When planning to merge with or acquire another company, a business owner needs to identify what’s actually being sold and estimate what those assets are really worth. Often the most valuable assets — such as goodwill, brand names, customer lists and patents — don’t appear on the balance sheet.
A preacquisition purchase price allocation helps an owner determine whether a purchase price is reasonable. In addition, how the purchase price is divvied up on the acquirer’s balance sheet has an impact on future earnings — thus affecting the transaction’s perceived success.
Identify the assets
Under Generally Accepted Accounting Principles (GAAP), companies that merge with or acquire another must allocate the purchase price among the assets and liabilities acquired according to Accounting Standards Codification (ASC) 805 (formerly covered by Statement of Financial Accounting Standards No. 141R).
The first step in any purchase price allocation is to identify all tangible and intangible assets included in the deal. Examples of tangible assets are accounts receivable, equipment and inventory.
To help categorize identifiable intangible assets, ASC 805 provides a framework based on whether the asset is related to:
- Marketing (trademarks, noncompete agreements, Internet domain names);
- Customers (customer lists, production backlogs);
- Artistic practice (copyrighted books, articles, photographs);
- Contracts (royalty agreements, franchises, leases, employment contracts); or
- Technology (patents, trade secrets, in-process research and development, computer software).
The acquirer must estimate a useful life over which to amortize each intangible asset. But some intangible assets, such as brand names and in-process research and development, may have indefinite economic lives. These are tested at least annually for impairment.
Estimate the cash-equivalent purchase price
The next step is to evaluate the total consideration to be paid for the company. Purchase price is obvious in many transactions. But the waters are muddier when private stock is exchanged, an entrepreneur signs a noncompete or employment agreement, contingent liabilities exist, or part of the selling price is contingent on future earnings.
A valuator can help convert these payment terms into a current cash-equivalent price and separate out personal payments to shareholders from the amount paid for business assets — a prerequisite to accurate purchase price allocations.
Value the assets
Now comes the heart of the purchase price allocation: valuing the assets. Book value may be a reasonable proxy for many tangible assets, including marketable securities, receivables and inventory. A real estate or machinery appraiser can help with fixed assets.
Intangible assets, while increasingly important in today’s knowledge-based economy, are more complex and difficult to appraise. ASC 805 recommends using the market approach to estimate the fair value of intangible assets, because it relies on actual market transactions. But in practice, the market approach may be difficult to apply due to the special nature of intangible assets as well as the lack of comparable transaction details.
Instead, valuators often opt for the cost approach or the income approach. Under the cost approach, fair value equals the cost to reproduce or replace the asset. This approach is most relevant for internally generated intangibles, such as software or secret formulas.
More common is the income approach for intangible assets, which bases value on an asset’s future economic benefits. For example, the relief-from-royalty method derives value from the cost savings of not having to pay a royalty for use of the intangible asset. Alternatively, valuators sometimes perform discounted cash flow analyses, in which an asset’s cash flows are projected and then discounted to their net present value.
When using the income approach, the valuator typically avoids double-counting one income stream for two (or more) separate intangible assets. Additionally, he or she ensures that discount rates are commensurate with the risks of the intangible asset, not necessarily the acquirer’s overall discount rate.
Assign the remainder to goodwill
After the appraiser has allocated value among identifiable assets and liabilities, the remainder is categorized as goodwill. Goodwill has an indefinite useful life. Therefore, it is no longer amortized under ASC 805.
The recession has forced some businesses to sell at bargain prices. In these cases, the combined amount allocated to the acquired assets may exceed the purchase price. Rather than record negative goodwill, the acquirer records a one-time gain at the time of sale under ASC 805.
Pay attention upfront
Too often an afterthought, purchase price allocations should be premeditated. Before embarking on a merger or acquisition, business owners and their legal advisors should work with a valuation professional to ensure the transaction makes sense from a financial reporting perspective and to eliminate unpleasant post deal surprises. Contact the valuation professionals at MFA today to learn more.