How managers can stuff their paychecks with goodwill during an acquisition

Selfish GreedGoodwill represents a particularly convoluted aspect of corporate take-overs that can often misrepresent the nature of a transaction. Between its fundamentally intangible nature, combined with the way financial statements treat it as being a physical asset, its ability to bolster the size of a company’s balance sheet, or even create losses on an income statement (in some situations) presents enough of a risk to an investor to require a general understanding of how to work around it when reviewing an investment opportunity, specifically during an acquisition or merger event.

As an asset, Goodwill represents the intangible aspect of acquired assets, usually pertaining to the purchase of something like a brand or informational value. Websites and online assets are notorious for being purchased at an extremely large premium, attributable almost entirely to goodwill, because of the way in which the online industry revolves around reputation, branding, and intangible recognition from search engines.

The end result is a situation where an acquisition of a website can add a great deal of intangible value to a company’s balance sheet, therefore improving the fundamental value of the stock price (per se), but still creating a great deal of incremental risk for the company (even if the website is generating a great deal of free cash flows). Worse yet, management teams maintain an incentive to complete these kinds of transactions (often using a great deal of debt in the process) so as to improve their variable compensations.

When evaluating an acquisition that comes with a great deal of goodwill premium, an investors needs to be aware of how it is that managers might be simply creating a needless transaction to improve their executive compensation packages. A manager has an incentive to do this when their compensation package is based on an increase in company size, rather than an improvement in profitability. For example, companies will often use the Net Present Value method to calculate growth in the company, which measures the rate at which the asset base of the company grows, rather than improvements in profitability, cash flows, or meaningful growth. Managers paid under this structure have an incentive to complete meaningless acquisitions at a premium, because they will improve the asset base of the company overall.

By then using debt to finance the purchase, they will generally maintain the integrity of their corporate income statement, and therefore protect the integrity of the company’s apparent earnings by capitalizing the risks of the acquisition onto the balance sheet as goodwill. In plain English, this means that they are taking the acquired risk associated with the premium paid for the acquisition, and storing it up as an ‘asset’ on the balance sheet. This asset will then either create gains or (more often than not) losses for investors to chew on into the years to come.

Goodwill on a balance sheet is a risk for investors because of the way in which it has the potential to be written down, and therefore create a loss in the future. For example, if it is later found that a website is not longer practical to operate, and needs to be shut down, the acquiring company will need to write-down the acquisition costs of the asset’s goodwill as a loss. This means that the company will effectively take a loss equal to the total value of the asset (as it can’t really be sold off), and cause some pretty serious damage to its stock price.

While companies will often use this sort of action as a strategy to avoid taxation, it is important to recognize how it is that the tax benefits of such a transaction are a one-time occurrence, while the write-down in the asset value is generally permanent. This means that a company with a great deal of goodwill on their balance stands with an opportunity to delay the losses associated with a bad acquisition until the acquired asset can be proven as worthless. The end result? An opportunity for a shady management team to purchase an asset at a premium, capitalize the potential risks as Goodwill, cash in on the variable compensation, and then allow the bad investment to be written off over time at the expense of public shareholders, long after they have already cashed out.

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