While the capital markets, economic conditions, political atmosphere, and numerous other factors impact commercial transactions in any given year, mergers and acquisitions generally remain a predominant tactic for driving corporate growth and return on investment. There were roughly 15,000 M&A transactions in the U.S. during 2012, representing over $830 billion of value.1
A substantial majority of these transactions require the buyer to allocate the purchase price for financial reporting purposes pursuant to Financial Accounting Standards Board Accounting Standards Codification Topic 805, Business Combinations (“ASC 805”). In brief, acquirers must perform a purchase price allocation (PPA) based on the Fair Values of the target’s current, tangible, and identifiable intangible assets. The residual is recorded as goodwill.
Ever since the elimination of the “pooling method” over a decade ago, C-suite executives, board members, financial advisors, securities analysts, and investors have become well versed in the topic of acquisition accounting due to its effect on the acquirer’s GAAP earnings following the transaction. The portion of purchase price allocated to intangible assets and goodwill has particular importance, as the post-transaction amortization periods for acquired intangible assets can range anywhere from one to 20 years, while goodwill produces no amortization expense. Not surprisingly, the Securities and Exchange Commission (SEC) and other regulators have also demonstrated a keen interest in acquisition accounting.
PPA for Financial Reporting Purposes
The transaction price generally establishes a Fair Value of the target’s assets as a whole, but it is silent as to the sources of such value. There can be numerous sources, such as a cost effective manufacturing process, a unique patent portfolio, innovative products based on proprietary technologies, a well-known brand name that evokes customer loyalty, a defensible market share due to long-term customer contracts or relationships, or an exceptional approach to running the business.
At a fundamental level, the analysis performed for the PPA deconstructs the target’s business in an effort to understand the critical value drivers and, importantly, determine the Fair Values of the intangible assets that meet the GAAP requirements for separate identification. The analysis commonly includes the attribution of the target’s company-wide projected earnings or cash flows to each source of value – technology, brand name, customer contracts, business processes, etc. The attribution process is often very detailed and can involve extensive financial modeling.
As required by ASC 805, the PPA analysis is performed on the basis of the target’s reporting units or, if the target has only a single reporting unit, on a company-wide basis. The PPA analysis is typically not performed on a legal entity basis, as the ownership distinction is generally not essential for financial reporting purposes. The issue of ownership tends to reside in the world of tax.
The interest in PPA results for tax reporting purposes generally pales in comparison to its EPS-driven financial reporting counterpart. Unless a transaction is structured as a taxable acquisition of the target’s assets, or a taxable purchase of the target’s stock with an Internal Revenue Code (IRC) Section 338 election, the acquirer assumes carryover tax basis in the acquired assets. None of the asset step-ups, identifiable intangible assets, or goodwill recognized in the PPA for financial reporting purposes is deductible fortax purposes. In transactions where the acquirer assumes a stepped-up basis in the target’s assets, all of the intangible assets and goodwill are amortized ratably over the statutory 15-year period per IRC Section 197.
The tide turns quickly when an M&A transaction has material tax consequences to the buyer or seller. The company’s tax department and external tax advisors engage in extensive diligence and planning. While it might be tempting to isolate these professionals until they determine the most tax-efficient structure for the transaction or post-integration plan, in doing so the acquirer would forego opportunities to leverage Fair Value measurements done for financial reporting purposes within their tax-planning initiatives. One such situation can arise when an M&A transaction involves a target that conducts business through multiple legal entities. For tax-planning purposes, it may be necessary to allocate the purchase price to the target’s legal entities, as illustrated in the following example.
Valuation of ABC Legal Entities
ABC Company is a privately held engineering and construction (E&C) company. The company began its operations in the Southeast and since expanded into other regions across the U.S. Separate legal entity subsidiaries were created to coincide with ABC’s geographic expansion. While the founding principal holds (directly or indirectly) controlling interests in each of the company’s subsidiaries, different key management personnel own minority positions.
ABC sold its assets on December 31, 2012 to a financial sponsor for an aggregate purchase price of $150 million, which was determined based on a multiple of 5.0x the company’s consolidated EBITDA of $30 million. As shown in Table 1 below, ABC is comprised of two C corporations and two S corporations. The after-tax transaction proceeds to the founding principal and each of the minority investors depends on the amount of purchase price allocated to each of ABC’s legal entities.
There are several ways to allocate the purchase price among legal entities, each with varying degrees of accuracy, complexity, and ability to withstand the scrutiny of the tax authorities. Three common allocation approaches include the following:
- Buyer and Seller Negotiations
- Relative Financial Metrics
- Relative Fair Market Values (FMVs)
Buyer and Seller Negotiations. This allocation method could itself vary greatly in terms of complexity and/or analytical support. The parties might consider factors similar to those in options #2 and #3 (discussed below, and on the next page), or they might simply select amounts that seem reasonable and appropriate to each party.
Relative Financial Metrics. In this method, consideration is given to the relative financial results of the legal entities, such as revenue, EBITDA, or some other measure. The analysis for ABC uses reported revenue and EBITDA for the most recent 12-month period preceding the transaction; however, other time horizons could be used (i.e., three-year average EBITDA, budgeted revenue or EBITDA for 2013, etc.). While this method has intuitive appeal and is fairly easy to implement, it explicitly assumes that all revenue and/or profit dollars are equally valuable.
As shown in Table 2, the concluded values differ between the revenue and EBITDA metrics due to the different margin levels of the entities. The concluded FMVs give primary consideration to the value indications derived from relative EBITDA metrics rather than revenue. Subsidiary B is assigned the majority of the purchase price since it generates the highest amount of EBITDA, while the opposite is true for Subsidiary C.
Relative Fair Market Values. The third method is a substantial expansion of the second option. In this case fundamental valuations are performed for each subsidiary using commonly accepted valuation techniques, including discounted cash flows (DCF) and valuation multiples derived from guideline publicly traded companies or M&A transactions. These methods are not restricted to static financial metrics used in option #2. Rather, the nature of the valuation process affords explicit consideration of the relevant factors that a hypothetical buyer and seller would consider in determining a purchase price for each legal entity. These factors could include their (i) nature and operations, including the industry dynamics and conditions of the target market; (ii) historical financial performance and trends; (iii) expected performance and financial outlook; and (iv) degree of risk, among many others.
As shown in Table 3, it is not expected that a sum-of-the-parts valuation of multiple legal entities will match exactly a transaction price negotiated on an aggregate, company-wide basis. As such, relative FMVs are used in this allocation method rather than absolute FMVs so that a complete reconciliation to the $150 million purchase price is achieved. All three options described herein are used in practice. The allocation method ultimately selected should consider the facts and circumstances of the transaction, including, but not limited to, the relative similarities and/or differences between the legal entities and the magnitude of the tax consequences.In the case of ABC, all of the legal entities are involved in E&C operations, and differ primarily with respect to geography. This fact pattern simplifies the analysis to some degree. If the legal entities under analysis are engaged in different activities, then the first and second options become more difficult to implement. For example, a multinational corporation may have subsidiaries that are distinctly engaged in product development, manufacturing, and distribution. This more complicated fact pattern would likely require option #3 to allocate the purchase price, as the method must be able to address each legal entity’s different functions, risks, and value drivers.
The aforementioned examples for ABC are relatively simple in their illustration and implicitly assume that the reported historical and projected financial data appropriately reflect each legal entity’s operations on a stand-alone basis. This is important as the objective of the exercise is to achieve valuations for each legal entity that are reflective of a Fair Market Value standard – the price at which each legal entity would transact between a hypothetical buyer and seller dealing at arm’s length.
The real world is often more complex and involves other issues. Two issues commonly encountered include the following:
- Management and Other Corporate Services
- Legal Ownership vs. Use of Intangible Assets
Management and Other Corporate Services. In certain cases, companies with multiple subsidiaries provide management and other corporate services (i.e., finance, IT, HR, etc.) through the parent company, or another designated entity, which employs the executive management team and other administrative personnel. It is important to ensure that the financial results of the legal entities reflect an appropriate allocation of the income and expenses related to the provision and receipt of such corporate overhead services. For example, the executive management team members of ABC are employed by the Parent. They provide management assistance to the company’s subsidiaries, but only allocate direct costs (i.e., travel, meals, entertainment, etc.) to each subsidiary for services provided. No allocations are made for the indirect costs of executive compensation and other benefits.
Ideally, the allocation of purchase price to ABC’s legal entities would rely on profit levels that reflect an appropriate allocation of costs commensurate with the benefits provided by the Parent. Absent this explicit adjustment, the concluded FMVs for the entities may be incorrect.
A relatively common method to allocate compensation-related costs is based on the time spent providing services to the benefit of the company’s subsidiaries. For example, if the Parent’s human resources (HR) department spends 10% of its time and effort on behalf on Subsidiary C, then 10% of the HR costs would be charged to the subsidiary. Of course other methods could also be considered.
Legal Ownership vs. Use of Intangible Assets. Similar consequences can result in situations where intangible assets are owned by one legal entity (say, the Parent), but are used by the company’s subsidiaries without payment to the Parent. For example, the Parent might legally own the ABC trademark and trade name, which the Parent and subsidiaries use in their business development and other marketing initiatives. A trademark and trade name that is recognizable among potential clients, or otherwise helps to generate future business, can enhance the value of the enterprise. The owner of this intangible asset would seek adequate compensation for its use. In the case of ABC, however, the Parent does not charge any amounts to the subsidiaries related to their use of the ABC name. Similar to unallocated costs for management and other corporate services, the allocation of purchase price to ABC’s legal entities would ideally rely on profit levels that reflect an appropriate charge for the use of this important intangible asset (and possibly others). Absent this explicit adjustment, the concluded FMVs for the entities may be incorrect.
Charges for the use of intangible assets across legal entities often take the form of a royalty or license fee. The conceptual basis for this approach is routinely employed in transfer pricing programs. Essentially, royalty rates are derived from analysis of third-party license agreements that involve comparable intangible assets. For example, in the case of ABC, a search of trade name license agreements for certain companies characterized as providing “business services” yields a range of royalty rates from 0.3% to 1.5% of revenue. If a royalty rate of 0.5% is deemed appropriate for the ABC trade name, then the subsidiaries would pay the Parent a license fee based on 0.5% of their respective revenue. While this method is relatively straightforward to apply, the degree of accuracy resides in the analytical and other support for the royalty rate selection. The PPA done for financial reporting purposes routinely addresses these and other assumptions related to intangible assets.
Table 4 illustrates the financial results for ABC in the event adjustments are made for these other items. The Parent incurs $1.0 million of expense for providing corporate services to the subsidiaries. Table 4 shows that the subsidiaries are allocated a corporate services charge in proportion to their revenues, while the Parent shows the $1 million increase in EBITDA. Likewise, each of the subsidiaries is assumed to pay a license fee to the Parent for the use of the ABC trade name, which is determined based on a royalty rate of 0.5% of revenue. The Parent shows the corresponding increase in EBITDA.
While the aggregate financial results of ABC are unchanged, the composition of profit, and hence the basis for allocating value, are much different after making these adjustments. For example, the Parent’s FMV of $20.9 million shown in Table 3 implies a multiple of 4.2x the entity’s unadjusted EBITDA of $5 million. If the same multiple is applied to the Parent’s adjusted EBITDA of $7.2 million shown in Table 4, its value increases nearly 45% to $30.1 million. This example assumes that the valuation multiple for the Parent is unchanged. In practice, however, the valuations of all ABC’s entities would be redone to consider the trade name ownership issue and the profit impact from the corporate services expense allocation. The revised FMV for the Parent would likely be above $30.1 million after performing the more detailed analysis.
The PPA analysis done for financial reporting purposes can be extensive. While the analysis is mainly done as a requirement to issue financial statements in compliance with U.S. GAAP, in some instances acquirers might be able to take advantage of opportunities to utilize Fair Value measurements done for financial reporting purposes within their tax-planning initiatives. It can be beneficial to perform the PPA and related tax analyses contemporaneously, as doing so improves the accuracy of each, reduces management time, and decreases professional fees. This best practice recommendation, however, comes with one word of caution. Financial reporting and tax reporting are not mirror images of one another. Financial reporting requires “Fair Value” measurements derived within the framework of ASC 805 and Topic 820, Fair Value Measurement. Tax reporting reflects a “Fair Market Value” premise as defined by the Internal Revenue Service.2 While similarities exist between the two standards in many cases, differences can arise that could critically impact the structure of the analysis and the final conclusions for tax reporting purposes.
1 Source: S&P Capital IQ. Represents announced transactions involving a change of control.
2 Rev. Rul. 59-60, 1959-1 C.B. 237; Treas. Regs. §20.2031-1(b) and §25.2512-1.