If you work in M&A long enough, you’ll hear the term “good will” used to explain how deals are valued. But what is good will, and what does it mean for the sale or value of your company? To understand good will, we need to start by understanding Net Asset Value, or NAV.
Some acquirers might offer a NAV to buy another company, typically when it is underperforming. In a NAV deal, the acquirer would pay for the accounts receivable (AR), plus the inventory, plus the fair market book value for machinery and equipment (M&E), minus agreed-upon liabilities such as accounts payable (AP). The acquirer would not assume debt, which has to be settled by the seller at closing. (Note: The fair market book value for M&E is usually determined through estimates made by a mutually agreed-upon appraiser.)
Shown in a formula, a NAV transaction looks like this: AR + Inventory + M&E Value – Assumed Liabilities = Net Asset Value. Like most M&A deals, NAV deals are done on a “cashfree/debt-free” basis, meaning the cash on the seller’s balance sheet (after it has been adjusted to satisfy the net working capital peg) belongs to the seller. That money is “swept” just before closing by the seller.
The precise Total Enterprise Value (TEV) that would be paid at close to a seller in a NAV deal is often unknown until the close, because AR, inventory, and assumed liabilities aren’t exactly known until they are examined in the days before closing. That said, a seller who is doing a NAV deal will not be flying entirely blind on the cash they will get at the closing, as the NAV can be estimated fairly closely by your investment banker.
Why should anyone focus on a NAV deal when there are so few of them that get done? Candidly, most companies are successful enough not to use a NAV formula, but we need to understand the concept of NAV to demonstrate what good will is. Strictly speaking, good will is the difference between the amount paid to a seller (TEV) and Enterprise Net Worth (Assets – Liabilities), where the NAV is a proxy for Enterprise Net Worth.
For ease of math, let’s say 1) a seller company’s AR is $2 million, 2) the Inventory is $2 million, 3) M&E Value is $2 million, and 4) the Buyer will assume Liabilities of $1 million. The Net Asset Value would be the total of #1, #2, and #3, minus #4, for a NAV of $5 million.
Now, let’s say that your business is generating a $4 million EBITDA each year. Assume that the acquirer is paying 5X on that EBITDA. The TEV of the business would be 5X $4 million, or $20 million; however, the NAV would be just $5 million. The good will is $15 million (the $20 million TEV minus the $5 million NAV).
Why is the profitable company so much more valuable than the company sold on a NAV basis? Assume that the $4 million EBITDA company has been generating EBITDA for some time and that it will continue to do so. Hence, its value is a multiple of that EBITDA. Even if that $4 million EBITDA company didn’t grow at all and stayed at $4 million/year, that acquirer would make back their $20 million purchase price in five years. Conversely, the company acquired on a NAV basis is probably not generating meaningful EBITDA, which is why it may have been channeled into a NAV sale structure. A company that is barely profitable or losing money is not going to get a multiple of its NAV. It’s worth just the value of its net assets, while the positive EBITDA company represents a good prospect for future cash flow—hence the strong value of the good will. And that’s why companies get acquired for the cash flow, and that’s why they obtain a good will premium above NAV.
