Companies often use contingent consideration when structuring M&A transactions to bridge differing perceptions of value between a buyer and seller, to share risk related to uncertainty of future events, to create an incentive for sellers who will remain active in the business post-acquisition, and other reasons. ASC 805 stipulates that acquiring entities are required to record the fair value of earn-outs and other contingent payments as part of the total purchase price at the acquisition date.
About a year ago, we discussed Facebook’s impending purchase of messaging service WhatsApp. At the time, the acquisition was the subject of much debate, but the intervening period gives us a chance to see how things have shaken out. This also gives us the chance to see how the purchase price has been allocated for accounting purposes.
Golden parachute payments have long been a controversial topic. These payments, typically occurring when a public company undergoes a change-in-control, can result in huge windfalls for senior executives and in some cases draw the ire of political activists and shareholder advisory groups. Golden parachute payments can also lead to significant tax consequences for both the company and the individual. Strategies to mitigate these tax risks include careful design of compensation agreements and consideration of noncompete agreements to reduce the likelihood of additional excise taxes.
Just before Christmas 2014, FASB issued Accounting Standards Update No. 2014-18, Accounting for Identifiable Intangible Assets in a Business Combination, a consensus of the Private Company Council (“ASU”). The ASU allows a private company (i.e. not a public or not-for-profit entity) to choose not to recognize two types of intangible assets separately from goodwill following a business combination: customer-related intangible assets that cannot be sold or licensed independently from other assets of a business, noncompetition agreements.
If you are a top company executive, salesperson, or are employed in a highly skilled technical field, you likely have a clause in your employment contract that prohibits you from leaving to work for a competitor or starting your own firm for a specified period of time. While commonplace for more senior positions and in certain industries, you may be surprised to find a non-compete agreement (NCA) in your contract if you assemble or deliver sandwiches at one of Jimmy John’s 2,000 restaurant locations.
At its September 16, 2014 meeting, the Private Company Council reached consensus on a proposed GAAP exception available to private companies completing a business combination. The exception must be endorsed by the FASB before becoming effective. The proposed exception would allow private companies not to recognize non-competition agreements and certain customer-related intangible assets acquired in a business combination. The PCC’s mandate is to reduce the cost and complexity of financial reporting for private companies. However, the degree to which this proposal meets that objective depends, in part, on two factors …
Jimmy Kimmel jokes that “Tax day is the day that ordinary Americans send their money to Washington, D.C., and wealthy Americans send their money to the Cayman Islands.” Tax day is now the day when Medtronic, a leading medical device company headquartered in Minneapolis, will be sending its money to Ireland. On June 15th, Medtronic and Irish healthcare company Covidien PLC announced they had signed an agreement in which the former would acquire the latter for approximately $42.9 billion. One motivation for Medtronic to acquire Covidien has to do with taxes. As part of the acquisition, Medtronic will have a new corporate tax rate of 12.5%, down from a top marginal rate of 35%, just by changing its address from the US to Ireland, using a strategy known as “inversion.”
Reaching average audiences of 18.4 million per episode, “Game of Thrones” is the most successful show in HBO’s history. The show’s vast popularity has boosted HBO’s licensing revenue and HBO holds more than sixty different licenses, including for brands of beer, jewelry, and cosmetics. HBO has also made moves to protect the integrity of its licensed products, sending cease-and-desist letters to manufacturers of unlicensed products. The success of both the show and HBO’s ability to capitalize on licensing opportunities leads to interesting observations about the techniques used to value tradenames and licensing rights, both valuable forms of intellectual property.
A recent post on the Wall Street Journal’s CFO Journal blog reported recent comments by Andrew Ceresny, head of enforcement at the SEC, signaling that financial reporting issues will be the subject of enhanced scrutiny as actions related to the financial crisis recede. In testimony before Congress this spring, SEC Chair Mary Jo White cited efforts by the newly-formed Financial Reporting and Audit Task Force to “identify areas susceptible to fraudulent financial reporting through an on-going review of financial statement restatements and revisions, analysis of performance trends by industry, and the use of technology-based tools.” Through Operation Broken Gate, the task force is focused on audit failures in addition to issuer fraud. The emphasis on valuation issues is not surprising, since the exercise of judgment is an inherent aspect of valuation.
Elon Musk just opened Tesla Motors’ patents to the public in “the spirit of the open source movement.” Perhaps shrewdly, he appears to have concluded that the cash flows he is giving up today in the form of foregone royalties or potentially lower margins will be more than made up by future cash flows from a more vibrant solar power-based transportation network.
Contingent consideration (otherwise known as earn-outs) has been in the news lately. From the acquirer’s perspective, contingent consideration functions as a hedge against poor future performance and the possibility that cash flow will not grow as much as projected. Additionally, it can serve as incentive for a seller to maintain or improve the performance of the company after a transaction. ASC 805 requires that the fair value of contingent consideration be recorded as a liability at the acquisition date, with the effective result of increasing the amount of goodwill in the transaction. This liability must be revalued annually until the contingency is resolved. The valuation of contingent liabilities is dependent on the probability of reaching various milestones at points in the future and is usually determined by probability-weighted expected future payments. There is no one-size-fits-all approach to contingent consideration valuation and it can be beneficial to have a valuation expert involved in your purchase price allocation process.
A while back, I shared a dinner with a group of friends that included a small business owner who runs a young trucking company. At one point, my friend wondered out aloud what price his company would fetch in the marketplace. A quick-witted pal amongst us suggested a number on the order of 1.01 times the book value (as a proxy for the value of the tangible assets). The business owner was a bit peeved – he was hoping for a higher figure, of course – but the quick-thinking friend was merely opining that this particular business did not yet have any intangible assets that a market participant acquirer would find valuable.
It’s no secret that the number of insurance agency acquisitions by banks and thrifts has declined considerably over the last ten years. According to SNL Financial, an average of 60 agencies were purchased by banks annually between 2004 and 2008. Over the next five years, the average annual tally dropped to 27. The most likely reason for this decline is the effects of the recession and less capital available for investment. Interestingly enough, however, the number of agency divestitures by banks has been fairly constant at about ten per year. In the broader market for insurance agencies/brokerages, transaction volume has only gotten more robust over the last ten years, including a record 361 deals completed in 2012. Private equity and strategic consolidators remain keenly interested in the sector. So is there any reason for banks to care about insurance anymore? A look at the numbers from some of the leading banks in insurance suggests that there is.
For hundreds of years, various Chinese dynasties prevented the dissemination of their sericultural secrets along the Silk Road by punishment of death. If anyone were caught smuggling a silkworm egg or cocoon or revealing any information about silk production, well, it would be off with their head. While axes have fallen out of fashion as the weapon of choice for protecting intellectual property, some might argue that they have been replaced by the equally controversial non-compete agreements (NCAs). Massachusetts is considering the adoption of policies to all but eliminate employee non-compete agreements (certain sales of a business are one exception), modeled after California legislation where courts have essentially refused to enforce them. While opinions are split, the winds of change may be blowing against covenants not to compete.
On April 8, 2014, the SEC charged CVS Caremark Corp. with misleading investors by failing to disclose certain financial setbacks and using improper purchase price allocation accounting that artificially boosted its financial performance. The SEC’s actions (and the resulting settlements) remind us that fair value matters often come under heavy scrutiny.
For public companies, it is increasingly necessary to disclose a preliminary allocation of purchase price in the 10-Q or 10-K immediately following the closing date. Preliminary allocation is important because the accounting for goodwill and intangibles drives future amortization expense which affects earnings per share. The split between amortizable and non-amortizable value can materially impact forward EPS. In addition, nobody likes surprises. A hastily prepared preliminary allocation may underestimate the value of certain intangibles, or worse, fail to initially recognize certain intangible assets that might have been discovered during a more thorough valuation process.
When a business announces a $16 billion transaction for a mobile messaging company that’s only been around since 2009, what are they actually purchasing? In this case, it’s Facebook acquiring WhatsApp. One of the interesting intersections between real-world M&A and accounting occurs when a company documents the purchase price allocation for a deal. In the world of fair value accounting, the purchaser is required to recognize and record the value of assets acquired in a deal. What intangible assets might Facebook ultimately record when it books the transaction? Clearly, one of the key components of value is the user base, but the accounting rules for intangible asset recognition require that the asset meet certain contractual-legal or separability criteria. Something like a user-base, in this instance, may not meet those criteria.
What are your customer relationships worth? One of the most common intangible assets identified in a business combination is customer relationships, which can include customer lists, order or production backlogs, and contractual or noncontractual customer relationships. Many factors can influence the value of these types of assets, including the type of underlying business, the typical “life” of the relationship between the customer and the firm, and the presence of other assets in the firm (tangible or intangible) that contribute to value.
M&A and IPO activity in the U.S. ended on a high note in 2013. Merger volume picked up in the second half of the year as companies took advantage of a low interest rate environment. Greater competition for deals and rising valuations in the United States have led some private equity firms to seek returns through less expensive (and non-conventional) minority investments and partnerships rather than buyouts. With a strong finish to 2013, there is renewed optimism that the momentum achieved in M&A and the IPO markets will carry on into 2014.
The volatility of the commercial banking industry during the financial crisis resulted in a number of banks recognizing bargain purchase gains as they acquired distressed banks. Indeed, as industries undergo cyclical changes and consolidation trends, the likelihood of strategic buyers recognizing a bargain purchase gain increases. Reviewing the methodologies and assumptions used in the initial purchase price allocation to value intangible assets and contingent liabilities is a crucial step in determining whether or not a transaction meets the criteria to be categorized as a bargain purchase.
While it may be natural to assume that brand intangibles are most important in consumer products and services, it is wrong to assume that they don’t matter for finance firms.