The following interview was conducted with Redwood Valuation’s Tim Iversen, Director (ASA). Tim has nearly 20 years of experience in business valuation during which time he has completed over 700 valuations for both public and private companies.

  1. What is a purchase price allocation?

It is the process of assigning a fair value to all the assets acquired and liabilities assumed of an acquired company (target). This process normally results in some unallocated, residual value generally comprised of an assembled workforce and goodwill.

  1. What are the typical circumstances that require a purchase price allocation? What are the relevant reporting standards?

The typical circumstance occurs when either a publicly or privately held company (acquirer), which prepares financial statements in accordance with U.S. GAAP or International Financial Reporting Standards (“IFRS”), acquires or merges with a target company (i.e., business combination) the purchase price paid for the target needs to be allocated among all the assets of the target. In addition, a purchase price allocation normally needs to be performed when there has been a change in control of the company which could happen outside the context of a business combination such as when an existing shareholder purchases an additional equity interest which then gives them a controlling interest in the company. The relevant primary business combination related accounting standards under U.S. GAAP are Accounting Standards Codification 805, Business Combinations (“ASC 805”), ASC 820, Fair Value Measurements (“ASC 820”), and ASU 2017-01, Definition of a Business (“ASU 2017-01”). For privately held companies which choose to adopt accounting alternatives for simplified reporting of business combinations and subsequent accounting for intangible assets ASU 2014-18, PCC Intangibles (“ASU 2014-18”) and ASU 2014-02, PCC Goodwill Test (“ASU 2014-02”) provide the relevant guidance.

  1. Into what broad categories do you separate out the value of a business enterprise? Can you provide some examples of each?

Broad categories consist of the following: (1) working capital items including current assets such as cash, accounts receivable, and inventory net of current liabilities such as accounts payable, accruals, and deferred revenue, (2) personal and real property such as machinery and equipment, leasehold improvements, and owned real estate, (3) identifiable intangible assets including developed technology, technology under development, customer relationships, trade name, and non-compete agreements, and (4) other intangible assets that do not meet the criteria of being separable from goodwill like an assembled workforce and goodwill.

  1. Valuing intangible assets sounds difficult. How do you arrive at a value for intangibles?

In most cases intangible assets are valued using various forms of a discounted cash flow (“DCF”) analysis. The analysis typically begins with the preparation of an internal rate of return (“IRR”) analysis based on the purchase price paid and a financial forecast reflecting the income attributable to the target’s business. That income is then allocated to the identifiable intangible assets such as developed technology, customer relationships, and trade name based on the amount of the total target business forecast income assigned to each respective asset incorporating the estimated remaining economic life and obsolescence or replacement considerations of the subject asset. As an example, the income attributable to developed technology will reflect both the annual rate at which the existing technology will change or be updated (i.e., technology migration) and the remaining period of time the acquirer expects to continue generating revenue from products or services that utilize the technology that existed as of the date the target was acquired acquirer.  The after-tax earnings attributed to an individual asset would then be discounted to present value at a risk adjusted discount rate.

  1. Can you walk us through a simplified example of a purchase price allocation?

The first step is typically to determine the elements and fair value of the purchase consideration then perform an IRR analysis to estimate the rate of return of the target’s business that is implied by the price paid and financial forecast for the target.  Based on discussions with the acquirer and the appraiser’s due diligence, the second step is to identify the intangible assets that need to be valued which typically include technology, customer relationships, and trade name.  The third step is to then apply the appropriate valuation – typically income approach based – methods to estimate preliminary values for each respective intangible asset.  The fourth and final step is to then assess whether the relative asset values and resulting amount of goodwill appears reasonable considering the purchase price paid, the target’s financial forecast and nature of its business, and market participant expectations

  1. What if a portion of the consideration is contingent upon achieving certain milestones (i.e. “earnouts”)?

The fair value of the purchase consideration that is allocated among all the assets of the target will include the value of the contingent consideration which reflects the various payouts and risks associated with achieving the thresholds and milestones related to earnouts. Because the financial forecast used to value both the contingent consideration (i.e., right side of the balance sheet) and the identifiable intangible assets (i.e., left side of the balance sheet) is normally the same, there should be symmetry between the two typically requiring no special adjustments when valuing the intangible assets.

  1. What are some of the tax implications to consider?

Tax regulations under the IRS tax code have varying degrees of impact on the valuation of intangible assets for financial reporting purposes under U.S. GAAP.  The impact generally comes via usage of any historical net operating losses (“NOL”) of the target in stock acquisitions and the hypothetical tax amortization benefit (“TAB”) in asset acquisitions which are incorporated into the analysis.  In stock acquisitions, some or all of the target’s historical NOLs could be utilized in the future by the acquirer, subject to certain restrictions, and are captured in the IRR analysis which assists with developing appropriate discount rates used to value intangible assets.  Under U.S. GAAP the value of an intangible asset should be the same regardless of how the transaction was structured for tax purposes (i.e., stock vs. asset purchase).  As a result, the value of an intangible asset under both stock and asset purchases is comprised of the present value (“PV”) of the forecast income attributed to the asset plus the value of the TAB, whether hypothetical (i.e., stock purchase) or actual (i.e., asset purchase), reflecting an assumed tax amortization of the value of the intangible asset over the tax life of 15 years in the U.S.  Additionally, because under an asset purchase the acquirer expects to receive a step up in the basis of the acquired intangible assets for tax purposes the acquirer was assumed to have included the value of that benefit in the price paid for the target.  When performing the IRR analysis the value of the TAB is included as a separate element of value of the business in addition to the PV of the business’ forecast income.

  1. How can a business be impacted by a poorly performed purchase price allocation?

If an acquirer prepares financial statements in accordance with GAAP or IFRS and makes an acquisition because they are bound by the reporting requirements of GAAP or IFRS they will be required to perform a purchase price allocation except on occasions when the acquisition is very small and therefore deemed to be immaterial.  The acquirer’s auditor is in turn required to perform a rigorous review of valuations performed including valuations for ASC 805 purposes.  In addition to paying the appraiser’s fee the acquirer also pays for the time spent by the auditor reviewing the valuation. The appraiser and potentially the acquirer will likely need to respond to questions from the auditor regarding the valuation which could range from a handful of questions to several pages of questions.  Typically the higher the quality of the valuation and the greater the experience of the appraiser the less time and lower cost will be incurred by the acquirer related to the audit review process.  If the valuation of the acquired intangible assets is of poor quality, or worse not acceptable to the auditor, the acquirer may have to hire a different, better qualified appraiser to perform the valuation all over again at additional cost.  So having an ASC 805 valuation performed by a very experienced appraiser who is well versed in the applicable accounting standards and industry best practices will save the acquirer time, money, and potentially a headache.

Do you have a business in need of a purchase price allocation? You can get in touch with our experienced PPA valuation experts by sending an email to info@redwoodvaluation.com. We’ll follow up promptly.