Finding the true price of an acquisition

“The rationale of the acquirer for entering into the transaction often provides an indication as to which major intangible assets the acquired company may have”

In the acquisition of a business, the price should be based on explicit performance expectations, taking into account the conditions of the specific business as well as assumptions regarding the development of the market, the sector and the macro-economic environment. To aggregate such expectations and assumptions into a cash figure is one of the key challenges in pricing a transaction.

This was the basic message of the first article in this series. The second article, following on from the one in VIR 1014, sees senior KPMG Vietnam advisory manager Dr. Franz Degenhardt* talk about an inverse step – to de-aggregate a transaction price into meaningful components to demonstrate what has actually been acquired and paid for.

Any business can be seen as a bundle of assets working together as a whole to generate a stream of cash.

Acquiring a business means paying a price in return for a claim on the future cash stream and – directly or indirectly – some degree of control over the assets and the management. In pricing an operating business, an investor should focus on the cash which the business will generate in the future, maybe after restructuring by the acquirer. This cash flow will be the return on the purchase price, and the price is appropriate if this return meets the investor’s requirements.

But there is another meaningful angle to look at the purchase price. It should not only be related to the cash generated by the business, but also to the assets that constitute it. In varying a well-known saying, one can phrase this “cash flow is what you pay for, assets are what you get”. Thus, a purchase price can be broken down in components that correspond to the assets of the acquired business. At this point, two questions occur: Why do this? How to do it?

Where goodwill arises

The “why” question has a standard answer – fair value based financial reporting standards like IFRS, HKFRS and US-GAAP and also VAS require the acquirer to do this kind of breakdown – the so-called “purchase price allocation” (PPA). The relevant standards include VAS 11, IFRS 3, HKFRS 3 and SFAS 141 which are all named business combinations. These standards require applying the principle of separate recognition to assets acquired in a business combination in a similar manner like it would be applied to individually purchased assets. If the acquisition is performed as a share deal, the assets of the acquired company have to be shown separately on the acquirer’s consolidated balance sheet. In the case of an asset deal, the acquired assets have to be carried separately on the acquirer’s single-entity balance sheet. In contrast, the single-entity financials of the acquired company are not affected by the result of the PPA.

Of course the standard setters implemented this requirement not for the sake of following abstract principles – they have reasons to believe that a PPA is useful. These reasons become obvious if one compares the traditional and fair value based post-acquisition accounting.

The traditional approach to the target’s assets is quite simple – allocate the purchase price, including assumed liabilities, to the book value of the assets carried on the target’s balance sheet and show the part of the purchase price that exceeds the sum of these book values as goodwill. This broadly defined “traditional goodwill” – as I will call it – is an aggregation of three or four quite different components:

l Differences between book values and fair values of the assets that the company acquired carries in its balance sheet. For example, a company may own a piece of real estate which is carried at historical cost, but would at the acquisition date sell in the market for a much higher price, resulting in a “hidden reserve” on the acquired company’s balance sheet which increases the purchase price

l Intangible assets that the acquired company generated internally over time and are not carried on its balance sheet. Depending on the business nature of the acquired company, these may include very different assets like brand names, intellectual property, customer lists, an R&D pipeline, qualification of the workforce or relationships with key customers and suppliers.

l A business is not just a collection of assets generating cash with assets is more than simply holding them. Therefore, a purchase price usually contains a premium over the sum of the market values of the acquired company’s individual assets. This premium is for the factors that make the assets interact in order to constitute a going-concern business. If this premium is negative, the acquirer can make a profit by just selling the acquired company’s assets part by part, which is the business model of a “corporate raider”. However, this situation should occur rarely and trigger another round of analysis whether assets have been overstated or liabilities have been overlooked

l An unwanted, but sometimes significant component of the goodwill may result from valuation errors by either of the transacting parties, resulting in an over- or underpayment for the acquired company.

An understanding of the nature of the goodwill paid in an acquisition is the basis to assess whether the acquisition is beneficial for the acquirer’s shareholders. Also the “stability” of the goodwill over time depends on its nature. For example, success factors of the target that are linked to the previous owner – sometimes called “dog goodwill” (like a dog goes with the owner) – are less useful for the acquirer than those which will stay with the acquired company after the acquisition – which is the “cat goodwill” (like cat will stay at its current place). Even shareholders who prefer dogs over cats as home pets would not want to see their company paying for “dog goodwill” in an acquisition.

In order to justify a transaction price, it is therefore necessary to break a big “traditional goodwill” down further into its component parts.

From “lumpy goodwill” to “core goodwill”

To perform such a breakdown, the acquirer has to come up with a list of the main assets that constitute the business acquired. For those of the assets which are carried on the acquired company’s balance sheet, the acquirer has to assess whether their fair value differs materially from the book value. If this is the case, the asset has to be valued, and a part of the “traditional goodwill” is allocated to the differences between fair values and book values.

Although this step can be far from easy – the more challenging part is often to identify and value the acquired company’s self-generated intangible assets and sometimes liabilities which are not carried on the balance sheet. The importance of purchase price allocations arises from the observation that these intangible assets often are very significant. In many industries, getting control over a company’s self-generated intangibles is an important driver for merger and acquisition activity.

The identification of self-generated intangibles has to be done individually for each company, taking its business nature, market environment and special strengths and weaknesses into account. The rationale of the acquirer for entering into the transaction often provides an indication as to which major intangible assets the acquired company may have. The acquirer knows, or at least should know, best whether the acquired company is purchased to get access to, say, advanced technology, an attractive customer base or a strong brand. However, the intangibles have to be identified and valued from a market’s perspective. If, for example, a competitor with a strong brand is acquired for the purpose to take exactly this competing brand from the market, the purchase price would still reflect the value of this brand. Therefore, it would have to be included in the purchase price allocation, regardless of the special intention of the acquirer.

Important in the identification process is also which intangible assets qualify for separate recognition. The accounting standards require the intangible asset to be “identifiable”, meaning that it is either capable of being separated from the acquired company, by selling, licencing etc, or arising from contractual or legal rights. Patented or unpatented technology, customer lists or brands are example of intangibles which fulfill at least one of these criteria, assembled workforce or customer and supplier relationships are counter-examples – these have to be included in the goodwill number.

How to value acquired intangibles?

After the relevant intangible assets are identified, the acquirer has to estimate their fair value. The first way of identifying the fair value of any asset is the traded or quoted market price for an identical or similar asset. Unfortunately, those are very rarely observable. Intangible assets tend to be very individual in nature, unfold their value only in the context with other assets of the acquired company and are often not easy to transfer. Even if there are market transactions, their terms and conditions are in many cases not disclosed in sufficient detail. In this situation, the acquirer usually has to rely on a valuation model.

The basic idea of these valuation models is to discount the cash flows – future additional income or cost savings – which can be achieved by using the intangible asset back to the acquisition date. Attributing cash flows to intangible assets is not in all cases completely straight forward. For intangibles like intellectual property (e.g. patents or trademarks) which are often licenced out, these cash flows can be the royalty payments that the acquired company would have to pay without the assets.

In practice, these are usually determined based on revenue forecasts and royalty charges on revenue which can be estimated based on licencing transactions seen in the market. Another common model to value intangibles is the “Excess Earnings Model” in which incremental income resulting from the intangible asset is discounted. In the valuation of a customer base, for example, this would be the income resulting from the sales to these customers. Charges for other assets which are needed to utilise the customer base are deducted in the calculation of the cash flows. These so-called “contributory assets” can include a wide spectrum of tangible and intangible assets. The cash flow projection also has to reflect the future lifetime of the asset. In the example of the customer base, the decrease would usually be based on annual customer attrition rates.

Some intangible assets cannot be reliably linked to future cash flows. These are valued based on the costs to develop them. An example can be individually designed software resulting in highly efficient internal processes of the acquired company. If such an asset has been developed some years ago, the development cost figure has to be adjusted for inflation and obsolescence.

Getting the reporting right helps to explain the transaction

Obviously, a PPA is a pure reporting exercise without any impact on the single-entity financial statements of the acquired company or on the cash position of any of the companies involved. However, it may have a significant impact on the acquirer’s consolidated earnings over future years. Under IFRS and US-GAAP, intangible assets are amortised over their useful life in case this is finite. Intangible assets with infinite useful life as well as goodwill are not amortised, but subject to a regular impairment testing – the so called “impairment-only approach”. Under VAS, goodwill is required to be uniformly amortised over its useful life which should not exceed 10 years. Likewise, the useful life of intangible assets is, under VAS, assumed to be at most 20 years.

The purchase price allocation determines the timing and amount of future amortisation costs. The impact under IFRS and US-GAAP is even bigger – goodwill and those intangibles which are deemed to have infinite useful life do not trigger regular amortisation costs, but may give rise to substantial impairment charges in future years. Since such impairments are more likely when the economic environment becomes difficult anyway, the impairment-only approach tends to add volatility to the consolidated P&L. There are a couple of potentially tricky challenges in a purchase price allocation which have not been discussed here.

Examples include the quantification of the purchase price paid if the acquirer pays in its own shares, this step alone may require a company valuation of the acquirer, identification of the acquirer sometimes not easy if the transaction is modeled as a “merger of equals”, off-balance sheet contingent liabilities of the acquired company have to be identified and valued in a PPA as well and treatment of a business combination achieved in stages. However, despite all the technicalities around the identification and valuation of intangibles, it should be seen that the outcome of a PPA conveys a very natural message – a high-level snapshot on what the acquirer has actually paid for.

The acquisition of a well-fitting business for favourable conditions can be a measure to significantly increase shareholder value. But given the high percentage of acquisitions with a disappointing outcome, such a step will be scrutinised carefully by the acquirer’s shareholders. Explaining which intangible assets have actually been acquired is essential to demonstrate the benefit of the acquisition and the reasonableness of the consideration paid. And intangible assets as success factors for businesses will become more and more important here while Vietnam is moving from a labour-based towards a knowledge-based economy.

* The author specialises in the valuation of companies and financial instruments. In his more than 10 years of experience in the field, he has performed valuations for a considerable number of Vietnamese companies and he also has extensive international experience. The views expressed by the author here do not necessarily represent the views and opinions of KPMG and VIR.

Tags: acquisition