M&A Agony and Ecstasy for Early Stage Technology Companies: Purchase Price Allocation
When I speak with the CFOs of our clients about the acquisitions they are making, it reminds me of the title of that old 1965 Charlton Heston flick, The Agony and the Ecstasy .
Many of our clients are venture capital backed technology companies that have been growing successfully and have commenced making acquisitions. On the one hand, they feel the ecstasy of getting their deals done. On the other hand, they must confront the agony of fair value accounting.
The Basics of Purchase Price Allocation
A company that makes an acquisition must adjust its financial statements to reflect the inclusion of the acquired assets and liabilities at their fair values. Fair value is closely related to the traditional concept of fair market value. For many items (such as cash assets, accounts receivable, and accounts payable) the determination of fair value is usually straight forward because the values recorded on the seller’s financial statements often reflect the items’ values. In the case of hard assets such as property, plant, and equipment, the market value of the assets may be different than the values carried on the seller’s books. As a result, the acquirer may have appraisals performed to determine fair value conclusions.
However, accounting principles require that the fair value of intangible assets and goodwill must also be determined. Intangible assets can include technology that was developed by the seller (or was in the process of being developed), existing customer relationships, marketing intangibles (such as trade names and trademarks), non-compete agreements, and other contractual arrangements that may be expected to generate economic benefits for the buyer, as well as other items. The extent to which the price paid for a company exceeds the fair value of the identifiable acquired assets (net of the fair value of assumed liabilities) is called goodwill.
Purchase Price Allocation studies determine the fair values of the tangible and intangible assets, as well as liabilities and goodwill.
The Challenge of Fair Value Accounting Principles
The challenge for a client is that the fair value framework entails concepts and definitions which may seem very distant from the specific business strategies and objectives that led to the acquisition in the first place. The challenge exists because the information needed to make the purchase decision is very different from the information required for fair value accounting measurement. The fair value of acquired assets (and liabilities) does not measure the value an asset to the acquirer based on what the acquirer intends to do with the asset. Instead, fair value is the value to a hypothetical “market participant” that will use the asset to its highest and best use.
Take a hypothetical example where one of our clients has just acquired a smaller relatively unsuccessful company that had developed an attractive technology. The conversation concerns the value of the acquired company’s brand name:
“We didn’t buy this company to get its brand name; we bought the company to get the technology. We thought this company was unable to build an adequate marketing and sales capability. That’s why their investors decided to exit. So obviously the brand name is worth nothing.”
The difference between value of the brand name as perceived by management and value under accounting rules may be extreme. In this case, a “market participant” might choose to utilize the acquired brand name. If so, its value would need to be quantified.
Another difference can occur when the client intends to utilize a specific asset, and expects synergies from the acquisition to produce significant economic returns. In this case, the “market participant” assumption can result in a lower accounting value than the value that is perceived by management. The fair value rules spell out “… buyer specific attributes and intent should be disregarded if different than another market participant.” (ASC 820, http://asc.fasb.org). Synergistic effects would not be included in determining the value of the asset. For instance, if the sales projections included synergies that are unique to the client and not available to other market participants, then the sales projections would need to be reduced to remove the synergies.
In summary, acquisitions require accounting and financial analysis to analyze the transaction from two different perspectives. The first perspective identifies the specific costs and benefits to the buyer – including synergistic benefits that may not be available to other potential acquirers. The second perspective is to examine the acquisition from the perspective of other potential acquirers (“market participants”), and assume each identifiable asset is put to its best and highest use.
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Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.
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