Purchase Price Allocation

Financial reporting standards (US GAAP, IFRS) require that the purchase price paid for the target is allocated to the assets acquired and liabilities assumed, a process referred to as Purchase Price Allocation (PPA).

Key Steps to the PPA

Identifying a Business Combination

Before an entity can apply the acquisition method, it must determine whether a transaction meets the definition of a business combination. Typically, a business combination occurs when an entity purchases the equity interests or the net assets of one or more businesses in exchange for cash, equity interests of the acquirer, or other consideration. However, the definition of a business combination applies to more than just purchase transactions: it incorporates all transactions or events in which an entity or individual obtains control of a business.

Identifying the Acquirer

For each business combination, one of the combining entities shall be identified as the acquirer. In a business combination effected primarily by transferring cash or other assets or by incurring liabilities, the acquirer usually is the entity that transfers the cash or other assets or incurs the liabilities. In a business combination effected primarily by exchanging equity interests, the acquirer usually is the entity that issues its equity interests. However, in some business combinations, commonly called reverse acquisitions, the issuing entity is the acquiree.

Measuring the Identifiable Assets and Liabilities

An acquirer must recognize, separately from goodwill, the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. Under the measurement principle, the acquirer must then measure the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at their acquisition-date fair values.

What is the fair value of the total purchase consideration?

Every PPA starts by first determining the fair value of the purchase consideration, which may include contingent consideration, warrants, minority interests, and other securities or purchase price elements.

Fair Value Principles

Valuation Framework

All assets, including intangible assets, and liabilities that are acquired in a business combination should be recognized at fair value on the acquisition date under its highest and best use.

Highest & Best Use

The use of a nonfinancial asset by market participants that would maximize the value of the asset or the group of assets and liabilities within which the asset would be used.

Market Participants

Market participants are those buyers and sellers transacting business in the principal market for an asset or liability. These participants are not related parties, have a reasonable understanding of the asset or liability, are capable of entering into a transaction, and are motivated to do so.

Recognition Criteria

Identifiable intangible assets are recognized separately if they: (a) arise from contractual or other legal rights (contractual criterion) and/or are capable of being sold, transferred, licensed, rented, or exchanged separately from the entity (seperability criterion).

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Commonly Identified Intangible Assets

Customer Relationships

Customer relationships meet the contractual criterion if an entity has a practice of establishing contracts with its customers, regardless of whether a contract exists at the acquisition date. Customer relationships also may arise through means other than contracts by meeting the separability criterion. Facts that indicate a relationship between an entity and a customer in the absence of a contractual agreements are: (i) the entity has information about the customer; (ii) the entity has regular contact with the customer; and (iii) the customer has the ability to make direct contact with the entity.

Valuation Considerations

Projected revenues and expenses directly attributable to the customer relationships (revenues, future growth, and EBITDA adjustments for sales, marketing, or other expenses)
Customer retention rate, impacting the remaining economic life of the existing relationships: quantitative attrition analysis based on historical data; qualitative analysis based on key factors that impact value, such as switching costs & and technology change
Adjustment for inventory/backlog valuation (if relevant)
Contributory asset charges
Discount rate

Trade Names & Trademarks

A trade name or trademark is defined as any word, name, symbol, or device, or combination thereof, adopted and used by a company to identify and manage a company’s business, goods, and/or services offered and to distinguish it from competitors. The owner of a trade name or trademark has a legal right to prevent competitors from using the name or similar mark in a manner that is likely to cause confusion in the mind of the consumer, thus preventing unfair competition.

Valuation Considerations

Estimation of the future economic life and selection of a hypothetical market royalty rate:
Longevity
Manner and cost of development
Degree of recognition
Contribution to customer loyalty
Competitive advantage, such as reliability and quality
Pricing premiums
Comparison to similar tradenames & trademarks
Expected duration of use in the future
Contribution to future sales and profitability

Technology

Technology generally represents patented technology, computer software, unpatented technology, databases, and trade secrets that are technologically feasible.

Technology can take many forms and includes, but is not limited to, the following: knowledge of materials, processes or methods, patents, regulatory approvals, specialized devices, patterns, formulas, tooling, and machine settings.

Technology has value to the extent that it provides an economic advantage in the marketplace or serves as a barrier to competition. The economic advantage can take the form of lower manufacturing and operating costs or allow a company to charge a premium price for its goods or services. The technology can also serve as a barrier to competition if, for example, a potential competitor is capable of developing similar technology, but the costs and time involved make it prohibitive.

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Rate of Return Analysis

Internal Rate of Return
(IRR)

The IRR is quantified by using the Discounted Cash Flow Method based on the transaction-specific deal financial model

The IRR refers to the rate of return that equates the amount or value of an investment and the present value of the cash flows assumed to be earned on that investment. In a business acquisition context, the IRR is the implicit return on the future cash flows of the business relative to the purchase price paid in the transaction

Key Valuation Considerations

Review and analysis of the deal model used as a basis for pricing the transaction, including projected revenues, expenses, taxes, capital expenditures, and working capital requirements
Assessment of synergies from a market participant viewpoint
Calculation of the terminal (sustainable) growth rate
Analysis of any non-operating assets or liabilities
Consideration of transaction type (stock or asset acquisition)

Weighted Average Cost of Capital (WACC)

The market-based WACC is calculated by employing the Capital Asset Pricing Model

The WACC estimates the overall rate of return (ROR) required for an investment by debtholders & equityholders, respectively, and is a function of the conditions prevalent in a particular industry. Guideline public companies that meet the market participant criterion are selected based on the business description and profile of the acquired entity.

Key Valuation Considerations

Calculation of the cost of equity, including the risk free rate, equity premium, beta, size premium, and unsystematic risk of the business
Selection of guideline public companies to calculate (a) the beta of each guideline company by regressing their historical stock prices using an appropriate stock index; (b) their capital structure
After-tax cost of debt based on corporate debt securities

Weighted Average Return on Assets (WARA)

WARA serves as a diagnostic check to assess the discount rates for the intangible assets

The WARA is a measure of the after-tax returns that would be required by an investor in a particular class of assets, weighted by the value of each asset relative to the total value of all assets acquired. The WARA is calculated using RORs based on the risk profile of each asset, ranging from the most liquid (cash) to the most illiquid (goodwill).

Key Valuation Considerations

The asset values incorporated in the WARA will be based on normal operating levels required to sustain the business, and will exclude any non-operating assets
Selected returns for: working capital & fixed assets will be less than WARA; identified intangible assets will likely be equal to or slightly higher than WARA; & goodwill (including assembled workforce) will be higher than WARA

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