A bargain purchase occurs when a buyer purchases an asset for less than it is worth. However, they are not very common. Normally, companies will work to generate interest from as many buyers as possible before selling an asset, even a distressed one, to ensure the highest price. Bargain purchases typically occur when that competitive buying process cannot take place. Usually, that’s because a company wants to sell an asset extremely quickly and does not have the time to go through normal go-to-market strategies.

Bargain purchases tend to occur in less attractive industries or for unappealing assets; otherwise, there would be enough buyers to create the competitive process. However, they can occur in any segment of the market. Even multi-billion-dollar companies may have a business division that they sell at a bargain purchase to rid themselves of it.

What Causes Bargain Purchases?

Bargain purchases may arise in both asset purchases and equity/stock purchases. In general, buyers are motivated to purchase only certain assets — including intellectual property, customer lists, fixed assets, and inventory. They want to avoid the assumption of all of the target company’s liabilities, including potential off-balance-sheet ones. In contrast, sellers are often motivated to sell the company’s stock to avoid being left with legacy liabilities or unwanted assets. While not always the case, stock acquisitions are generally more prevalent if there are enough willing buyers for the target.

Typically, a bargain purchase occurs when a company owns an asset or assemblage of assets that are not generating enough income. Ownership of the asset drains cash flow or other resources. In those situations, the owner may be willing to sell the asset for less than it is worth simply to stop losing money or to free up resources. As such, bargain purchases grow in frequency during economic downturns as more companies and assets become distressed, motivating the owners to sell quickly.

For example, consider a restaurant chain that has a massive E. coli outbreak that leads to a huge drop in revenue at five stores. Those stores become severely overleveraged. Then, an investor offers to buy those stores for less than fair value. In that situation, if the business is draining money so quickly that the owner does not have the time to canvass the market for other buyers, then it may sell the stores for a price below the aggregate value of the assets and create a bargain purchase

If an asset is being sold for a below-market amount there is likely something in need of rectifying with the asset. The buyer in a bargain purchase, therefore, is inherently assuming the risk associated with the distressed asset. This risk transference is a result of the buyer believing it can fix the distress of the asset or make better use of it. In the previous example, perhaps the restaurant investor believes it can repurpose the buildings to become more profitable as a different business.

Bargain purchases can also come about due to contract obligations. For example, suppose a buyer enters into a transaction to purchase an asset at an agreed-upon price but the deal does not close for six months. Six months later the value of the asset is significantly higher due to changes in the target business. In that case, the buyer may have completed a bargain purchase by being locked in at an earlier, cheaper price. A similar situation can arise if a buyer enters into a transaction and the purchase price is based on a fixed number of buyer’s shares, and the buyer’s stock price drops materially prior to the transaction’s effective date.

Balance Sheet Accounting

Following a bargain purchase, a valuation is performed to demonstrate that the fair value of the asset is more than what the buyer paid, which then leads to special accounting treatment.

In a normal transaction, the buyer takes the purchase price and subtracts the fair value of the acquired net assets to arrive at any residual goodwill amount. However, in a bargain purchase, because the purchase price is less than the fair value of the acquired net assets, the math yields an implied “negative goodwill” amount. Ultimately, goodwill is recorded at zero on the balance sheet and the “negative goodwill” balance is recorded as a gain that the buyer would need to expense through the income statement.

Auditors are often hesitant to acknowledge the existence of a bargain purchase, arguing that since there were two independent parties negotiating, the transaction yields a market value of the acquired net assets.

As a result, management needs to be prepared to both qualitatively and quantitively support the existence of a bargain purchase if the situation does arise. The qualitative rationale needs to explain why the bargain purchase occurred, including justification of why the seller may have been motivated to sell or avoid a typical vetting process to yield a competitive auction or whether there was something unique in the way the transaction price was agreed upon between the negotiation process and the close date.

From a quantitative perspective, bargain purchases typically yield various metrics that would need to be presented to support why the transaction is not at-market. That may include an internal rate of return above the intrinsic discount rate for the acquired business or a below-market implied pricing multiple for the acquired business.

However, it is also important that such metrics are supported by an underlying forecast for the acquired business that reflects the current reality of the company and how other market participants would view the business.

Bargain purchases often comprise a seller who is dealing with a distressed asset in need of selling quickly, and they require a buyer willing to purchase that distressed asset in a similar abbreviated timeline (potentially with expedited or even limited diligence). These purchases are rare but become more frequent in economic downturns, and it’s important for those engaging in the transactions to be aware of the unique accounting treatment associated with them.

This piece was previously published in CFO Dive.