improve those forecasts? Do we have the right team in place to do it? What opportunities exist that might not be currently fully exploited?

So where does small-g goodwill come into it? As stated above, you are often purchasing a complete enterprise. Including that company’s culture.  And this is an area where the classic Financial methods of valuing a target company can perhaps be incomplete.  Taking the time to learn about a company’s culture and personality in an M&A process is a critical element in understanding how valuable a company is or can be. 

Of course, the concept of corporate culture and other elements of goodwill don’t really “fit” into a financial formula or model. It can often be overlooked or dismissed. But it can tell you a lot about the company you are looking to acquire.  For instance:

1. We often ask how reliable the forecasts are. But what about how committed the teams are to delivering them? How do P&L owners view the forecasting process – as a necessary evil or a blueprint for their upcoming year?

2. How has the company previously handled situations with a high level of change? Is it talked about as a negative situation, or do people focus on the positives that came out of it?

3. Hybrid working / Work-from-home / Office culture: this says a lot about an organization. Do they trust and empower their employees? Do they allow flexibility? If they recently made a transition from one to another, how did it go? Was there any attrition? What benefits are they reaping?

4. How do employees interact with one another? Is there collaboration? Trust? Kindness? Diversity of thought? An open-door policy with management? If these foundational traits aren’t there when things are going well, they certainly won’t be there during times of stress.

I’m sure smarter people than me have looked at various ways of trying to “value” corporate culture. It is highly subjective. And what might be viewed as a positive “must have” to one organization may not be valued by another – DEI initiatives are a recent example of that. That’s what makes it so difficult to put a box around. But even if corporate culture doesn’t end up being an “official” asset on your opening balance sheet, let’s be clear: you definitely bought it.

But don’t wait until a transaction to “capitalize” on this asset! (that’s an accounting pun…..) Just because small-g goodwill can’t be recognized on your balance sheet, it is still a critical asset that should be treated as such.  It needs to be actively managed and prioritized. Your company and your employees will be better off because of it.