When one company is acquiring another, the deal price is often the primary factor considered. Too many times, however, critical issues are overlooked, says Sean R. Saari, CPA/ABV, CVA, MBA, senior manager with Skoda Minotti’s Valuation and Litigation Advisory Services Group and Accounting and Auditing Team.
“Deals get started and then take on a life of their own. During the acquisition process, the company is often focused on negotiating and finalizing the deal. However, there are a number of valuation-related issues that can be important to consider, but which are often overlooked,” says Saari. “Some companies try to address these issues after the fact, but the earlier you’re able to get the valuation and accounting issues handled on the front end, the easier things are going to be on the back end.”
Smart Business spoke with Saari about the five things you need to know regarding business valuation before making an acquisition.
What is the appropriate standard of value to consider in an acquisition scenario?
There are two different standards to keep in mind — fair market value and strategic value. Fair market value represents the value of the business if it were to be sold to an unrelated third party and it sets the floor value to what an acceptable purchase price may be. Fair market value is typically most appropriate when financial buyers are involved because they don’t really have any synergies to squeeze out of the company, they simply want to purchase the business ‘as-is’ and continue its operation. However, if the potential acquirer is in the same industry as the target company and the deal is a strategic acquisition, it is important to consider the ‘strategic value’ of the business. Under this standard of value, the acquirer considers the impact of certain redundant expenses that may be eliminated. The elimination of certain expenses may allow a strategic acquirer to pay a price that is greater than fair market value while still receiving an appropriate return.
Can the structure of an acquisition impact the price paid for the target company?
There are competing benefits between structuring a deal as a stock or an asset deal, which can impact the purchase price of an acquisition. Generally, sellers prefer stock deals because their proceeds are taxed only once as capital gains. In stock deals, however, the buyer cannot pick the assets and liabilities that it would like to assume, all unknown and contingent liabilities must be assumed by the buyer and the buyer gets no step up in the basis of the assets purchased. Therefore, buyers typically prefer asset deals because they can pick the assets and liabilities they want and they get a step up in the basis of the assets acquired. This step up, typically for fixed assets and intangible assets, creates additional depreciation tax deductions for the buyer, which can allow them to pay more than they would under an asset deal. This is particularly true when fixed assets with little carrying value are purchased or when intangible assets make up a significant portion of the purchase price. Sellers can be averse to asset deals, however, because contingent and unknown liabilities existing as of the purchase date typically are retained and the sale proceeds can be subject to double taxation.
How are earnouts accounted for?
Earnouts can be an effective tool to bridge the gap if the owner and the seller can’t agree on price. In an earnout, the buyer and seller agree that, after the transaction has closed, there may be additional payments to the seller based upon company performance. It allows the buyer to compensate the seller if certain levels of activity are achieved or to keep the purchase price lower if the targets aren’t met.
However, while it is a great tool, there are some accounting issues that the acquirer is often not aware of.
When an earnout is present, generally accepted accounting principles require the buyer to record the fair value of the earnout as a liability on its books. This is based on the likelihood of the earnout being paid and how much the earnout payment might be. Buyers often don’t realize they have to carry that extra liability on their books and that the balance has to be adjusted every reporting period until the earnout is settled, with the changes in value being reported in the income statement.
What other accounting requirements must be addressed when an acquisition is made?
When making an acquisition, consider the post-acquisition purchase price allocation, in which the purchase price is allocated to the various assets acquired. In many cases, the purchase price exceeds the value of the tangible assets acquired. Accounting rules require that the purchase price in excess of the tangible asset value be allocated to the intangible assets purchased, such as trademarks, customer relationships, technology and non-competition agreements. Any unallocated purchase price left after the intangible assets have been valued is assigned to goodwill.
Determining the fair value of intangible assets acquired is a complex process and typically involves the use of a third-party valuation expert to develop a supportable valuation analysis that will withstand scrutiny from the acquiring company’s auditors.
What are the potential issues if you overpay for an acquisition?
If an acquirer overpays, it results in a lower return on their investment or possibly the loss of a portion of the investment.
From an accounting standpoint, if an overpayment has occurred, it’s likely that goodwill and certain intangible assets may need to be impaired, which can result in a significant charge to the company’s earnings in the period of impairment. Assistance from a third-party valuation expert is often necessary when goodwill or intangible asset impairment is present to determine an appropriate amount that satisfies the company’s auditors.
Sean R. Saari, CPA/ABV, CVA, MBA, is senior manager with Skoda Minotti’s Valuation and Litigation Advisory Services Group and Accounting and Auditing Team. Reach him at (440) 449-6800 or email@example.com.
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