When to Value a Company – Part 10: Allocating the Purchase Price for an Acquisition
What is a Purchase Price Allocation (PPA)?
This involves allocating the total purchase price paid for a business to all its identifiable tangible and intangible assets and liabilities, even if some of those assets are not listed on the balance sheet.
When is a Purchase Price Allocation Required?
After the deal has been closed, the acquiror’s external accountant/auditor would require the transaction to be properly recorded for year-end financial reporting. Accounting rules such as IFRS 3 Business Combinations and ASPE 1582 Business Combinations require that after finalizing a business acquisition, the consideration paid, along with the assets and liabilities obtained, must all be recorded at their fair value (FV) as of the acquisition date (the Acquisition Date).
Main Components of a Purchase Price Allocation
A PPA generally involves the following steps:
- Quantify the FV of the consideration paid to acquire the business. Not all the consideration paid may be in the form of cash.
- Identify and revalue all tangible assets acquired and liabilities assumed to their respective FV as of the Acquisition Date. Tangible assets include physical assets like buildings, land, equipment, and inventory. Liabilities include accounts payable, outstanding loans or long-term debts.
- Identify and value intangible assets acquired: Intangible assets include items like patents, brand names and trademarks, developed technology, customer relationships and other assets that have been developed over years.
- Allocate the purchase price: Once the fair values of tangible and intangible assets and liabilities are determined, the remaining amount of the purchase price is allocated to goodwill. Goodwill represents the premium paid for the acquired business above the fair value of its identifiable assets and liabilities.
FV of the Consideration
The consideration paid for the acquisition could come in many forms, including cash, common shares of the purchaser, promissory notes, contingent payments, earnouts, and other types of assets that could be used as payment in a business combination. The consideration must be recorded at FV as of the Acquisition Date.
If the acquisition was paid in all cash, then the FV of the consideration would equal the face value of the transaction. Where it gets complicated is when complex financial instruments, private company shares, deferred payments, or contingent consideration are included as part of the purchase price. In these situations, a valuator must properly assess the type of asset and value it based on an acceptable valuation approach.
Under IFRS 3 and ASPE 1582, all assets and liabilities obtained in a business combination must be recorded at FV as at the Acquisition Date. This typically includes a review of the working capital, property, plant, and equipment and an assessment as to whether the FV of these assets differs significantly from their reported book value. For capital intensive companies, the FV of the equipment would likely be different than their reported book values.
Identify Intangible Assets Acquired
An important part of the PPA process is to identify all identifiable intangible assets acquired as part of the business combination. According to IFRS 3 and ASPE 1582, an intangible asset is considered to be identifiable if it is separable or arises from other contractual rights. Common intangible assets are as follows:
- Marketing-related intangible assets:
- Trademarks, service markets and related items.
- Internet domain names and websites.
- Non-compete agreements.
- Customer -related intangible assets:
- Customer lists or similar databases.
- Customer contracts (open orders and production backlogs).
- Customer relationships that generate recurring business.
- Technology-related intangible assets
- Software licenses.
- Technology developed in-house or under development.
- Contract related intangible assets
- Franchise rights.
- Licensing arrangements.
- Supplier agreements.
The following are examples of assets found in business combinations that do not meet the definition of an identifiable intangible asset. These may affect the value of other assets, or they are just included in goodwill.
- Previously recognized goodwill does not arise from contractual or legals rights and therefore does not meet the definition of an identifiable intangible asset.
- Assembled workforce is also not considered an identifiable as there is usually insufficient control over the economic benefits that result from the assembled workforce.
- Synergies expected from the merger are typically not identifiable as they do not arise from contractual or other legal rights and are not capable of being separated from the purchaser.
Although IFRS 3 and ASPE 1582 require identifiable assets and liabilities acquired in a business combination to be recorded by the acquirer at FV, there is limited guidance on how FV should be determined. Below are a few examples of the most accepted approaches.
- Asset approaches – Asset approaches seek to estimate FV by quantifying the amount of money that would be required to repurchase or reproduce the asset under review. The two most popular asset approaches to FV intangible assets are:
- Reproduction Cost Method; and
- Replacement Cost Method.
- Market approach – The market approach provides an indication of FV by comparing the asset under review to similar assets that were bought and sold in recent market transactions. The two most popular market approaches to FV intangible assets are:
- Sales Transactions Comparison Method; and
- Market Multiples Method.
- Income approach – Valuation methods following the income approach estimate the price an asset could be sold for in an arm’s length transaction on the basis of the asset’s expected future income stream. Popular methods to FV intangible assets are:
- Relief From Royalty Method;
- With and Without Method; and
- Multi-Period Excess Earnings Method.
Allocate Remaining Purchase Price to Goodwill
Under IFRS and ASPE, the acquirer shall recognize goodwill as of the Acquisition Date, measured as the excess of the consideration transferred, and the of the acquisition-date amounts of identifiable assets acquired and the liabilities assumed.
Reasonability of the PPA – Comparing the IRR of the transaction to the WACC
The internal rate of return (IRR) is the discount rate at which the present value of the acquiree’s forecast debt-free cash flows is equal to the purchase price paid for the business assets. As opposed to the weighted average cost of capital (WACC), which represents the rate of return required by market participants, the IRR represents the acquirer’s rate of return expected to be achieved in the acquisition.
Although in theory the IRR should approximate the WACC, differences can arise. If the WACC is higher than the acquired entity’s IRR, then the acquirer may have paid more than the aggregate FV of the assets acquired. As a result, a higher degree of goodwill is recognized than would otherwise be expected. An implication of higher-than-expected goodwill would be potential challenges in supporting the value of goodwill on the required annual impairment test dates.
A WACC lower than the IRR suggests the acquirer made a cost-effective acquisition and the resulting value of goodwill would be lower than otherwise expected. However, caution must be taken where the IRR exceeds the WACC, as the difference may be the result of Buyer-Specific Synergies included in the forecasts. Alternatively, the difference could indicate the transaction was not an orderly transaction and therefore was not representative of FV.
The preparation of a PPA can be a daunting and complicated process. It requires a comprehensive understanding of the acquired business, along with experience in applying the various valuation methodologies to properly FV the intangible assets acquired.
Our valuation team is experienced in the preparation of PPAs and intangible asset valuations and can offer valuable support in matters related to business combinations. If you have a client that recently went through a business combination, please consult one of our CBVs to assist in preparing a PPA.