2022 Core Deposit Intangibles Update

On September 21, 2022, the Federal Reserve increased the target federal funds rate by 75 basis points, capping off a collective increase of 300 basis points since March 2022. With the expectation of additional rate increases this year, it’s a good time to evaluate recent trends in core deposit values and discuss expectations for deposit valuations in the coming months.

Mercer Capital previously published articles on core deposit trends in August 2020 during the early stages of the pandemic and again in August 2021. In those articles, we described a decreasing trend in core deposit intangible asset values. In response to the pandemic, the Fed cut rates effectively to zero, and the yield on the benchmark 10-year Treasury reached a record low. While many factors are pertinent to analyzing a deposit base, a significant driver of value is market interest rates. As shown below, we find ourselves in a very different interest rate environment today.

Figure 1 :: U.S. Treasury Yield Curve

Trends In CDI Values

Using data compiled by S&P Capital IQ Pro, we analyzed trends in core deposit intangible (CDI) assets recorded in whole bank acquisitions completed from 2000 through mid-September 2022. CDI values represent the value of the depository customer relationships recorded by acquirers as an intangible asset. CDI values are driven by many factors, including the “stickiness” of a customer base, the types of deposit accounts assumed, the level of noninterest income generated, and the cost of the acquired deposit base compared to alternative sources of funding. For our analysis of industry trends in CDI values, we relied on S&P Capital IQ Pro’s definition of core deposits.1

In analyzing core deposit intangible assets for individual acquisitions, however, a more detailed analysis of the deposit base would consider the relative stability of various account types. In general, CDI assets derive most of their value from lower-cost demand deposit accounts, while often significantly less (if not zero) value is ascribed to more rate-sensitive time deposits and public funds. Non-retail funding sources such as listing service or brokered deposits are excluded from core deposits when determining the value of a CDI.

Figure 2 summarizes the trend in CDI values since the start of the 2008 recession, compared with rates on 5-year FHLB advances. Over the post-recession period, CDI values have largely followed the general trend in interest rates—as alternative funding

recorded by acquirers

became more costly in 2017 and 2018, CDI values generally ticked up as well, relative to post-recession average levels. Throughout 2019, CDI values exhibited a declining trend in light of yield curve inversion and Fed cuts to the target federal funds rate during the back half of 2019. This trend accelerated in March 2020 when rates were effectively cut to zero.

Figure 2 :: CDI as % of Acquired Core Deposits

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CDI values have showed some recovery in the past few quarters (with an average CDI value of 93 basis points year-to-date in 2022 as compared to 64 basis points for all of 2021). Despite the recent uptick, CDI values remain below the post-recession average of 1.29% in the period presented in the chart and meaningfully lower than long-term historical levels which averaged closer to 2.5% to 3.0% in the early 2000s. They are also markedly lower than one might expect, given the current cost of wholesale funding.

As shown above, reported CDI values have not increased in tandem with the recent increase in FHLB rates. The average CDI value increased just 25 basis points from September 2021 to September 2022, while the five-year FHLB advance increased a dramatic 228 basis points over the same period. In late-2018 the 5-year FHLB rate approximated the current, mid-September 2022 level, but the average CDI value at that time was 2.42% (compared to the third quarter 2022 average value of 0.75%). The CDI values in recent quarters are somewhat counterintuitive. There are likely three drivers for the relationship between recently reported CDI values and market interest rates:

  • Reporting time lag. The increase in the 5-year FHLB rate has occurred rapidly over the past few months. The deals that closed in the second and third quarters of 2022 were announced in an extremely low interest rate environment. Following third quarter 2022 filings, we expect some upward migration in CDI values to occur as recently announced deals are completed, which reflect the Federal Reserve’s recent rate actions.
  • Deposit levels. Since the beginning of the pandemic, banks have been inundated with deposits. It was initially expected that the increase in deposits would be transient in nature as the economy re-opened, PPP funds were spent or invested, and consumer confidence improved. However, deposit growth continued through 2021 for nearly all banks and into 2022 for some banks. The growth rate in deposit balances is slowing, and September 2022 balances ($17.95 trillion) were lower than August 2022 balances ($18.0 trillion). Given the low average loan-to-deposit ratios, banks have not been in a hurry to increase deposit rates. With the excess of deposits, there may have been a tendency for bank acquirers to discount core deposit value given the lack of immediate funding needs or concern that, with higher market rates, the long anticipated reversal of the pandemic-related deposit influx may finally occur.
  • Uncertain Rate Outlook. While rates are expected to continue rising in the near-term, some market participants may remain concerned that a zero rate environment will remain the long-term norm. If this view is correct, which implicitly assumes that the Federal Reserve can choke inflation, CDI values will remain constrained.

Nineteen deals were announced in August and September 2022, and five of those deals provided either investor presentations or earnings calls containing CDI estimates. These CDI estimates ranged from 1.5% to 2.0%, which is more in line with the numbers we have observed in our valuation analyses. We expect CDI values to continue rising in concert with market interest rates. However, market interest rates are not the only driver of CDI value, and there are some potentially mitigating factors to CDI values in the near term.

  • Deposit levels. Over the past year, consumers were likely hesitant to go to the trouble of seeking higher interest rates as the marginal benefit of a rate enhancement would have been low in comparison to the necessary expenditure of effort. This inertia is not expected to last indefinitely. There is already evidence that excess deposit balances are beginning to exit the system. Higher attrition rates, all else equal, translate into a lower CDI value.
  • Deposit mix. Over the past decade, nationwide average deposit mix has shifted in favor of noninterest bearing deposits. In 2007, retail time deposits constituted an average of 31% of financial institution deposits with noninterest bearing deposits comprising 16%. In 2022, this mix is nearly reversed (28% of balances in noninterest-bearing accounts and 15% in retail time deposits). As banks face increasing interest rate pressure, the deposit mix is likely to begin shifting in favor of interest-bearing deposits that have lower CDI values.

Figure 3 :: Deposit Mix Overtime

  • Service charge income. The industry is facing pressure from regulators and the public to reduce overdraft charges and other fees. Lower service charge income produces lower CDI values, all else equal.
  • Deposit interest rate betas. Historical average deposit betas may be insufficient to forecast future deposit interest rates over the life of an acquired deposit base. For example, deposit betas for money market accounts have historically averaged approximately 50%. At September 23, 2022 the national average money market rate was 0.15%. A 50% beta may not be aggressive enough to yield a reasonable ongoing interest rate for an acquired deposit base with a starting interest rate of 0.15%. Using an inappropriately low beta would artificially enhance core deposit value by understating future interest rates on the acquired deposit base.

Trends In Deposit Premiums Relative To CDI Asset Values

Core deposit intangible assets are related to, but not identical to, deposit premiums paid in acquisitions. While CDI assets are an intangible asset recorded in acquisitions to capture the value of the customer relationships the deposits represent, deposit premiums paid are a function of the purchase price of an acquisition.

Deposit premiums in whole bank acquisitions are computed based on the excess of the purchase price over the target’s tangible book value, as a percentage of the core deposit base. While deposit premiums often capture the value to the acquirer of assuming the established funding source of the core deposit base (that is, the value of the deposit franchise), the purchase price also reflects factors unrelated to the deposit base, such as the quality of the acquired loan portfolio, unique synergy opportunities anticipated by the acquirer, etc. As shown in Figure 4, deposit premiums paid in whole bank acquisitions have shown more volatility than CDI values. Deposit premiums in the range of 6% to 10% remain well below the pre-Great Recession levels when premiums for whole bank acquisitions averaged closer to 20%.

Additional factors may influence the purchase price to an extent that the calculated deposit premium doesn’t necessarily bear a strong relationship to the value of the core deposit base to the acquirer. This influence is often less relevant in branch transactions where the deposit base is the primary driver of the transaction and the relationship between the purchase price and the deposit base is more direct. Figure 5 (on the next page) presents deposit premiums paid in whole bank acquisitions as compared to premiums paid in branch transactions.

Deposit premiums paid in branch transactions have generally been less volatile than tangible book value premiums paid in whole bank acquisitions. Branch transaction deposit premiums averaged in the 3.0% to 7.5% range during 2020, up from the 2.0% to 4.0% range observed in the financial crisis. During 2021 and the first quarter of 2022, branch transaction deposit premiums averaged 2.5% to 5.25%. Unfortunately, none of the branch transactions completed in the second or third quarters of 2022 reported franchise premium data.

Figure 4 :: CDI Recorded vs. Deposit Premiums Paid

Figure 5 :: Average Deposit Premiums Paid

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Some disconnect appears to exist between the prices paid in branch transactions and the CDI values recorded in bank M&A transactions. Beyond the relatively small sample size of branch transactions, one explanation might be the excess capital that continues to accumulate in the banking industry, resulting in strong bidding activity for the M&A opportunities that arise–even in situations where the potential buyers have ample deposits.

Accounting For CDI Assets

Based on the data for acquisitions for which core deposit intangible detail was reported, a majority of banks selected a ten-year amortization term for the CDI values booked. Less than 10% of transactions for which data was available selected amortization terms longer than ten years. Amortization methods were somewhat more varied, but an accelerated amortization method was selected in approximately half of these transactions.

Figure 6 :: Selected Amortization Term (Years)

Transactions Completed 2008 – September 25, 2022

Figure 7 :: Selected Amortization Method

For more information about Mercer Capital’s core deposit valuation services, please contact a member of our Depository Institution Services Team.

1 S&P Capital IQ Pro defines core deposits as, “Deposits in U.S. offices excluding time deposits over $250,000 and brokered deposits of $250,000 or less.”

Importance of an Independent Informed Valuation

In contested cases where a business interest comprises a significant portion of a divorcing couple’s net worth, it is common for one or both parties to retain a business appraiser to value the business. Post-divorce, if only one spouse retains an interest in the business, all else equal, a higher business interest value typically implies the other party will receive a greater share of the remaining marital assets, as compared to a lower business interest value. As we will discuss in this article, the facts and circumstances of the business interest being valued may reasonably support various assumptions when comparing two valuation conclusions.

As the client, attorney, or judge, it can be difficult to receive two appraisals that differ significantly in their conclusions. Which one is right? While there is not typically an absolute “right” answer, one may well be more reasonable than the other. In this article, we examine how changes to one or a few assumptions can lead to possible material changes in valuation conclusions.

Setting the Scene

Disclaimer: the following examples and narrative are for instructional purposes and do not represent absolute opinions. Facts, circumstances, and time differ thus, no two valuations are the same, even for the same company as of different dates. Facts and circumstances should support assumptions and conclusions within a range of reasonableness. The goal of this article is to illustrate differences between valuations and the drivers behind those differences, not to opine that a specific discount rate, growth rate, or methodology to analyze earnings trends is “right” or “wrong.” Always and never should generally be avoided.

Ideally, appraisers would be given the same qualitative and factual overview of the company including history, future outlook, growth and risk. Sometimes, this isn’t the case, and appraisers may receive different versions leading to variations in interpreting the risk profile and/or earning potential of the business, which can lead to differences in concluded values between appraisers. An independent, prudent valuator will be able to analyze the ebbs and flows of historical earnings, though an important step in the valuation process is discussing these trends with management. Management’s perspective behind the numbers can be helpful in understanding the trajectory of the business. In the context of litigation, it may be important for the appraiser to consider the sources of the information they are receiving.

An Illustrative Example of Valuation Math

Under the income approach, there are two general methods to value a business:

  1. Single period earnings capitalization
  2. Discounted future earnings (or benefits)

If a company/management provides the two appraisers with projections of future financial performance, these may be assessed in the multi-period discounted cash flow method. However, projections may not be available, and in such cases, the single period earnings capitalization method is more commonly employed.

To value a business under the single period income capitalization method, appraisers must specify three valuation elements:

  1. the expected cash flow (earnings)
  2. the appropriate discount rate (r), and
  3. the expected long-term growth rate in earnings (g)

The basic valuation equation is:

Value = Expected Cash Flow / (r – g)

The denominator is (r – g), and 1 / (r – g) is the implied multiple of earnings. (r – g) is also sometimes referred to as a capitalization rate or cap rate.

This equation is generalized. Depending on the measure of expected earnings or cash flow, the appropriate discount rates and expected growth rates must be used.

For this example, assume the following:

  1. Ongoing earnings is $5.0 million.
  2. The discount rate is 16.0%.
  3. The expected long-term growth rate is 3.5%, which means that ongoing earnings will grow at that rate into the future.
  4. Based on the valuation equation above, we determine the appropriate multiple to be 8.0x, calculated by 1 / (16.0% – 3.5%).

With our assumptions, we can develop a valuation indication using the single-period income capitalization method.

As seen in the figure above, the analysis can be synthesized into simple multiplication. Higher earnings or a higher multiple will lead to a higher value and vice-versa. The multiple is a function of a company’s discount rate (or risk profile) and growth rate. All else equal, companies that are growing slower or are deemed riskier, as compared to peers, the industry, and historical performance, typically

Both ongoing earnings and the multiple have numerous inputs and assumptions, and appraisers frequently use many of the same sources for the inputs in their analysis. For example, one of the first steps of a valuation is to request historical financials statements, to which appraisers make appropriate normalization adjustments to place the reported financial statements at market levels. Cost of capital data is used to assess risk and return, and appraisers commonly use similar sources in determining the risk of a business.

Range of Reasonableness

There are numerous reasons why appraisers may ultimately determine different values for the same subject business, so we won’t try list them all. Using our above example, if this valuation was the “right” answer for the purposes of this example, let’s make modest adjustments on both ends to show how much the answer might change with an optimist’s view and a pessimists’ view.

For simplicity, we will assume the appraisers used the same risk-free rate, beta, size premium, growth rate, and level of earnings (which are highlighted in the below diagram in gray). The scenarios differ in the equity risk premium and specific company risk premium.

While many of the components of the discount rate are similar, the concluded discount rates are different and range from 13.5% to 18.5%. On the surface, neither the equity risk premium nor specific company risk premium utilized by either the optimist or pessimist appear “too far” away from what we are calling the “correct” appraisal, based on the facts and circumstances of this hypothetical case.

Despite seemingly small differences, the optimist’s conclusion is 50% higher than that of the pessimist. This is where the expertise and experience of an independent appraiser is key in determining what makes the most sense within a range of reasonableness. In an ideal world, two appraisers would not be 50% apart, but, as we’ve demonstrated above, reasonable assumptions could lead appraisers to have conclusions that are significantly apart.>>>

Appraisals Bordering on Advocacy

While reasonable appraisers may disagree, there comes a point at which certain assumptions border on aggressive and in the context of other assumptions, yield a conclusion that is unreasonable based on the facts and circumstances present. An appraiser might be on the high side of earnings and growth assumptions and on the low side on the corresponding risk assumption. Unless the assumptions are supported by the facts and circumstances for the specific company, the conclusion may become too aggressive and vice versa.

In the figure below, we have illustrated how different assumptions can impact value. Only the risk-free rate, beta, and size premium (all highlighted gray) are the same. For the highest and lowest indications, we use more even more divergent specific company risk premiums, growth rates, and ongoing earnings levels.

Given the assumptions in the figure, the “high” conclusion is more than quadruple the conclusion of the “low” appraisal ($92.3 million versus $21.6 million). As presented above among the scenarios, i.e., next to the more reasonable range, neither the high or low is reasonable and are examples of conclusions that are likely advocative in nature, rather than providing independent conclusions of value.

Concluding Thoughts

Many assumptions that make up an appraisal are interrelated. Risk is a function of the assessment of ongoing earnings. If earnings are assumed to be much lower than the company has recently demonstrated, it makes sense that the risk in achieving lower performance would be lower than assuming the status quo or further increases in earnings. With earnings and risk being two of the key inputs in a valuation, it is important that each are reasonable on their own and when considered together.

In the “high” example above, the appraiser uses high-end earnings and growth and low-end risk assumptions. There is likely a double counting of positive factors. In the “low” example, the appraiser uses low-end earnings and growth, and high-end risk assumptions. There is likely some double counting of negative factors there.

NIB Deposits Anesthetize Bond Pain

The August Bank Watch looks at unrealized losses in bank bond portfolios based upon Call Report data as of June 30, 2022. Our review of unrealized losses as of March 31 can be found here.

Fed Chair Powell gave a short 8-minute speech on August 26 at the annual Jackson Hole, Wyoming economic summit that is hosted by the Federal Reserve Bank of Kansas City. The gist of Powell’s speech is that the Fed is solely focused on reducing inflation. Powell’s speech in 2021 discussed “transitory” inflation and the timing of when the Fed might begin to reduce its monthly purchase of $120 billion of U.S. Treasuries (“UST”) and Agency MBS. At the time consumer prices were then advancing around 5% vs 9% now.

Last year, equity markets liked what it heard from Powell at Jackson Hole regarding the liquidity spigot; not so this year as the S&P 500 declined 3.4% and the NASDAQ declined 3.9% the day Powell spoke. The NASDAQ Bank Index declined 2.4% and is down 12.8% year-to-date through August 26.

Interestingly, UST yields did not move much even though Powell said it would not be appropriate to stop hiking at a “neutral” rate. As such, bank bond portfolios did not incur additional losses. In fact, the peak loss for most bank bond portfolios was in mid-June when the yield on the 10-year UST rose to 3.49% compared to 2.98% on June 30 and 3.04% on August 26.

Based upon our review of bank second quarter earnings calls and analysts’ write-ups, investors seem to be taking the losses in stride given solid growth in spread revenues as NIM expansion has been dramatic. Last spring that was not the case when the ~150bps increase in intermediate- and long-term rates produced significant losses in bond portfolios given little coupon to cushion the higher term structure.

As shown in Figure 1, the Fed has hiked the Funds target rate much faster and by a greater magnitude than it did in 1994 when the Fed waylaid the bond market with 300bps of hikes. Bond portfolios were hammered as the hikes and an upturn in inflation drove longer-term rates higher by ~275bps. The curve became flatter but never inverted as investors assumed a recession would not develop.1

Figure 1: 1994 Bond Bear Market vs 2022 Bond Bear Market

Powell’s comments last week imply short-term policy rates may go as high as 4% by next Spring based upon futures markets. Given little movement in UST yields, bond investors are pricing in slowing economic activity and possibly lower yields to come. If so, the inverted UST curve prospectively will become more inverted if the Powell Fed can stomach the seemingly probable fallout as it pushes short rates higher.

Figure 2: Unrealized Bond Portfolio Losses vs Cost Basis and Tier 1 Capital

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Figure 3: Unrealized Bond Portfolio Losses vs Cost Basis and Tier 1 Capital

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As shown in Figure 2, unrealized losses as of June 30 were significant though losses and gains are excluded from regulatory capital for all but the largest banks.

Unrealized losses in available-for-sale (“AFS”) designated portfolios ranged from an average of 5.7% of cost for banks with less than $100 million of assets to 8.0% for banks with $1 billion to $3 billion of assets. As a percent of tier one capital the range was from 11.3% for banks with $100 billion to $250 billion of assets to 22.5% for banks with $100 million to $500 million of assets.

Figure 3 provides the same data as of year-end 1994 when the ten-year UST was near a cyclical peak of ~8%. The bear market of 2022 is far worse than the 1994 bear market. Unlike 1994, portfolios today have little coupon to cushion the impact of rising rates. Also, duration may be longer today.

The “coupon issue” today is reflected in low portfolio yields. As an example, the average taxable equivalent portfolio yield for banks with $1 billion to $3 billion of assets was only 1.96% in 2Q22 compared to 1.80% in 4Q21 immediately before the Fed began to hike. By way of comparison, the yield on one-month T-bills as of August 26 was 2.21% and 30-day LIBOR was 2.49%. Cash yields more than bond portfolios and prospectively will yield much more if the Fed pushes the Funds target to 4% by next spring.

The good news is that portfolio cash flow should be reinvested at much higher yields to the extent it is not used to fund loan growth or deposit run-off. The same applies to fixed rate loans, which are not marked-to-market but may have comparable losses given both higher rates and wider credit spreads.

The exceptionally good news is that non-interest-bearing (“NIB”) deposits, which are the core of core deposits, are driving NIM expansion and growth in spread revenues. Rate hikes this year are inflating the value of NIB deposits. There is no mark-to-market report for a board to see this; rather, the value is in the income statement.

The unknowable question is if the Fed can push short-term rates higher without producing a sharp downturn or serious credit event that forces the Fed to blink again. The downturn in bank stocks this year primarily reflects investor expectations about the potential impact a recession would have on credit costs next year; it is not about unrealized losses in bond portfolios.

Figure 4: Credit Spreads Widen

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About Mercer Capital

Mercer Capital is a national valuation and transaction advisory firm that has advised banks for 40 years through bear and bull markets. Please call if we can be of assistance.

1 The Fed rate hiking campaigns of 2004-2006 (425bps of cumulative hikes to 5.25%) and 2015-2018 (225bps to 2.50%) did not produce as great of losses as the current cycle and 1994. The curve was exceptionally steep in 2004 such that long-term UST rates rose less than 100 bps (Greenspan called it a “conundrum”) while it took a couple of years for long-term yields to peak in 2018 around 3% vs the “all-at-once” episode this year.

The Importance of Purchase Price Allocations to Acquirers

This is the final article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.

Growing up an avid sports fan, I always enjoyed picking up the paper and flipping to the sports section to see the box scores from the prior day’s games. While the headline score told you who won or lost, the box score gave more information and insights into who played well and the narrative of the game. For example, the box score might tell you that even though your favorite team won, they were dominated by the other team in all the categories except turnovers, or that the team that lost actually “won” each quarter except the fourth and their star player had a bad game.

In my view, a purchase price allocation is similar to a box score in that it provides greater detail from which to derive insights on a particular transaction. While a purchase price allocation (PPA) analysis is primarily an accounting (and compliance driven) exercise, it is also a window into the objectives and motivations behind the transaction. When used proactively and/or during the M&A process, the disciplines of PPA analysis can provide buyers with important perspective concerning the unique value attributes of the target’s intangible asset base, which can help rationalize strategic acquisition consideration or forewarn of potentially unstable or short-lived intangible asset value.

Below we explore PPAs further with a broad overview and then a deeper look into the pitfalls and best practices related to them.

Introduction to PPAs

Acquirers conduct PPAs to measure the fair value of various tangible and intangible assets of the acquired business. Any excess of the total asset value implied by the transaction over the fair values of identified assets is ascribed to the residual asset, goodwill.

Intangible assets commonly identified and measured as part of PPA analyses include:

  • Trade name – Trade name intangibles may be valuable if they enhance the expected future cash flows of the firm, either through higher revenue or superior margins. The relief from royalty method, which seeks to simulate cost savings due to the ownership of the name, is frequently used to measure the value of trade names.
  • Customer relationships – Customer relationships can be valuable because of the expectation of recurring revenue.
  • Technology – Technologies developed by the target business are valuable because the acquirer avoids associated development or acquisition costs. Patents and other forms of intellectual property may provide legal protection from competition and help secure uniqueness and/or differentiation.
  • IPR&D – Ongoing R&D projects can give rise to in-process research and development intangible assets, whose values are predicated on expected future cash flows.
  • Contractual assets – Contracts that lock in pricing advantages – above market sales prices or below market costs – create value by enhancing cash flow.
  • Employment / Non-competition agreements – Employment and non-competition agreements with key executives ensure a smooth transition following an M&A transaction, which can be vital in reducing the likelihood of employee or customer defection.

The value of an enterprise is often greater than the sum of its identified parts (both tangible and intangible), and the excess is usually reflected in the residual asset, goodwill. GAAP goodwill also captures facets of the target that may be value-accretive, but do not meet certain criteria to be identified as an intangible asset. Notably, fair value measurement presumes a market participant perspective. Goodwill may also include acquirer-specific synergistic or strategic considerations that are not available to other market participants. Consequently, goodwill has tended to account for a significant portion of allocated value in truly strategic business combinations.

Pitfalls and Best Practices of PPAs

Below we highlight some pitfalls and best practices gleaned from providing purchase price allocations to acquirers since the advent of fair value accounting.

What are some of the pitfalls in purchase price allocations?

Sometimes differences arise between expectations or estimates prior to the transaction and fair value measurements performed after the transaction. An example is contingent consideration arrangements – estimates from the deal team’s calculations could vary from the fair value of the corresponding liability measured and reported for GAAP purposes. To the extent amortization estimates are prepared prior to the transaction, any variance in the allocation of total transaction value to amortizable intangible assets and non-amortized, indefinite lived assets – be they identifiable intangible assets or goodwill – could also lead to different future EPS estimates for the acquirer.

What are the benefits of looking at the allocation process early?

The opportunity to think through and talk about some of the unusual elements of the more involved transactions can be enormously helpful. Similar to a coach who may look at the box score from the first half of a game during the halftime break, we view the dialogue we have with clients when we prepare a preliminary PPA estimate prior to closing as a particularly important part of the M&A project. This deliberative process results in a more robust – well-reasoned analysis that is easier for the external auditors to review, and better stands the test of time requiring fewer true-ups or other adjustments in the future. Surprises are difficult to eliminate, but as they say, forewarned is forearmed.

Can goodwill be broken into different components?If so, what are the different components and how are they delineated?

In the world of FASB, goodwill is not delineated into personal goodwill and corporate or enterprise goodwill. However, in the tax world, this distinction can be of critical importance and can create significant savings to the sellers of a C corporation business.

Many sellers prefer that a transaction be structured as a stock sale, rather than an asset sale, thereby avoiding a built in gains issue and its related tax liability. Buyers want to do the opposite for a variety of reasons. When a C corporation’s assets are sold, the shareholders must realize the gain and face the issue of double taxation whereby the gain is taxed at both the corporate level, and again at the individual level when proceeds are distributed to the shareholders. Proceeds that can be allocated to the sale of a personal asset, such as personal goodwill, may mitigate the double taxation issue.

The Internal Revenue Service defines goodwill as “the value of a trade or business based on expected continued customer patronage due to its name, reputation, or any other factor.”1 Recent Tax Court decisions have recognized a distinction between the goodwill of a business itself and the goodwill attributable to the owners/professionals of that business. This second type is typically referred to as personal (or professional) goodwill (a term used interchangeably in tax cases).

Personal goodwill differs from enterprise goodwill in that personal goodwill represents the value stemming from an individual’s personal service to that business, and is an asset owned by the individual, not the business itself. This value would encompass an individual’s professional reputation, personal relationships with customers or suppliers, technical expertise, or other distinctly personal abilities which provide economic benefit to a business. This economic benefit is in excess of any normal return earned on other tangible or intangible assets of the company.

What other problems/issues beyond a PPA can you help acquirers navigate?

As part of our full suite of services for acquirers, we can handle a number of different kinds of special projects that corporate finance departments may be looking to outsource, completely or partially. For example, our firm helps clients think through certain financial or strategic questions – what level of cash flow reinvestment will best balance competing shareholder interests? Or, what is the appropriate hurdle rate when evaluating internal projects vs. acquisitions for capital budgeting exercises? In other instances, we perform financial due diligence and quality of earnings analyses for transactions.


As the “box score” of transactions, PPAs can be an important tool for acquirers and provide greater insight into the motivations and narrative behind a transaction by illustrating the value of various intangible components of a business beyond the collection of tangible assets and how those compare to the purchase price being paid. Our purchase price allocations can be more robust with fewer surprises when we have also worked with the clients before the close of the transaction on elements such as financial due diligence or contingent consideration estimates, or even broader corporate finance and PPA studies.

Mercer Capital has extensive experience valuing intangible assets for purchase price allocations (ASC 805), impairment testing (ASC 350), and fresh-start accounting (ASC 852) and assisting buyers during financial due diligence. Call us – we would like to help.

1 IRS Publication 535: Business Expenses, Ch. 9, Cat. No. 15065Z

Navigating Tax Returns | Tips and Key Focus Areas for Family Law Attorneys and Divorcing Individuals/Business Owners

This piece is designed to help you better understand how to navigate tax returns on behalf of your clients. Why? The information contained in tax returns can provide support for marital assets and liabilities, sources of income, business ownership(s), and can lend cause for further analysis. Reviewing multiple years of tax returns and accompanying supplemental schedules may provide helpful information on trends and/or changes and could indicate the need for forensic investigations.

We know you are not a forensic or finance specialist but in your role as a family law attorney, understanding the tax returns schedules, disclosures, and why that information is important can be valuable. That is what this short piece provides you. Form 1040, Schedule A (Itemized Deductions), Schedule K-1 and other relevant business-related schedules are addressed in this short, easy to read and easy to understand piece. We hope you will find this a handy reference that will become a well-worn resource in your practice.

Mercer Capital is a national business valuation and advisory firm providing subject matter and industry-related expertise in financial, valuation, and forensic services. You’ll find more information about our national litigation team in this piece and here. When your clients have business valuation and/or forensic needs, please don’t hesitate to contact us.

Buy-Side Solvency Opinions

This is the ninth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.

With the potential rise of corporate bankruptcies, if the U.S. enters a sufficiently deep recession next year, debt funded acquisitions and dividend recap transactions that were common the past couple of years after rates plunged may be subject to intense scrutiny. Of course, if there is no recession or only a shallow recession, then these musings may be premature.

Nonetheless, acquirers who anticipate levering a target’s capital structure and owners who are contemplating a dividend recap should be familiar with solvency opinions and the concept of fraudulent conveyance, concepts that were litigated in the 2020 bankruptcy of Neiman Marcus.


Neiman Marcus: A Restructuring Case Study

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What Is a Solvency Opinion?

The Business Judgement Rule, an English case law doctrine followed in the US and Canada, provides directors with great latitude in running the affairs of a corporation provided directors do not breach their fiduciary duties to act in good faith, loyalty and due care. However, there are instances when state law prohibits certain actions including the fraudulent transfer of assets to stockholders that would leave a company insolvent.

This straightforward statutory prescription has taken on more meaning over the past decade because Corporate America has significantly increased its use of debt given very low interest rates. Investors have been willing to fund the increase because negligible rates on “safe” assets have pushed individuals and institutions further out the risk curve to produce income.

Transactions that may meaningfully alter the capitalization of a company include leveraged dividend recapitalizations, leveraged buyouts, significant share repurchases, and special dividends funded with existing assets. Often a board contemplating such actions will be required to obtain a solvency opinion at the direction of its lenders or corporate counsel to provide evidence that the board exercised its duty of care to make an informed decision should the decision be challenged.

A solvency opinion addresses four questions

  • Does the fair value of the company’s assets exceed its liabilities after giving effect to the proposed action?
  • Will the company be able to pay its debts (or refinance them) as they mature?
  • Will the company be left with inadequate capital?
  • Does the fair value of the company’s assets exceed its liabilities and surplus to fund the transaction?

A solvency opinion is typically performed by a financial advisor who is independent, meaning the advisor has not arranged financing or provided other services related to the contemplated transaction. The opinion is based upon financial analysis to address the valuation of the corporation and its cash flow potential to assess its debt service capacity.

Also, the opinion is just that—it is an informed opinion. It is not a pseudo statement of fact predicated upon the “known” future performance of the Company. It provides a reasonable perspective concerning the future performance of the Company while neither promising to stakeholders that those projections will be met, nor obligating the Company to meet those projections.

Test 1: The Balance Sheet Test

Does the fair value and present fair saleable value of the Company’s total assets exceed the Company’s total liabilities, including all identified contingent liabilities?

The balance sheet test is a valuation test in which the value of the company’s liabilities are subtracted not from the assets recorded on the balance sheet, but rather the fair market value of the firm on a total invested capital basis. The value of the firm on a debt-free basis is estimated via traditional valuation methodologies, including Discounted Cash Flow (“DCF”), Guideline Public Company and Guideline Transactions (M&A) Methods. In some instances, the Net Asset Value (“NAV”) Method may be appropriate for certain types of holding companies in which assets can be marked-to-market.

Test 2: The Cash Flow Test

Will the Company be able to pay its liabilities, including any identified contingent liabilities, as they become due or mature?

This question addresses whether projected cash flows are sufficient for debt service. A more nuanced view evaluates the question along three general dimensions:

  • Revolver Capacity: If financial results approximate the forecast, does the Company have sufficient capacity, relying upon its revolving credit facility if necessary, to manage cash flow needs through each year?
  • Covenant Violations: Does the projected financial performance imply that the Company will violate covenants of the credit or loan agreement, or the terms of any other credit facility currently in place or under consideration as part of the subject transaction?
  • Ability to Refinance: Is it likely that the Company will be able to refinance any remaining balance at maturity?

Test 3: The Capital Adequacy Test

Does the Company have unreasonably small capital with which to operate the business in which it is engaged, as management has indicated such businesses are now conducted and as management has indicated such businesses are proposed to be conducted following the transaction?

The capital adequacy test is related to the cash flow test. A company may be projected to service its debt as payments come due, but a proposed transaction may leave the margin to do so too thin to address operating needs—something many companies discovered this year during which they were able to operate with high leverage as long as business conditions were favorable.

There is no bright line test for what “unreasonably small capital” means. We typically evaluate this concept based upon pro forma and projected leverage multiples (Debt/EBITDA and EBITDA/Interest Expense) relative to public market comps and rating agency benchmarks. While management’s projections represent a baseline scenario, alternative downside scenarios are constructed to asses the “unreasonably small capital” question in the same way downside scenario analyses are constructed to address the question of whether debts can be paid or refinanced when they come due.

Test 4: The Capital Surplus Test

Does the fair value of the Company’s assets exceed the sum of (a) its total liabilities (including identified contingent liabilities) and (b) its capital (as such capital is calculated pursuant to Section 154 of the Delaware General Corporation Law)?

The capital surplus test replicates the valuation analysis prescribed under the balance sheet test, but also includes the Company’s capital in the subtrahend (Hey! There is a word we haven’t seen since early primary school. The subtrahend is the value being subtracted.)

Section 154 of the Delaware General Corporation Law defines statutory capital as (a) the par value of the stock; or in stances when there is no par value as (b) the entire consideration received for the issuance of the stock. Capital as defined here is nuanced. Often it may be a small amount if par is some nominal amount such as a penny a share, but that may not always be the case. What is excluded is retained earnings (or deficit) from the equity account.

The Mosaic of Solvency

The tests described above are straightforward. Sometimes proposed transactions are straightforward regarding solvency, but often it is less clear—especially when the subject company operates in a cyclical industry. Every solvency analysis is unique to the subject transaction and company under review and requires an objective perspective to address the solvency issue.

Mercer Capital renders solvency opinions on behalf of private equity, independent committees, lenders and other stakeholders that are contemplating a transaction in which a significant amount of debt is assumed to fund shareholder dividends, an LBO, acquisition or other such transactions that materially lever the company’s capital structure.

Solvency Analysis as a Decision Tool

Not only is a solvency opinion a prudent tool for board members and other stakeholders, but the framework of solvency analysis is ready made to score strategic alternatives and facilitate capital deployment. If your board, senior management team, or capital providers need to discuss a significant financing in confidence, Mercer Capital’s advisory team is prepared to serve your needs.

>> Learn More About Our Solvency Opinion Services

Strategic Benefits of Stress Testing in an Uncertain Economic Environment

Having gone on many a camping trip over the years, the only consistency between these trips into the woods is that there is no consistency. While some trips might have beautiful weather, others might be plagued with storms, cold fronts, heat waves, or strong winds. The campsite may or may not have amenities. And most importantly, contending with the wildlife adds another variable that can’t be predicted. However, the key element of how the trip goes is how prepared we are. The trips where we assumed blue skies were by far the most stressful. If we prepared for different outcomes and weather based on the uncertainty of going into the woods, the trip could always be salvaged.

Banks and credit unions are currently facing a similar “into the woods” predicament, as the economic environment seems to grow more volatile and contradictory day by day. While hiring remains strong and unemployment continues to stay near historically low levels with the Bureau of Labor Statistics reporting 3.6% as of June 2022, other indicators are flashing warning signs.

Inflation concerns continues to plague the economy after accelerating to 9.1% in June 2022, the highest increase since November 1981. Drivers of inflation in the past several months include rising food and gas prices as global supply remains disrupted from Russia’s invasion of Ukraine and the remnants of the pandemic. Economists are taking notice, with nearly 70% of economists surveyed by the Financial Times and the Initiative on Global Markets believing that the National Bureau of Economic Research (NBER) will make a call at some point in 2023 identifying a recession.

These conflicting indicators are convoluting the economic forecast through the rest of 2022 and 2023, and the differing potential circumstances would have very different impacts on banks and credit unions. Though this uncertainty can certainly cause headaches and stress for banks and credit unions worried about their capital positions in a severely adverse economic scenario, stress testing can help to prepare your bank or credit union in the face of uncertainty and help to optimize strategic decisions.

Stress Test Overview

A stress test is defined as a risk management tool that consists of estimating the bank’s financial position over a time horizon – approximately two years – under different scenarios (typically a baseline and severely adverse scenario). The OCC’s supervisory guidance in October 2012 stated “community banks, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial conditions.” 1 Further, the OCC’s guidance considers “some form of stress testing or sensitivity analysis of loan portfolios on at least an annual basis to be a key part of sound risk management for community banks.” 2 A stress test can be defined as “the evaluation of a bank’s financial position under a severe but plausible scenario to assist in decision making with the bank.” 3

There are a few different types of stress tests that banks and credit unions can utilize in estimating their financial position:

Transaction Level Stress Testing: This method is a “bottom up” analysis that looks at key loan relationships individually, assesses the potential impact of adverse economic conditions on those borrowers, and estimates loan losses for each loan.

Portfolio Level Stress Testing: This method involves the determination of the potential financial impact on earnings and capital following the identification of key portfolio concentration issues and assessment of the impact of adverse events or economic conditions on credit quality. This method can be applied either “bottom up,” by assessing the results of individual transaction level stress tests and then aggregating the results, or “top down,” by estimating stress loss rates under different adverse scenarios on pools of loans with common characteristics.

Enterprise-Wide Level Stress Testing: This method attempts to take risk management out of the silo and consider the enterprise-wide impact of a stress scenario by analyzing “multiple types of risk and their interrelated effects on the overall financial impact.” 4 The risks might include credit risk, counter-party credit risk, interest rate risk, and liquidity risk. In its simplest form, enterprise-wide stress testing can entail aggregating the transaction and/or portfolio level stress testing results to consider related impacts across the firm from the stressed scenario previously considered.

By utilizing one or more of these stress testing exercises, banks and credit unions can better position themselves for multiple different economic scenarios in order to assure they have sufficient capital and financial strength to withstand an economic downturn if there is one.

Economic Scenarios Overview

One question that often arises is: Given the uncertainty, what economic scenarios should we consider in our stress testing? While it is difficult to answer this question, the most recent Stress Test scenarios prepared by the Federal Reserve are described in a February 2022 report, 2022 Supervisory Scenarios for Annual Stress Tests Required under the Dodd-Frank Act Stress Testing Rules and the Capital Plan Rule, and provide some guidance to assist with this decision. The scenarios start in the first quarter of 2022 and extend through the first quarter of 2025. Each scenario includes 28 variables, nineteen of which are related to domestic variables in the U.S.

While the more global economic conditions detailed in the Fed’s supervisory scenarios may not be applicable to community banks or credit unions, certain domestic variables within the scenarios could be useful when determining the economic scenarios to consider. The domestic variables include six measures of real economic activity and inflation, six measures of interest rates, and four measures of asset prices. The baseline scenario includes an economic expansion over the 13-quarter scenario period, while the severely adverse scenario is a hypothetical scenario that includes a severe global recession, accompanied by heightened stress in commercial real estate and corporate debt markets. Below, we have included charts of some of the more relevant domestic variables (GDP, unemployment rates, the Prime Rate, and commercial/residential real estate prices) and their historical levels through year-end 2021 as well as the Fed’s assumptions for those variables in the baseline and severely adverse scenarios.

2022 Supervisory Economic Scenarios Overview

Benefits of the Stress Test

As the U.S. moves into a more uncertain economic environment, a financial institution’s preparation for its trip “into the woods” of this uncertain economic environment can reap dividends. Improved valuation, performance enhancement from enhanced strategic decisions, and risk management are some of these benefits. Greater clarity into the bank or credit union’s capital position, credit risk, and earnings outlook under different economic circumstances helps management to make more informed operational decisions.


We acknowledge that bank and credit union stress testing can be a complex exercise. The bank or credit union must administer the test, determine and analyze the outputs of its performance, and provide support for key assumptions/results. There is also a variety of potential stress testing methods and economic scenarios to consider when setting up their test. In addition, the qualitative, written support for the test and its results is often as important as the results themselves. For all of these reasons, it is important that bank and credit union management begin building their stress testing expertise sooner rather than later.

In order to assist financial institutions with this complex and often time-consuming exercise, we offer several solutions, including preparing custom stress tests for your institution or reviewing ones prepared by the institution internally, to make the process as efficient and valuable as possible.

To discuss your stress testing needs in confidence, please do not hesitate to contact us. For more information about stress testing, click here.

1OCC 2012-33 “Supervisory Guidance” on Community Bank Stress Testing dated October 18, 2012 and accessed at www.occ.gov/news-issuances/bulletins/2012/bulletin-2012-33.html.
2 Ibid.
3 “Stress Testing for Community Banks” presentation by Robert C. Aaron, Arnold & Porter LLP, November 11, 2011.
4 OCC 2012-33 “Supervisory Guidance” on Community Bank Stress Testing dated October 18, 2012 and accessed at www.occ.gov/news-issuances/bulletins/2012/bulletin-2012-33.html.

Buy-Side Fairness Opinions: Fair Today, Foul Tomorrow?

This is the eighth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.

Directors are periodically asked to make tough decisions about the strategic direction of a company. Major acquisitions are usually one of the toughest calls boards are required to make.

A board’s fiduciary duty to shareholders is encapsulated by three mandates:

  • Act in good faith;
  • Duty of care (informed decision making); and
  • Duty of loyalty (no self-dealing; conflicts disclosed).

Directors are generally shielded from courts second guessing their decisions by the business judgment rule provided there is no breach of duty to shareholders. The presumption is that non-conflicted directors made an informed decision in good faith. As a result, the burden of proof that a transaction is not fair and/or there was a breach of duty resides with the plaintiffs.

An independent fairness opinion helps demonstrate that the directors of an acquiring corporation are fulfilling their fiduciary duties of making an informed decision.

Fairness opinions seek to answer the question whether the consideration to be paid (or received from a seller’s perspective) is fair to a company’s shareholders from a financial point of view. Occasionally, a board will request a broader opinion (e.g., the transaction is fair).

A fairness opinion does not predict where the buyer’s shares may trade in the future. Nor does a fairness opinion approve or disapprove a board’s course of action. The opinion, backed by a rigorous valuation analysis and review of the process that led to the transaction, is just that: an opinion of fairness from a financial point of view.

Delaware, the SEC and Fairness

Fairness opinions are not required under Delaware law or federal securities law, but they have become de rigueur in corporate M&A ever since the Delaware Supreme Court ruled in 1985 that directors of TransUnion were grossly negligent because they approved a merger without adequate inquiry and expert advice. The court did not specifically mandate the opinion be obtained but stated it would have helped the board carryout its duty of care had it obtained a fairness opinion regarding the firm’s value and the fairness of the proposal.

The SEC has weighed in, too, in an oblique fashion via comments that were published in the Federal Register in 2007 (Vol. 72, No. 202, October 19, 2007) when FINRA proposed rule 2290 (now 5150) regarding disclosures and procedures for the issuance of fairness opinions by broker-dealers. The SEC noted that the opinions served a variety of purposes, including as indicia of the exercise of care by the board in a corporate control transaction and to supplement information available to shareholders through a proxy.

Dow’s Sour Pickle

Buy-side fairness opinions have a unique place in corporate affairs because the corporate acquirer has to live with the transaction. What seems fair today but is deemed foul tomorrow, may create a liability for directors and executive officers. This can be especially true if the economy and/or industry conditions deteriorate after consummation of a transaction.

For instance, The Dow Chemical Company (“Dow”), a subsidiary of Dow Inc. (NYSE: DOW), agreed to buy Rohm and Haas (“RH”) for $15.4 billion in cash on July 10, 2008. The $78 per share purchase price represented a 75% premium to RH’s prior day close. The ensuing global market rout and the failure of a planned joint venture with a Kuwait petrochemical company led Dow to seek to terminate the deal in January 2009 and to cut the dividend for the first time in the then 97 years the dividend had been paid.

Ultimately, the parties settled litigation and Dow closed the acquisition on April 1, 2009 after obtaining an investment from Berkshire Hathaway (NYSE: BRK.A) and seller financing via the sale of preferred stock to RH’s two largest shareholders.

Dow was well represented and obtained multiple fairness opinions from its advisors (Citigroup, Merrill Lynch and Morgan Stanley). One can question how the advisors concluded a 75% one-day premium was fair to Dow’s shareholders (fairness is a mosaic and maybe RH’s shares were severely depressed in the 2008 bear market). Nonetheless, the affair illustrates how vulnerable Dow’s Board of Directors or any board would have been absent the fairness opinions.

Fairness and Elon

Before Elon Musk reneged on his planned acquisition of Twitter, Inc. (NYSE: TWTR) on July 8, 2022, one of the most recent contentious corporate acquisitions was the 2016 acquisition of SolarCity Corporation by Tesla Inc. (NASDAQGS: TSLA). Plaintiffs sought up to $13 billion of damages, arguing that (a) the Tesla Board of Directors breached its duty of loyalty, (b) Musk was unjustly enriched (Musk owned ~22% of both companies and was Chairman of both); and (c) the acquisition constituted waste.

Delaware Court of Chancery Judge Joseph Slights ruled in favor of Tesla on April 27, 2022. Slights noted courts are sometimes skeptical of fairness opinions; however, he was not skeptical of Evercore’s opinion, noting extensive diligence, the immediate alerting of the Tesla Board about SolarCity’s liquidity situation and the absence of prior work by Evercore for Tesla.



Tesla Walks the Entirely Fair Line with SolarCity

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Tesla Walks the Entirely Fair Line with SolarCity

In March 2016, Jonathan Goldsmith retired from a long advertising stint for Dos Equis beer as the Most Interesting Man in the World with a final commercial in which he was sent on a one-way trip to Mars. The same month Elon Musk, arguably the most interesting man in global business then and now, was laying the ground work for the merger of Telsa, Inc. (NASDAQ: TSLA) and SolarCity Corporation of which he owned about 22% of both companies.

Fairness as an adjective means what is just, equitable, legitimate and consistent with rules and standards. As it relates to transactions, fairness is like valuation in that it is a range concept: transactions may not be fair, a close call, fair or very fair.

This presentation looks at the issues raised by plaintiffs who alleged Musk orchestrated the deal to bail-out SolarCity, and how the Delaware Court of Chancery ruled on the issues on April 27. 2022 under the entire fairness standard rather than deferential business judgment rule.


Tesla Walks the Entirely Fair Line with SolarCity

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Valuing Stock Options of Start-up Companies: A Complex Issue in Marital Dissolutions

The valuation of stock options is a complex issue that divorcing parties may face during the determination and division of the marital estate. Designed as compensation to both reward past performance and retain employees in the future, these benefits can be difficult to value, particularly at a specific point in time for the purpose of marital dissolution.

We previously wrote about the valuation models as set forth by the AICPA Quick Reference Guide. In this piece, we walk through an example of how to value a not so simple stock option situation – one in a start-up company.

Stock options ultimately derive their value from the value of the underlying business. While pricing data of publicly traded companies is readily available, that is not the case for privately owned businesses since by definition they are not traded daily on an active market.

Overview of Stock Options & Importance in Marital Dissolution

A stock option is a contract that provides the owner the right, but not the obligation, to purchase stock in the company at a specified price.

These options can be issued by publicly traded or privately held companies. In its most basic structure, an option contract consists of:

  • Grant Date and number of options granted
  • Vesting Date: date when the granted shares become exercisable
  • Exercise (or Strike) Price: the price at which the stock can be purchased
  • Expiration Date: the date the stock option expires

The vesting schedule is important, particularly in the context of marital dissolution, as the options may not be immediately exercisable and vest ratably over a period of time.

A vesting schedule sets out the period of time over which options vest and become exercisable. For example, a common vesting schedule may provide for an equal amount of the options of a specific grant to become exercisable each year over a certain period, perhaps four or five years. If an employee leaves the company, he or she may forfeit unvested options. The terms differ by company and sometimes even by grant, so one should carefully review the terms as specified in the plan documents.

An example of a vesting schedule over a four-year period is shown below.

In the context of marital dissolution, there are many important factors to consider relative to stock options, most notably what is marital vs. separate and what is the value of said options.

  • First, what is marital versus separate may vary by state statute. This extends to stock options regarding vested and those which are still vesting as of the date under consideration which may be date of marriage, separation and/or divorce.
  • Next, what is the value of the options? If the parties intend to split options based on a percentage, perhaps the value is less of a consideration, but, if the parties intend to offset the value of the stock options with another asset of the marital estate, valuing the stock options bears much more importance.

Valuing Stock Options

In the case of options issued by a publicly traded company, the intrinsic value can be easily determined as the value of the option if it were exercised today. Simply, intrinsic value is the option strike price relative to the share price today. The option is said to be “in-the-money” if the strike price is below the current market value.

A simple example calculation of the intrinsic value of an option to purchase stock of a hypothetical public company is shown below.

Using the example from above, if Current Public Co stock price is $120 or below, the stock option owner would likely not exercise their right to purchase the stock. The option would have little to no intrinsic value today if the current stock price were below the option strike price, but it may still have time value.

The other component of the option value is time value, which relates to the premium relative to the time remaining until an option expires. The time value represents the value of holding a stock option over time. We have previously written about stock option valuation models, such as lattice, Black-Scholes, and Monte Carlo models. These models are useful when dealing with options issued by publicly traded companies, particularly because the assumptions and inputs for the Black-Scholes model can be taken directly from the respective public company’s public filings and historical pricing data.

Unique Considerations for Valuing Start-Up Stock Options for Marital Dissolution

In many instances, start-up companies issue stock options to employees, typically as a form of compensation called incentive-based compensation. The valuation of these options can be especially difficult given the lack of an active market for the company’s shares and the uncertainty and potential volatility associated with early-stage companies with limited operating history.

While the option exercise, or strike price, is defined with the option grant, the underlying share price as of a specific date may be more complex to determine for a start-up company.

Funding rounds and respective 409A valuations can provide useful valuation information for start-up companies.

Start-ups seek to raise capital from investors such as venture capitalists and private equity funds. Capital raises are a primary indication of investors’ views and pricing activity on the company. 409A valuations are performed in conjunction with a company issuing equity or options and thus occur concurrently to funding rounds. However, funding rounds happen sporadically, and the time period between each round may vary between start-ups.

In the case of a fast-growing company, valuations can change considerably between funding rounds as different milestones are achieved. Alternatively, a valuation may be down between funding rounds due to poor performance or general downward macroeconomic trends, perhaps such as during a recessionary time.

In the context of marital dissolution, funding rounds, time since last round, and 409A valuations are important pieces of information to gather. Another possible piece of information to gather is any recent transactions or buy-sell offers for the start-up stock; one such example would occur for a departing employee who may be soliciting offers to sell his/her vested interest.

As discussed above, the considerations of marital versus separate and the vesting schedule are also important during this process unique to start-ups. However, in the following discussion, we will focus on the unique attributes of valuing start-up stock options using the information gleaned from funding rounds, 409A valuations and any recent transactions data of the underlying stock.

For marital dissolution purposes, unless stock options are divided based on percentage, the key question is what is the value as of a specific date? Perhaps the value is necessary as of multiple dates (marriage, separation and/or divorce date).

Since the price as of a specific date is necessary, hence arises the difficulty unique to start-up stock option valuations – because funding rounds are sporadic and value as of a certain date is necessary, the financial expert must have the skills to value these situations. As a clear example, it is unlikely a funding round occurred exactly on the date of marriage. Similarly, a funding round likely did not close on the exact date of divorce.

If the dates of marriage, separation and/or divorce fall on or proximate to a funding round, the financial expert could base the determination of value of the stock options on the per share value implied by the funding round. However, if the relevant dates are between two funding rounds, the financial expert must carefully evaluate the implied pricing at that point in time.

One reasonable method is the mathematical process of interpolation to determine the implied value at those dates. Interpolation determines the implied value between two dates by assuming a liner relationship between the value at the most recent funding round prior to the valuation date and the funding round most immediately following the valuation date. While early-stage companies could possibly be more volatile and have periods of exponential growth, using a linear relationship is supported by the comparison of the growth between the two funding round dates and can be understood by a layperson.

The chart below shows an example of interpolation of value implied by a series of funding rounds for a hypothetical start-up company. The x-axis represents the date, and the y-axis is the share price; to illustrate, the first funding round was on December 1, 2015 for a $5.00 share price, followed by a funding round on May 1, 2017 for a $15.00 share price and so on, with the last funding round on March 31, 2021 for an $80.00 share price. In this example, the date of marriage (“DOM”) is December 31, 2016, which falls between two funding rounds, and the date of separation (“DOS”) is December 31, 2020, also falling between two funding rounds. Neither date falls directly on or just after a funding round. The orange dots on the chart represent the interpolated values at the date of marriage and date of separation.

The magnitude of using interpolated values versus choosing a previous funding round share price can have a meaningful impact, depending on the number of shares owned.

While interpolation may be a reasonable methodology in certain situations, there may be other reasonable methodologies of determining the value of a start-up company’s share price at a point in time which falls outside of funding rounds. The financial expert may also consider an independent business valuation, during which the expert considers quantitative and qualitative elements of the company, as well as performance expectations as of the current date.

Individual Transactions of Start-Up Shares

Typically, individual seller’s shares transact at a discount to the value implied by the most recent funding round, while 409A valuations are often seen as a floor for any potential transactions or investments. However, if there is strong demand for the start-up, or other buyer motivation, a premium to the funding round is not out of the realm of possibilities, particularly if the company is growing quickly or has hit certain milestones since the last funding round.

But, let’s hone in on the possible discount – the discount relative to the share price of the most recent funding round reflects considerations such as the lack of an active market for the shares and the lack of influence available to a minority shareholder. As an example, lets say the start-up offers at-home cooking classes and the last funding round was during the pandemic; now, two years later and with the pandemic behind us (hopefully), people are back to dining at restaurants and spending disposable income on travel, pushing demand for at-home cooking classes down. Even though there is not a current funding round to support a decline in the share price valuation, one can discern a likelihood of downward trend on pricing.

Discounts (and/or premiums) can vary based on the situation, and there is no standard discount, as facts and circumstances vary tremendously between start-up companies. However, such transactions among individual stockholders or offers received by shareholders can provide potential indications of an appropriate discount, which may then be appropriate for value determination for marital dissolution as of a certain date (marriage, separation and/or divorce).

If the options are vested, or exercisable at the valuation date, a similar process of the intrinsic value calculation, presented earlier, can be used. This provides an estimate of value based on the profit that could be realized if the options were exercised on the valuation date.


In summary, stock options entail unique valuation considerations compared to a traditional business valuation.

A start up company’s stock options also have unique attributes that must be considered and valued carefully. In certain situations, start-up stock options may comprise a significant component of the marital balance sheet.

An experienced financial expert can accurately value these complex assets. Mercer Capital has experience in valuing stock options for private, publicly traded and start-up companies.

Bond Pain and Perspective on Bank Valuations

Equity investors define a bear market as a 20% or greater reduction in price from the most recent high price. There is no consensus for fixed income. A bond’s maturity and coupon are key variables in determining the sensitivity of price except when overlaying credit and prepayment variables when applicable.

A simple definition might be when the price falls more than three times the annual income for any bond with a maturity greater than five years. If so, it is a low bar when coupons are as low as they are. Definitions aside, the bond market is in a bear market.

Figure 1 :: 1994 Bear Market vs 2022 Bear Market

The yield on the 10-year U.S. Treasury note (“UST”) was 3.21% on June 27, up from 1.51% as of year-end. Ignoring the impact of the intervening six months for what would be a bond with 9.5 years to maturity, the increase in yield has produced a ~14% loss in value.

The last bond bear market that was brutal occurred in 1994 when the Fed raised the Fed Funds target rate from today’s aspirational rate of 3.0% beginning in February to 6.0% by February 1995. The yield on the 10-year UST rose from 5.19% on October 15, 1993 to a peak of 8.05% on November 7, 1994 once the market could see the last few Fed hikes to come. The 286bps increase in yield pushed the price of the 10-year UST down by 17%, which modestly exceeds the 14% loss this year.

Coupons matter. Fixed income investors entered the current rising rate environment with little coupon to cushion rising yields unlike in the years immediately after the Great Financial Crisis when the Fed first implemented a zero-interest rate policy (“ZIRP”).

Worse, banks entered the current bear market with much bigger securities portfolios given the system was inundated with excess deposits because of actions taken by the Fed and government to offset the COVID-19 recession.

To get a sense of the damage in bank bond portfolios consider Figures 2 and 3 where we have compared the unrealized losses in bank bond portfolios as of March 31 with the unrealized losses as of year-end 1994, which roughly corresponded to the bottom of the 1994 bear market. The data reflects averages.

Figure 2 :: Unrealized Losses in Bank Portfolios as of March 31, 2022

Figure 3 :: Unrealized Losses in Bank Portfolios as of December 31, 1994

We make the following observations for banks with $1 billion to $3 billion of assets:

  • Banks are better capitalized with average leverage and tier one capital ratios of 10.6% and 17.0% as of March 31, 2022 compared to 8.3% and 12.9% as of year-end 1994.
  • Securities classified as available-for-sale (“AFS”) and held-to-maturity (“HTM”) averaged 19.0% and 2.5% of assets as of March 31, 2022 compared to 11.2% and 14.6% as of year-end 1994.
  • The unrealized loss in the AFS portfolio equated to 4.7% of the cost basis and 11.3% of tier one capital (excludes the deferred tax asset adjustment) as of March 31, 2022 compared to 2.8% and 5.7% as of year-end 1994. 1
    Unrealized losses in HTM portfolios in Figure 2 may appear too small even though many banks classify long-dated municipals as HTM because these illiquid bonds had not been adequately marked yet to reflect a rapidly declining market.
  • Unrealized losses will increase once June 30 data is available because UST rates have risen ~75bps since March 31.

Banks are sitting on large unrealized losses today. Investors know that. The bear market in bank stocks (the NASDAQ Bank Index is down ~19% YTD) primarily reflects investor expectations about the potential impact a recession would have on credit costs next year even though NIMs will increase this year (excluding the impact of PPP loan fees) and next provided the Fed does not pivot and reduce rates. The current equity bear market is not about unrealized losses in bond portfolios; it is about the economic outlook.

From a valuation perspective, we primarily look to the impact of rising (or falling) rates on a bank’s earnings rather than how changes in rates have impacted the value of the bond portfolio and tangible book value. Assuming an efficient market, the unrealized losses represent the opportunity cost of holding bonds with coupons below the current market rate. If the underwater bonds are sold and immediately repurchased, then the bonds repurchased will produce enough extra income over the life of the bonds to recoup the loss (assuming an efficient market).

Further, the AFS securities portfolio is the only asset for most banks that is marked-to-market other than mortgage loans pending sale. Fixed rate residential and CRE loans would have sizable losses, too, if subjected to mark-to-market. Rates have risen, prepayment speeds have slowed and in the case of CRE credit spreads have widened.

Also not marked-to-market are deposits. Though a liability, core deposits are the key “asset” for commercial banks. Value for deposits—especially non-interest-bearing deposits—are soaring given a low beta to changes in market interest rates when loan-to-deposit ratios are low.

The monthly report that really matters is not the bond report but the asset-liability model (“ALM”). Banks manage net interest margin (price) and assets (volume) to drive earnings; and earnings (or cash flow) drive stocks over time. Earnings also build book value to the extent earnings are retained.

Rising rates—gradually rather than rapid—are a positive development given the commercial bank business model, assuming that credit quality does not deteriorate.

Having said that, we cannot completely dismiss the unrealized losses in the bond portfolios. Some investors focus on tangible book value, though we view it as a proxy for earning power because tangible book value is levered to produce net interest income.

Also, M&A is more challenging because day one dilution to tangible BVPS is greater to the extent unrealized bond losses are recognized via fair value marks applied to all assets. Of course, earnings then increase from accreting the discounts as additional yield.

Aside from the soaring value of core deposits, the glass half full view is bonds and fixed rate loans eventually mature. In the interim, cash flows should be reinvested to produce better yields.

About Mercer Capital

Mercer Capital is a national valuation and transaction advisory firm that has advised banks for 40 years through bear and bull markets. Please give one of our professionals a call if we can be of assistance.

Considering Contingent Consideration

This is the seventh article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.

Contingent consideration is a common feature of M&A when both parties are private, or the acquirer is public, and the target is private. There are many forms of contingent consideration in M&A. These include post closing purchase price adjustments that can alter total transaction value or that can alter the payment and realization of net proceeds through the recovery of transaction set-asides such as escrow balances or the payment of holdbacks and deferrals.

What Do Earnouts Entail?

The most common contingent payment is an “earn-out” that bridges the buyer’s bid and the seller’s ask by ensuring the business produces an agreed upon level of revenues and/or earnings (typically EBITDA) within an agreed timeframe before the payment is made.

Earn-outs could be considered the ultimate form of confirmatory due diligence. From a buyer’s perspective, earn-outs reduce risk by reducing up-front cash and the likelihood of materially overpaying absent an adverse turn in the economy or industry conditions. From a seller’s perspective, contingent consideration allows sellers to obtain an acceptable price and sometimes a premium or stretch valuation if the Company attains the agreed-upon targets. Further, earnouts create an alignment of interests to the extent roll-over management and ownership is incented to optimize the company’s performance.

In our experience, most buyers are willing to pay in a range of value that produces an acceptable return based upon conservative assumptions about the business’ future earning power (EBITDA or EBITDA less capex) and growth rate. Unless the business is viewed as having above average risk, most buyers’ required rate of return on an unlevered basis will be conservative but not ridiculously high. This reflects buyers’ natural aversion to risks that may not be readily apparent to most sellers. An earn-out is a means by which to close or narrow this gap.

When earnouts are involved, buyers and sellers must understand the waterfall of post-closing events, and their respective timing and terms to gain a full understanding of transaction consideration. Earnouts are a form of purchase consideration where acquirers tender value to the target seller if certain future events occur. Earnouts provide sellers with potential value fulfillment or upside while simultaneously allowing buyers to defer payment of consideration with the possibility of recovering a designated portion of the purchase price if post-closing hurdles are not achieved.

By its nature, contingent consideration adds complexity for both buyers and sellers, particularly when the features of the earnout reflect significant speculation on post-closing outcomes. These might include high growth, reversals of trend, or specific events such as new business developments or failed business retention.

Despite the complexities, earnouts and other forms of contingent consideration can be critical to achieving a successful closing when market conditions are ebbing more than flowing or when winning the day requires the buyer to make a stretch offer.

Mid-Market Deals Increasingly Reflect Up-Market Deal Structures

According to GF Data®, a firm that provides data on private equity-sponsored M&A transactions with an enterprise value of $10 to $250 million, 38% of 432 transactions in 2021 entailed either seller financing or earnouts compared to 44% of 329 deals in 2020. The reduction last year reflected a seller’s market that was characterized by too much capital chasing a limited pool of sellers. Given tighter financial conditions this year that may lead to a recession later this year or next, it would not surprise us to see the percentage of deals with an earnout increase because the risk to a target’s earnings and maybe long-term growth prospects will rise.

A financial advisor can be an important intermediary for both buyer and seller to craft a well structured earnout to facilitate successful deal negotiations rather than letting a poorly crafted and/or poorly socialized earnout create a negotiation wedge that can delay or overwhelm momentum required to finalize a purchase agreement.

Buyer Awareness and Financial Reporting

While it should not impact the economics of a transaction, buyers face the added burden of accounting for contingent consideration per FASB’s ASC 805, which addresses business combinations. It requires that the fair value of contingent consideration be recorded as a liability at the acquisition date, resulting in an increased amount of goodwill or other intangible asset depending upon how value is allocated to the acquired assets. Fair value also must be re-measured for each subsequent reporting period until the contingency is settled. Mercer Capital’s years of M&A purchase price allocation work for both strategic and financial acquirers gives us unique insight into the sometimes nettlesome issues of purchase price allocations in M&A transactions.

Concluding Thoughts

While this article is an installment in our larger buy-side series of content, it is important to draw advice for buyers from our near universal advice to sellers.

We often advise sellers to be content with the consideration they receive at closing and to assess contingent consideration with a healthy degree of skeptical risk, particularly when achieving the earnout represents a stretch in future outcomes.

A logical extension of that advice for buyers is to be prepared to pay even if the benchmarks are deemed a stretch. The occasional extraordinary outcome can create significant buyer liability. Whether the net effect on the buyer is a beneficial deferral of payment or a deal premium (or otherwise) must be assessed in the context of the overall offering stack.

Buyers should determine the reason for using an earnout and then determine an appropriate design for the earnout. Clear, unambiguous terms and measurements are recommended to minimize negotiating friction and incent smooth post-closing integration and alignment of interests both operationally and financially.

If your development needs involve growth through acquisition, and you find the market for quality targets requires the thoughtful use of earnout consideration, Mercer Capital can provide useful insight while helping quantify the real-time financial equivalency of any earnout consideration offered.

Tesla Walks the Entirely Fair Line with SolarCity

Evaluating Fairness of the Tesla Motors, Inc. and SolarCity Corporation Merger

In March 2016, Jonathan Goldsmith retired from a long advertising stint for Dos Equis beer as the Most Interesting Man in the World with a final commercial in which he was sent on a one-way trip to Mars. The same month Elon Musk, arguably the most interesting man in global business then and now, was laying the ground work for the merger of Telsa, Inc. (NASDAQ: TSLA) and SolarCity Corporation of which he owned about 22% of both companies.

Fairness as an adjective means what is just, equitable, legitimate and consistent with rules and standards. As it relates to transactions, fairness is like valuation in that it is a range concept: transactions may not be fair, a close call, fair or very fair.

This presentation looks at the issues raised by plaintiffs who alleged Musk orchestrated the deal to bail-out SolarCity, and how the Delaware Court of Chancery ruled on the issues on April 27. 2022 under the entire fairness standard rather than deferential business judgment rule.

Meet the Team – David W. R. Harkins, CFA, ABV

In each “Meet the Team” segment, we highlight a different professional on our Family Law team. The experience and expertise of our professionals allow us to bring a full suite of valuation and forensics services to our clients. We hope you enjoy getting to know us a bit better.

David Harkins, CFA, ABV began his valuation career at Mercer Capital as an intern in the summer of 2016. After finishing his degree at Sewanee, David joined Mercer Capital in 2017 as a financial analyst.

He works in our Nashville office and is a member of the firm’s Litigation Services Support team. In this role, David has worked on family law engagements with scores of companies in a wide range of industries. However, as a member of the firm’s Auto Dealership industry team, he has industry-specific experience working with auto dealership clients throughout the U.S.

What is the most rewarding part about your job?

David Harkins: I like that the numbers matter.

In litigation support engagements, we are valuing businesses and giving a number that will be used for selling, buying, or dividing a business. I think these types of engagements are interesting because of the immediate, tangible importance of the final answer.

The report will be thoroughly read and there needs to be an in-depth analysis to make sure that the concluding number is as reasonable as possible. It makes the work rewarding that our analysis is valuable to the clients.

What should family law clients understand about valuation and the services a firm like ours can provide?

David Harkins: I think the most important thing is for clients to involve us early on in the process. We can help narrow or expand the scope of an engagement to guide our clients and make the process as efficient as possible. We offer valuable services that are often underutilized.

Outside of solely giving a number for the value of a business, we can provide guidance throughout the process. We help clients understand the value of their business, explain another expert’s testimony, assist with questions, and provide expert advice on what steps should be taken in litigation matters, especially to ensure financial efficiency.

Another piece of advice I have for divorcing clients is to consider joint retainment. This is when both parties hire one financial expert. This could alleviate some of the stress that comes with divorce conflicts and help to avoid financial disputes that come up in court. We give the most accurate and reasonable valuation possible, and joint retainment can ultimately be beneficial to both sides.

What type of family law matters do you work on?

David Harkins: I am involved in numerous aspects of litigation-related engagements, but the majority of my work in this area comes back to a business owned by divorcing parties. We can help the business spouse translate their day-to-day operations and cash flows into the valuation and help the non-business spouse understand the key levers that drive the value of the business.

We also provide ancillary services such as setting up the marital balance sheet or assisting in determining a reasonable range for alimony expenses, should it be relevant to the case. While some of this may sound intuitive, we often find having someone well-versed in this area can help put the picture together much more efficiently.

What top three skills or traits do you think someone needs to pursue a role in family law litigation support in a business valuation firm?

David Harkins: Number One is taking notes and juggling many projects at a time because litigation projects can be stop/start. Continuations, attempts to reconcile, and failed mediations can lead to large gaps throughout the normal course of a project or accelerate the timeline of our work. The ability to efficiently transition between projects is valuable, but this is also an underrated benefit of hiring a firm with the appropriate bench of analysts to make sure client needs are met in a timely manner.

Number Two is attention to detail. And Number Three is experts providing litigation support must be reasonable in their conclusions and unbiased in the presentation of their conclusions. Misconstruing opinions as facts can make an expert less reliable to a trier of fact.

What influenced your concentration in the auto dealer industry?

David Harkins: I started following the industry based on the experience of my colleague Scott Womack.

I particularly enjoy the analytical opportunities provided by the dealer financial statements which dealers must report to the manufacturers on a monthly basis. Combining these statements with available benchmarking data from the vast dealership network in the U.S. gives us a good picture of the dealership’s operations before we even get a chance to discuss operations with the dealer principal.

What is the best advice that you received throughout your career?

David Harkins: I find myself holding onto little nuggets from colleagues that have helped my professional development.

“Be an analyst” reminds me to not solely focus on setting up the analytical framework for a project but to make sure our assumptions are reasonable and lead to a conclusion that makes sense.

“Say what you mean” is particularly important in a litigation context to make sure that our opinions are stated plainly. While we want our reports to be well written, it is more important that our conclusions are understood by all parties involved.

Negotiating Working Capital Targets in a Transaction

This is the sixth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.

In middle market transactions, some of the most crucial points of negotiation are the net working capital targets agreed upon by the buyer and seller. Net working capital targets set a defined minimum amount of working capital that the buyer requires the seller to leave in the business at the close of a transaction.

Given that net working capital targets can have a direct effect on the final purchase price of a transaction, understanding the how and why of these types of negotiations is crucial for buyers looking to negotiate deals that not only look good at closing but also pass the test as the buyer takes over the operation of the newly acquired business.

Defining Net Working Capital

Before negotiating working capital targets and benchmarks, it is important that the buyers, sellers, and their advisors in a deal setting have a clear understanding of what will and won’t be included in net working capital for the purposes of closing the deal.

By the book, net working capital is defined as current assets less current liabilities. While this definition is acceptable for financial statement analysis and other accounting-adjacent applications, in the M&A universe, the most commonly used measure of net working capital is cash-free, debt-free net working capital. This is the standard definition of net working capital in a deal setting because it assumes that a seller will retain the cash in the business after paying off any short-term debts that the business owes. These debts could potentially include related party notes and lines of credit with banks.

In an M&A transaction, net working capital and net working capital targets are often defined terms in both the letter of intent and the purchase agreement. For buyers, it is crucial to understand these definitions because the basis of the net working capital calculation could directly affect the final purchase price.

Why Are Net Working Capital Negotiations Necessary in a Deal?

Net working capital targets are necessary in deal settings because the amount of net working capital in a business often fluctuates from month-to-month and even week-to-week. Therefore, it is important that a benchmark or base level of net working capital to be left in the business at closing is agreed upon by both the buyer and the seller.

For example, a seller could aggressively collect accounts receivable in the months leading to closing in an effort to convert these receivables into cash. Conversely, a seller could let accounts payable inflate in the months leading to closing and theoretically retain a higher amount of cash. Even absent any sort of concentrated effort to impact the working capital, most companies have some level of fluctuation in their various balance sheet accounts. Setting a net working capital target negates the impact of these fluctuations and prevents the seller from “gaming” cash and working capital levels in anticipation of a transaction.

If net working capital levels at closing are not in line with the targets established in the negotiation process, an adjustment to the purchase price can be triggered.

The purchase price adjustment related to net working capital is typically applied after the close of the transaction – based on a final accounting as of the closing date. Usually, a defined amount of the purchase price is set aside in a short-term escrow specifically for any negative adjustment related to the final net working capital balance. If the final determination of net working capital comes in below the established threshold, then the buyer retains funds from the escrow to make up for this shortfall. If the final net working capital figure is above the threshold, the buyer makes an additional payment to the seller for the excess amount.

From the buyer’s perspective, it is important to negotiate an escrow amount that is large enough to cover any potential swings in net working capital that could result at closing.

Negotiating Net Working Capital Targets

The most practical and commonly used method of setting net working capital targets and benchmarks is to calculate a historical average amount of net working capital needed to fund a company’s operations. This is most often done by calculating the average net working capital on a monthly basis over the twelve months preceding the valuation date used in the transaction.

Calculating an average over a historical period removes any seasonality effects and reveals a “normalized” level of net working capital needed to support the company’s ongoing operations with no capital disruption. Since valuations are typically predicated on trailing twelve months EBITDA (or some other measure of earnings), it is typical that the lookback period for the net working capital target calculation coincides with the twelve-month period in which EBITDA is calculated. In other words, the calculation of a net working capital target should be on the same historical basis as that of the measure of earnings used to support the transaction value.

In situations where EBITDA from the most recent period is deemed to be unsustainable or if there is significant short-term growth underlying the transaction value, it might be necessary to calculate the net working capital benchmark by applying a percentage (based on historical averages) to an ongoing revenue figure in order to consider that net working capital needs will change as revenue either declines or increases post-closing.

While conducting due diligence, buyers may find potential adjustments to certain balance sheet items that comprise net working capital, which can affect the calculation of the net working capital target. Buyers will want to confirm that the seller has properly accrued (both historically and at closing) for certain items such as accrued vacation, payroll, bonuses, warranty obligations, etc. These potential adjustments can add another layer of complexity to the negotiation of net working capital targets, as buyers may find that there is an excess or deficiency of net working capital at certain points in the historical lookback period.

Sellers will often make the argument that they have historically operated with excess working capital based on comparisons to industry averages. Buyers should always approach any “excess” adjustment of this type with caution. It can be difficult to understand why the selling company would have operated with this “excess” when the capital could have been paid out to shareholders or invested in another way. With further analysis, there is often an explanation as to why the “excess” working capital has historically been carried on the company’s balance sheet.

As an example, the “excess” could have historically resulted from a quick turnover of payables such that the company has lower current liabilities than the industry average. The quick payments may have earned the company discounts from its vendors, which likely equated to higher profit margins. If the cash flow figures underlying the transaction value include the benefit of these discounts, then it could be double counting to adjust the net working capital to a “normalized” level.

One question that will arise in the negotiations is whether a specific dollar amount or a range should be utilized as the net working capital target. The logic of applying a range is straightforward – it prevents minor variances from creating a post-closing adjustment and reduces the likelihood of disagreements between the buyer and seller regarding the calculation of net working capital to the specific dollar. A word of caution on ranges: if the range is left too wide, it invites the same type of balance sheet “gaming” from the seller that the setting of a target was meant to prevent in the first place.

Our experience has been that, if a range is preferred, it should be tight enough that any amount that would be potentially gained from the closing working capital figure falling at the bottom or top of the range should be immaterial to both the buyer and the seller.

Concluding Thoughts

Having a team of seasoned advisors to assist with the acquisition and due diligence process can ensure buyers that the net working capital targets, and thus the purchase price, are set at levels that are appropriate and fair to the buyer. Mercer Capital has acted in this capacity in hundreds of transactions over our 30+ years of existence. If you are looking for an experienced team of professionals to assist in the due diligence and negotiation process, please reach out to one of our Transaction Advisory Group professionals to assist.

Buy-Side Considerations

Many observers predict that the market is rife for an unprecedented period of M&A activity, as the aging of the current generation of senior leadership and ownership pushes many middle-market companies to seek an outright sale or some other form of liquidity.

Obviously, not all companies are in this position. For those positioned for continued ownership, an acquisition strategy could be a key component of long-term growth.

For most middle-market companies, especially those that have not been acquisitive in the past, executing on a single acquisition (much less a broader acquisition strategy) can be fraught with risk. There are many elements, from finding the right targets, to pricing the deal correctly, to successfully integrating the acquired business that could derail efforts to build shareholder value through acquisition.

In this series of articles, we cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market.

Click the links below to read the articles in this series.

1. Identifying Acquisition Targets and Assessing Strategic Fit

Our first topic in this buy-side series starts at the beginning. Whether your motivations to buy are based on synergies, efficiencies, or simply on the inertial forces of consolidation that cycle through many industries, a well-organized and disciplined process is paramount to examining and approaching the market for hopeful growth opportunities.

2. How to Approach a Target and Perform Initial Due Diligence

This is the second article in a series on buy-side considerations from the perspective of middle-market companies looking to enter the acquisition market. Our focus in this article is to summarize some practical considerations for approaching and vetting an identified target.

3. Strategic Premiums: Can 2+2 Equal 5?

Many acquirers buy businesses at a value higher than this intrinsic value, paying what is referred to as a strategic premium. In this article, we discuss the theory behind strategic premiums, and how they can be advantageous or detrimental to acquirers.

4. Considerations in Merger Transactions

When considering a buy-side transaction to expand, many middle-market companies may not consider a merger transaction as an option compared to an outright acquisition. Mergers are often seen as transactions for big conglomerate-type companies on Wall Street, but they can be effective for middle-market businesses as well. In this article, we discuss the key questions that must be addressed when considering a merger transaction, including, corporate governance, social issues and economic questions.

5. The Importance of a Quality of Earnings Study

This is the fifth article in a series on buy-side considerations. Our focus in this article is on how the quality of earnings (QoE) analysis can help acquirers better analyze possible acquisition targets.

6. Negotiating Working Capital Targets in a Transaction

This is the sixth article in a series on buy-side considerations. Our focus in this article is on understanding how and why net working capital targets are crucial for buyers looking to negotiate deals that look good at closing and pass the test as the buyer takes over the operation of the newly acquired business.

7. Considering Contingent Consideration

This is the seventh article in a series on buy-side considerations. In this article we discuss the many forms of contingent consideration in M&A. These include post closing purchase price adjustments that can alter total transaction value or that can alter the payment and realization of net proceeds through the recovery of transaction set-asides such as escrow balances or the payment of holdbacks and deferrals.

8. Buy-Side Fairness Opinions: Fair Today, Foul Tomorrow?

This is the eighth article in a series on buy-side considerations. Directors are periodically asked to make tough decisions about the strategic direction of a company. Major acquisitions are usually one of the toughest calls boards are required to make. Buyside fairness opinions have a unique place in corporate affairs because the corporate acquirer has to live with the transaction. What seems fair today but is deemed foul tomorrow, may create a liability for directors and executive officers. This can be especially true if the economy and/or industry conditions deteriorate after consummation of a transaction.

9. Buy-Side Solvency Opinions

In the ninth article of this series we discuss solvency opinions.Not only is a solvency opinion a prudent tool for board members and other stakeholders, but the framework of solvency analysis is ready made to score strategic alternatives and facilitate capital deployment.

10.The Importance of Purchase Price Allocations to Acquirers

In the last article of this series we provide a broad overview of PPAs and then a deeper look into the pitfalls and best practices related to them.

The Importance of a Quality of Earnings Study

This is the fifth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.

Acquirers of companies can learn a valuable lesson from the same approach that pro sports teams take in evaluating players. Prior to draft night, teams have events called combines where they put prospective players through tests to more accurately assess their potential. In this scenario, the team is akin to the acquirer or investor and the player is the seller. While a player may have strong statistics in college, this may not translate to their future performance at the next level. So it’s important for the team to dig deeper and analyze thoroughly to reduce the potential for a draft bust and increase the potential for drafting a future all-star.

A similar process should take place when acquirers examine acquisition targets. Historical financial statements may provide little insight into the future growth and earnings potential for the underlying company. One way that acquirers can better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE).

What is a Quality of Earnings Study?

A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer. The QoE can help the acquirer assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors.

Ongoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long-term growth can be expected. This estimate of earning power typically considers an assessment of the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness, growth potential, and potential volatility of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.

Analysis performed in a QoE study can include the following:

  1. Profitability Procedures. Investigating historical performance for impact on prospective cash flows. Historical EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-backs; (2) Non-recurring items; (3) Pro-forma adjustments/synergies.
  2. Customer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysis.
  3. Business and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring.

The prior areas noted are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:

  • Workforce / employee analysis
  • A/R and A/P analysis
  • Customer Analysis
  • Intangible asset analysis
  • A/R aging and inventory analysis
  • Location analysis
  • Billing and collection policies
  • Segment analysis
  • Proof of cash and revenue analysis
  • Margin and expense analysis
  • Capital structure analysis
  • Working capital analysis

For high growth companies in certain industries such as technology, where valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:

  • The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit. These unit economics provide a foundation from which to forecast and/or test the reasonableness of projections.
  • A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers’ perception of the company and its products.

The QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to utilize the QoE study to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers.

Leveraging our valuation and advisory experience, our quality of earnings analyses identify and assess the cash flow, growth, and risk factors that impact value. By providing our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows of a potential target, we help them to increase the likelihood of a successful transaction, similar to those teams and players that are prepared for draft night success.

Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers and reach out to us to discuss your needs in confidence.

Strategic Premiums: Can 2+2 Equal 5?

This is the third article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read previous articles click here.

When given the choice between paying more or less for a good or service, it only makes sense that people prefer to pay less. Following this, a rational person would be expected to pay no more than the minimum available price for an item. Many modern business acquisitions appear to defy this logic – at least at first glance. According to Bloomberg, acquirers paid an average premium of 25.86% when making transactions in 2021. In other words, the average acquirer was willing to pay almost 26% above the intrinsic market value of a target business to successfully bid on an acquisition.

Theory holds that the value of any corporation, especially a controlling interest in such corporation, should have a value equal to the present value of the cash flows expected to benefit shareholders. This is called a financial control value and represents the intrinsic value of the company on a stand-alone basis. As evidenced by the premium data noted above, many acquirers buy businesses at a value higher than this intrinsic value, paying what is referred to as a strategic premium.

What Is a Strategic Premium?

A strategic premium exists when a buyer expects that two plus two equals five, or possibly even some figure above five. In less abstract terms, acquirers pay a strategic premium when they expect that the combination of their business with another will generate more cash flow than both businesses on a standalone basis. A strategic premium reflects the portion of this added benefit that the buyer is willing pay to the seller to secure a deal.

To give an example, let’s say that Company A and Company B both generate $2 in EBITDA each year. Both companies may have an intrinsic stand-alone value of $12 (6x EBITDA). When Company A acquires B, they might pay 7.5x EBITDA ($15) because they expect that by combining into Company AB, the Company will generate a total of $5 of EBITDA per year (2+2=5) – providing for a combined intrinsic value of $30 (6x EBITDA). The difference between Company B’s stand-alone value of $12 and the $15 that Company A is willing to pay for it is $3, a 25% strategic premium. Company A spends $15 to increase their value from $12 to $30 – a deal that is accretive to shareholder value.

What Justifies a Strategic Premium?

The framework we provided for the strategic premium begs a larger question: what justifies a strategic premium? Ultimately, there are several possible explanations. Acquirers pay a strategic premium when they expect to gain some sort of efficiency through a business combination. As outlined in our previous example, they expect that these efficiencies will generate more cash flows than both companies can produce on a standalone basis. There are many efficiencies that companies could expect from a transaction, but three are most common.

Cost Savings

Cost savings are the most common justification for strategic premiums, often because they are comparatively easy to forecast.

Let’s go back to our two companies from earlier. Let’s say that Companies A and B both need to purchase the same raw material to create widgets. Once the companies combine, they still need the same amount of raw materials, but they will likely place a smaller number of larger orders. Since each order that comes in will now be larger, their suppliers may give them a bulk discount, which lowers the overall cost. By combining, Companies A and B are spending less money to bring in the same amount of revenue-generating raw materials, leading to larger amounts of profit and free cash flow.

Cost savings can come from supply costs, staff eliminations, or any number of other areas. These savings are usually both the most obvious and quickly achieved strategic enhancements following an acquisition.

Revenue Enhancements

Revenue enhancements are another common justification for strategic premiums but are harder to model.

There are many ways in which revenue enhancements can occur, but we focus on a simple example for the sake of this article. If Company A has a large distribution network, they can use that network to sell Company B’s products to a larger group of people than Company B had been able to previously. Bringing in this additional should increase profits and create more free cash flow.

Process Improvements

Process improvements come about when the companies involved in a transaction absorb each other’s core competencies or assets. Mixing these competencies or assets can create revenue enhancements and/or operational efficiencies.

Continuing our examination of Companies A and B, Company A might pay a premium for Company B if they see that Company B has some sort of proprietary efficient process for creating widgets that Company A could learn and take advantage of. In today’s world, such considerations often focus on technology – be it software of some other form of technology. If the target company’s technology can be utilized by an acquirer to enhance the acquirer’s own cash flow, a strategic premium may be in the offing.

Should You Pay a Strategic Premium?

Now that we have reviewed the theory behind strategic premiums, we discuss how they can be advantageous or detrimental to acquirers.

Perhaps the most obvious benefit of paying a strategic premium is that it can prevent other firms from purchasing the acquiree first. Sellers in a transaction are incentivized to maximize price. By paying a higher premium, strategic acquirers can entice sellers away from financial buyers or other seemingly “less strategic” buyers. On the other hand, paying a strategic premium is a potential risk. A higher acquisition price increases the amount of cash flows necessary to recoup the acquirer’s investment. If the premium is too high, even an acquisition with compelling strategic benefits can become unprofitable.

Ultimately the reasonable price to pay for a target depends on the buyer. Different suitors will expect different efficiencies from the acquisition. To avoid paying too large of a premium, acquirers must have a realistic notion of what they can pay for a target before entering negotiations. Even then, buyers need to exercise discipline and know when to walk away from a bidding war that has gotten too heated.

Acquirers are most likely to be successful when they have an organized process for ensuring that the rationale behind the acquisition justifies the transaction price. Such a process usually includes the analysis (and scrutiny) of the specific enhancements anticipated from a transaction. Strategic enhancements often seem reasonable when considered generally but may fall apart (or at least shrink in magnitude) when under the light of detailed financial inspection. Premiums paid on the basis of only a general consideration of strategic enhancements could be doomed for failure. The success of such deals is often based more on luck than anything else.

Concluding Thoughts

To mitigate the risk of overpaying for an acquisition (and to reduce the impact of pure luck), we recommend a detailed financial inspection of both the target company and the potential strategic value of any transaction. As part of this analysis, it will likely benefit an acquirer to retain a transaction advisory team that possesses financial and valuation expertise.

Since Mercer Capital’s founding in 1982, we have worked with a broad range of public and private companies and financial institutions. As financial advisors, Mercer Capital looks to assess the strategic fit of every prospect through initial planning, rigorous industry and financial analysis, target or buyer screening, negotiations, and exhaustive due diligence so that our clients reach the right decision regardless of outcome. Our dedicated and responsive deal team stands ready to help your business manage the transaction process.

Considerations in Merger Transactions

This is the fourth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.

When considering a buy-side transaction to expand, many middle market companies may not consider a merger transaction as an option compared to an outright acquisition. Mergers are often seen as transactions for big conglomerate-type companies on Wall Street, but they can be effective for middle-market businesses as well.

A merger is a combination of two companies on generally equal terms in which the transaction is structured as a share exchange although sometimes a modest amount of cash may be included, too. There are many questions that must be addressed. The key economic question involves the exchange ratio to establish the ownership percentages based upon the value of each company and the relative contribution of sales, EBITDA and other measures to the combined company.

Corporate governance and social issues are important factors to consider also. Because the “target” shareholders are not cashed out, a significant amount of time early in the process should be spent exploring the compatibility of directors, executive management and shareholders.

Why a Merger?

A basic premise from a shareholder perspective is that a merger will increase value through enhanced profitability, growth prospects and perhaps from the perspective of an acquirer of the combined company.

Stated differently, both shareholders should own shares in a company that will be more valuable than the interest in each independent company.

Assuming the parties are comfortable with governance and social issues, a merger can be an excellent means to grow the business when one of two conditions exist:

  1. Neither ownership group wants to truly exit; and/or
  2. Neither company has enough capital to fund a buy-out acquisition.

In the first situation, it may be that certain market, business or personal life cycle dynamics will keep one or both parties from wanting to sell the business. There is too much opportunity in the existing business to forego and owning a smaller percentage of a large pie is not an insurmountable hurdle. A merger gives both sets of ownership the value enhancements related to the expansion without forcing either group to exit their ownership position.

Mergers also have another very practical element. Cash is conserved because all or most of the consideration consists of shares issued by the surviving corporation to the shareholders of the company that will be merged into the surviving corporation. Some cash will be expended for professional fees, but the funds usually are nominal relative to the value of the combined companies. Importantly, existing excess liquidity and/or the borrowing capacity of the combined company can be used for expansion.

Relative Value

In a merger transaction, there is a two-sided valuation question. While in an acquisition, the buying party is typically bringing cash to the transaction (cash being easy to value), the merger parties are effectively both paying for the transaction with stock. The value of both companies must be set to determine the relative value percentages. If Company A (valued at $110 million) merges with Company B (valued at $90 million), the relative value percentages are 55%/45%. Following the merger, the former Company A shareholders should have 55% of the equity ownership in the merged entity, with the former Company B shareholders holding the remaining 45%.

In addition to considering the stand-alone valuation of each company, a contribution analysis should be constructed based upon sales, EBITDA, equity and other financial metrics. The valuations and contribution analysis then provides a range of exchange ratios (or ownership percentages) to conduct negotiations.

While the valuation and contribution math may be straightforward (or not at all), negotiating merger transactions can be complicated since one party is not paid to go away. Mercer Capital is often hired on a joint basis by entities seeking to negotiate a merger transaction.

While the final decision to go through with the merger remains with our clients in this situation, we serve as an independent advisor to both sides of the merger to establish the relative value parameters. An independent assessment of the relative values can help tremendously in building confidence with shareholders and boards that the terms of the merger are reasonable for both sides.


As with most deals, merger transactions usually include certain post-transaction “true-ups” to ensure that each entity delivers adequate levels of working capital (or other assets) at closing. A typical structure is for the parties to create escrow accounts funded with cash in amounts proportional to the post-merger ownership percentages. These escrow accounts serve as a mechanism to adjust for any shortfall at one entity.

If needed, a portion of the escrow cash is contributed into the merged entity, serving to make-up for any shortfall at closing. This keeps the ownership percentages at the agreed-upon relative value percentages. The excess cash left in the escrow accounts after these adjustments is distributed to the shareholders of the former (now merged) entities.

In our experience, shareholders and boards do not like the uncertainty of shifting ownership percentages – this escrow structure prevents the percentages from changing based on post-closing adjustments.

Who Is in Charge?

As with any acquisition, an organized post-transaction integration is critical to the success of a merger.

No matter how compelling the economics of a combination may be, the cultural fit of the two businesses will be a key element in determining the eventual success of the transaction. From the initial stages of the transaction, issues related to the cultural fit should be discussed and strategies should be implemented to increase the probability of a successful integration.

A basic question to be addressed early in the process is who will run the combined company. Public companies sometimes use co-CEOs, but not often for good reason. There should not be any question who is in charge, the responsibilities of subordinates, and the chain of command and accountability.

A comprehensive agreement on overall governance structures (including regional management, board construction, etc.) can provide some comfort for the side that might see themselves as being on the losing end of the potentially more political question of chief executive.

Shareholder control is another issue that has to be dealt with explicitly. If both entities consist of a large number of shareholders with no shareholder in direct control, the control issue is moot because there will be no controlling shareholder in the merged entity. Such prospective mergers are easier to negotiate because one shareholder (or voting block) does not have to give up control.

However, when one or both entities has a controlling shareholder (which could be represented by a single individual or a family block of stock), loss of control in a combined company may trump compelling economics. Both parties need to examine this issue closely and provide for conflict resolution mechanisms through the corporation’s by-laws and buy-sell agreements. Like marriages, getting out of a transaction is a lot harder and more expensive than entering into it.

Concluding Thoughts

We think mergers are a viable strategy to expand a business when the economics and social aspects are compelling for many small and middle market companies. Reasonable valuations and a detailed contribution analysis are the initial building blocks to quantify the economics. Mercer Capital is an active transaction advisor. While we most often are retained by one party, some of our most successful and rewarding projects have been those where we were jointly retained by both parties to advise on the transaction structure. If you are considering a merger (or in the middle of a current transaction), please call one of our Transaction Advisory Group professionals to assist.

First Quarter 2022 Review: Volatility Resurfaces

The first quarter of 2022 marked the most volatile period since the first quarter of 2020.  The quarter began with significant deterioration in the market’s outlook for growth stocks, particularly those lacking demonstrable earning power.  Then, a geopolitical crisis, building for some time, intensified with the invasion of a European country, roiling markets ranging from commodities to equities.  Last, the Federal Reserve announced, as expected, a 25 basis point change in its benchmark rate and telegraphed six more rate increases in 2022, taking the Federal Funds rate to nearly 2.00% by year-end 2022.  In a speech on March 21, 2022, though, Chairman Powell suggested a greater likelihood that future Fed moves may occur in 50 basis point, rather than 25 basis point, increments to combat inflation, which mirrors the position taken by Governor Bullard in dissenting to the Fed’s 25 basis point rate change at the mid-March meeting.

The following tables summarize key metrics we track regarding equities, fixed income, and commodity markets leading up to the invasion of Ukraine on February 23, 2022 and thereafter.

Equity Indices

Index data per S&P Capital IQ Pro

Treasury Rates

Treasury yields per FRED, Federal Reserve Bank of St. Louis

Debt Spreads

Corporate Credit Spreads per FRED, Federal Reserve Bank of St. Louis
CMBS spreads per ICE Index Platform


Oil price represents West Texas Intermediate; WTI prices per FRED, Federal Reserve Bank of St. Louis
Corn & wheat prices per Bloomberg

Residential Mortgages

How to Approach a Target and Perform Initial Due Diligence

This is the second article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.

Business is good for many middle market operators and investment capital is generally plentiful. Are you an investor whose capital is industry agnostic, or does your capital need to be targeted at add-on investments that build on a pre existing business platform?

All business investors are “financial” investors – the real question is how “strategic” is their ability to leverage the assets of the target. Providing practical guidance on approaching a business target and conducting initial due diligence depends on the investor’s criterion, competencies, and execution bandwidth.

In this article we assume you have identified a target or group of targets and you are attempting to learn enough about the target to determine whether to proceed with developing a meaningful indication of interest. Of course, an active seller is likely prepared for the sale process and represented by an advisor who is postured to provide the financial and operating information necessary for investors to quickly determine the suitability of a deal (i.e., a pitchbook and defined protocols for communication and information access).

However, many desirable targets may not be seeking a sale because business conditions are favorable, and their businesses have been managed to provide options to the owners regarding continued independence and turn-key ownership and management succession. If the former, you, as a prospective buyer may have already pinged on the radar of the seller, and if the later, you have mined for target opportunities and are ready for the next step to accomplish an acquisition.

Our focus here is to summarize some practical considerations for approaching and vetting an identified target.

First Contact

M&A is not easy. For every transaction that is announced a very long list of items for both the buyer and seller were satisfactorily addressed before two parties entered into a merger or purchase agreement. For the acquirers, first impressions matter a lot. There are no second chances to make a good first impression.

How a target is contacted can be pivotal to achieving receptivity and obtaining a critical mass of information. In cases where market familiarity or professional collegiality already exist, it can make sense for an investor’s senior leadership to make direct contact with the target’s senior management and/or owners.

In cases where the target is not familiar to the investor, then following a respectful and empathic set of protocols is key. Investors using professional advisors and/or who involve their senior decision makers are likely to be taken seriously by the target. Peer-to-peer contacts too far down the chain of command are more likely to be dismissed.

Owners and senior managers are keen to prevent the rumor mill from derailing business momentum and disturbing internal calm. A mindful and considerate process of first contact and initial discussions that is highly sensitive to the discrete nature of exploratory discussions will increase the probability that initial discussions and diligence can proceed to the next phase as a relationship based on trust develops.

In our experience, contacting a target through a financial advisor has an important signal function that the potential acquirer is serious and has initiated a process to prioritize and vet targets. Diligence procedures will be thorough and well organized; deal consideration and terms will be professionally scrutinized. Alternatively, some business owners and investors who initiate a process may be perceived as canvassing to see what sticks to the proverbial wall. This can inadvertently serve to inflate seller requirements and expectations assuming the initial inquiry is successful.

Initial Due Diligence

Once the initial contact is established, it is important to follow-up immediately with an actionable agenda. Actions and processes include:

  • Non-disclosure agreement;
  • Information request list;
  • Clear set of communication protocols involving specified individuals;
  • A centrally controlled and managed information gateway;
  • Establishment time frames and target dates for investigative due diligence, IOI, LOI, pre-closing due diligence, deal documentation, and ultimately closing.

Organization begets pace and that pace culminates in a go or no-go decision.

Preliminary Valuation

Procedurally, our buy-side clients typically request that we perform a valuation of the target using a variety of considerations including the standalone value of the target and potentially the value of the target inclusive of expected synergies and efficiencies.

A properly administered valuation process facilitates an understanding of the target’s business model, its tangible attributes, its intangible value, its operating capacity, its competitive and industry correlations, and many other considerations that investors use not only for the assessment of target feasibility but as an inward-looking exercise to assess the pre-existing business platform.

For first-time buy-side clients, our services may also include building leverageable templates and processes for future M&A projects. Additionally, our processes may also be critical to the buyer’s Board consents, the buyer’s financing arrangements, and other managerial and operating arrangements required to promote target integration.

Concluding Thoughts

Conducting target searches, establishing contact, and performing initial due diligence are critical aspects of successful buy-side outcomes. In general, there are as many (if not more) consequential considerations for buyers as there are for sellers.

Some buyers covet the conquest and go it alone without buy-side advisory representation. Conversely, even seasoned investors can benefit from third-party buy-side processes. Unseasoned acquirers may find their first forays into the M&A buy-side world untenable without proper guidance and bench strength.

As providers of litigation support services, we have seen deals that have gone terribly wrong as if predestined by inadequate buy-side investigation. As providers of valuation services, we have valued thousands of enterprises for compliance purposes and strategic needs. As transaction advisors, we have rendered fairness opinions, conducted buy- and sell-side engagements and advised buyers concerning a wide variety of deal structures and financings. If you plan to take a walk on the buy-side, let Mercer Capital’s 40 years of advisory excellence guide and inform you.

Understand the Asset Approach in a Business Valuation

What Is the Asset Approach and How Is it Utilized?

In previous posts, we wrote about the income and market approaches used in business valuations. This article presents a broad overview of the third approach, the asset approach. While each approach should be considered, the approach(es) ultimately relied upon will depend on the unique facts and circumstances of each situation.

The asset approach refers to methodologies used under the economic principle that the value of a business can be viewed as an assemblage of net assets. In practice, appraisers begin with the company’s balance sheet, which lists the assets, liabilities, and equity of the company. The values shown on a company’s balance sheet are the “book” values of the assets and liabilities, which are based on accounting standards. As such, these book values may or may not align with current market values. The appraiser will analyze each asset and liability and adjust values (as needed) to reflect market value. The market value of the company’s liabilities are then netted against the market value of the company’s assets to arrive at a Net Asset Value of the business.

The asset approach is appropriate for valuing real estate holding companies, investment holding companies, and capital-intensive operating companies. In the case of operating companies, the asset approach’s indicated value can be interpreted as the value of an assemblage of revenue-producing assets. However, sometimes the operating company is worth more than its assets, for a myriad of reasons. Understanding how well the balance sheet represents the business’s ability to generate earnings is a logical way to evaluate if the value per the asset approach is appropriate.

Asset Classes and Typical Balance Sheet Adjustments

The asset approach is applied based on the identification and discrete appraisal of the company’s assets and liabilities. The assets, if necessary, are adjusted to reflect their market values. Generally, the identifiable assets fall into five categories:

  1. Financial Assets
  2. Inventory
  3. Tangible Real Property
  4. Real Estate
  5. Intangible Assets

Financial Assets

Financial assets include cash and highly liquid investments like marketable securities, accounts receivable and prepaid expenses. This class of asset is typically the most straightforward to adjust, as the book values of cash and receivables usually require no adjustments to reflect market value.


In some cases, inventory can be marked up or down based on the economic reality underlying those inventory balances. If there is identified obsolete inventory, a downward adjustment might be necessary. If the company carries its inventory at historical cost and the value of that inventory has increased or decreased, an upward or downward adjustment might be necessary. An example of this could be a company that holds commodities as inventory.

Tangible Real Property

Tangible real property includes furniture, fixtures, and equipment. The value of these assets may decrease over time through use or obsolescence. Accountants capture this effect by depreciating the book value of these assets over a period of time. If the assumptions used in the accounting depreciation of these assets are in line with the economic depreciation of these assets, the book value may be a reasonable indication of the assets’ market values. Otherwise, appraisals of the individual furniture, fixtures, and equipment may be necessary.

Sometimes, businesses may choose to take accelerated depreciation for tax benefits, while the financial statements may reflect either that same tax depreciation, or straight-line depreciation; it is important to be careful in understanding the historical depreciation methods within the financial documents.

Real Estate

The book value of real estate may reflect current market values of the underlying properties or may be dated and require a current appraisal. This can be attributed to appreciation or depreciation in value over time.
Intangible Assets

A company might have intangible assets on its balance sheet. Intangible assets are typically added to the balance sheet during the accounting process of an acquisition, and can be comprised of customer relationships, customer files, existing favorable contracts, existing workforce, tradenames, intellectual property, proprietary technology and general goodwill. In practice, Net Asset Value typically does not include value attributable to intangible assets because it is presented on a tangible, operating basis.


The asset approach is an intuitive approach to valuation, as it is based on the market value of a company’s equity, i.e. assets less liabilities. The asset approach can be a more insightful business valuation approach for entities which hold and manage assets, or perhaps entities which have high balances of machinery and equipment. A competent valuation expert is needed to thoroughly review a company’s balance sheet and assess the adjustments necessary to reflect market value of the underlying assets and liabilities, as well as determine if the approach best represents the value of the business at hand.

Identifying Acquisition Targets and Assessing Strategic Fit

Identifying Acquisition Targets and Assessing Strategic Fit

With aggregate M&A activity setting records in 2021 and continuing a strong pace in 2022, many businesses are exhibiting a thirst for growth or conversely their shareholders are eyeing an exit at favorable valuations.

With labor tightness, supply chain disruptions for capital goods, and financing costs fluctuating in real time, buyers and sellers are increasingly strategic in their mindset. Inflation and interest rates represent potential headwinds, but pent-up demand and plentiful war chests are likely to fuel elevated M&A activity in the foreseeable future. More than a few baby boomers have held on to their business assets making ownership succession and liquidity significant concerns.

Additionally, many middle market business assets are churned by financial investors with defined holding periods. Large corporate players and private equity buy-out groups generally have their own corporate development teams. However, small and mid-market companies, occupied with day-to-day operations, often find themselves with limited bandwidth and a lack of financial advisory resource to identify, vet, and develop a well-crafted strategic M&A rationale and then execute it.

This article provides touch points and practicalities for identifying viable merger and acquisition targets and assessing strategic fit.

Motivation and Objectives

A rejuvenated appreciation for optimal capital structures and fine-tuned operations has largely debunked the oversimplified notion that bigger is always better. However, right-sizing is about achieving a proper, often larger scale at the proper time for a supportable price. A classic question in strategizing to achieve the right size is that of “buy” versus “build.”

Many acquisitions are as much about securing scarce or unavailable hard assets and labor resources as they are about expanding one’s market space.

Whether your investment mandate is to alleviate scarcities or to achieve vertical or horizontal diversification and expansion, tuning your investment criterion and financial tolerance to motivations and objectives is key.

These collective questions, among others, help address the who and the what of recognizing potential targets and assessing the pricing and structural feasibility of a business combination in whatever form that may take (outright purchase or merger in some form).

Given our experiences from years of advising clients, we have learned that the most obvious or simple solution is generally best. Many buyers already know the preferable target candidates but lack the ability to assess and the capacity to engage those targets. Additionally, many well-capitalized buyers lack the financial discipline to score, rank, and sequence their target opportunities with the expertise employed by large, active corporate developers and private equity investors.

Understanding the magnitude and timing of the returns resulting from your investment options is critical. Constructing financial models to study the options of now-versus-later and the interactive nature of deal pricing, terms, and financing is vital to the process. These technical and practical needs must be addressed competently to grant buyers the freedom of mind and energy to critically assess deal intangibles that often influence the overall decision to move forward with a target or not. Cultural fit, command and control for successful integration, brand and product synergies, and many other factors ultimately manifest in an investment’s total return on investment.

Scoring opportunities by way of traditional corporate finance disciplines using NPV and IRR modeling as well as using various frameworks such as SWOT Analysis or Porter’s Five Forces is highly recommended. However, blind ambition and soulless math may not result in the best choice of targets.

One common sense and often overlooked assessment is how a seller’s motivations may have a bearing on the risk assessment of the buyer. A seller today may be alerting today’s buyer about future realities the buyer may experience. In some cases, sellers are motivated by a deficit of ownership and management succession. In other cases, a seller’s motive may be the result of industry dynamics and disruption that may one day be the concern of today’s consolidators. Get informed, get objective and be rational when assessing a target. If you cannot do that with in-house resources, get help. If you have in-house resources, have your mandates reviewed and your target analysis checked by an experienced advisor with the right balance of valuation and transaction awareness.

Take a Walk in the Seller’s Shoes

We know that sellers often fear opening-up their financials and operations to certain logical strategic buyers. This may stem from generations of fierce competition or from a concern that not selling means the seller has revealed sensitive information that will compromise their competitive position or devalue the business in a future deal. Many sellers are extremely sensitive to retaining their staff and keeping faith with suppliers and customers. Buyers should understand that sellers require comfort and assurance regarding confidentiality.

Being proactive with non-disclosure agreements and even better using a third party such as Mercer Capital to establish contact may facilitate a process of mutual assessment that is initially a no-go for many tentative sellers. Buyers that demonstrate empathy for the seller’s position and who employ a well-conceived process to initiate exchange are more likely to gain access to essential information.

It is common for the seller’s initial market outreach to set the hurdle price for the winning buyer. That may occur as a result of the seller having reasonably skilled advisors who help establish deal expectations or through first-round indications of interest. As such, it should be no surprise for truly strategic buyers to be able to hurdle the offers of first round financial buyers or less optimal fringe buyers.

Buyers should also be aware that third party deals must win against the seller’s potential ability to execute a leveraged buy-out with family members or senior managers, which may facilitate favorable tax outcomes versus the asset-based structures in open-market M&A processes. Of course, strategic buyers should be equally aware that many private equity or family-office buyers may also be strategic in their motivations and pricing capabilities based on pre existing portfolio holdings.

Awareness of competing concerns for the target must be considered if you intend to win the deal. Buyers, with the help of skilled advisors, can actually help sellers address the balance of considerations that underpin a decision to sell. Having plans for human resource, communicating employee benefits and compensation structures, and laying the groundwork for a smooth integration process are part of walking the talk of a successful acquisition.

Concluding Thoughts

Whether your motivations are based on synergies, efficiencies, or simply on the inertial forces of consolidation that cycle through many industries, a well-organized and disciplined process is paramount to examining and approaching the market for hopeful growth opportunities.

Regardless of your past experiences and deal acumen, we recommend retaining a transaction advisory team familiar with your industry and possessing the valuation expertise to maximize transaction opportunities and communicate the merits your firm has to offer the target and all its stakeholders.

Since Mercer Capital’s founding in 1982, we have worked with a broad range of public and private companies and financial institutions. As financial advisors, Mercer Capital looks to assess the strategic fit of every prospect through initial planning, rigorous industry and financial analysis, target or buyer screening, negotiations, and exhaustive due diligence so that our clients reach the right decision regardless of outcome. Our dedicated and responsive deal team stands ready to help your business manage the transaction process.

Acquire or Be Acquired (AOBA) 2022: Review & Recap

After going virtual in 2021, the Omicron waved peaked just in time for the Acquire or Be Acquired (AOBA) conference to resume its normal physical presence in Phoenix, Arizona during late January.  The virtual sessions in 2021 lacked their normal impact, given the inability, through face-to-face communications, to delve deeper into emerging strategies and industry trends with peers and subject matter experts.  The most common sentiment expressed this year was simply the gratitude that we could gather once again, connecting with existing industry contacts and establishing new relationships.

AOBA’s emphasis has evolved.  When we first attended the conference, the sessions emphasized acquisitions of failed banks to such a degree that presenters struggled to avoid overlapping content.  Then, the conference shifted to emerging from the Great Financial Crisis and the transition to unassisted M&A transactions.  We still remember the years that distressed debt buyers roamed the halls looking for unsuspecting bankers with loans to sell.

More recently, the traditional financial services industry structure—with separate, and somewhat inviolable, silos for banking, insurance, wealth management—has been fractured by new challengers from the FinTech sector.  Armed with venture capital funding, a willingness to tolerate near-term losses, and a mindset not shackled by traditional operating strategies, the FinTech challengers have sought product lines prone to automation and homogeneity, like consumer checking accounts and small business lending.  However, while seeking to disrupt the banking industry, FinTech companies also need the banking industry for compliance expertise, funding, access to payment rails, and the ability to conduct business across state lines.

AOBA 2022 sought to unify several discordant themes.  The first theme is fracturing and convergence.  While FinTech companies seek to challenge the traditional banking industry, they rely on the industry and, indeed, have entered into M&A transactions to acquire banks.  The second theme is threat and opportunity.  Banks face challenges from FinTech companies for certain customer segments, but FinTech products and partnerships offer access to new products, new markets, and more efficient operations.  For fans of price/tangible book value multiples, though, AOBA 2022 still offered plenty of perspective on recent bank M&A trends.  We’ll cover four themes from AOBA 2022.

1. FinTech Competitors/Partners & the Nature of Competition

FinTech’s presence continued to increase at AOBA, both in terms of conference sponsors and mentions throughout the conference.  The most popular breakout session we attended was entitled “Crypto/Digital Assets – A Threat or Opportunity for Your Bank,” although it is difficult to ascertain whether the attendance reflects mere curiosity or a leading indicator that more banks will enter the Crypto space.

One common thread of FinTech-related presentations is that bankers should take a more expansive view of their competitors.  Three FinTech-related companies would rank among the twenty largest U.S. banks, as measured by market capitalization, including Paypal Holdings (#4), Square (#9), and Chime (#12, based on the value implied by its last funding round).  One speaker encouraged banks to adopt an “ecosystem” strategy instead of an “industry” strategy, noting that families often have 30 to 40 relationships with financial services providers, defined broadly.1  Thus, banks’ strategies should not be defined by traditional boundaries but rather embrace the entire financial “ecosystem” in which a range of competitors seek to displace banks from their traditional roles.  In this view, banks compete for customers from the “inside out,” while FinTech companies challenge from the “outside in.”

It remains difficult to quantify the direct impact on community banks from the current crop of non-bank competitors.  Nevertheless, banks’ strategic plans should evolve to reflect the growing population of well-financed non-traditional competitors, for which the pandemic has in some cases accelerated customer adoption.

The last FinTech theme related to “partnerships.”  This term has evolved towards a somewhat expansive definition this millennium, with seemingly any relationship (even as a customer/vendor) deemed a “partnership.”  Certainly, many banks are evaluating FinTech products, with an eye on both expanding revenues and increasing efficiencies.  Others are becoming more intertwined with FinTech companies, either as investors or as the banking platform used by the FinTech company itself.  There is some evidence that banks more closely allied with FinTech companies are being warmly received by the market, given their potential revenue upside.

When evaluating “partnerships,” we suggest deploying a risk/reward framework like banks use in evaluating other traditional banking products.  The lower risk/lower reward end of the spectrum would entail limiting the “partnership” to a particular FinTech product or service, such as for opening consumer checking accounts or automating a lending process.  The higher risk/higher reward part of spectrum would include equity investments or facilitating the FinTech’s business strategy using the bank’s balance sheet, compliance expertise, and access to payment rails.  Like with any bank product, different banks will fall in different places along this spectrum, given their histories, management and board expertise, shareholder risk tolerance, regulatory relationships, and the like.

2. Traditional Bank M&A:  Tailwinds & Headwinds

Mercer Capital provided its outlook for bank M&A in the December 2021 Bank Watch .  Naturally, the investment bankers at AOBA are bullish on bank M&A in 2022.  This optimism derives from several sources, including the pressure on revenue from a low interest rate environment and the technological investments needed to keep up with the Joneses.

Several headwinds to activity exist though:

  • Some transactions initiated prior to the COVID-19 pandemic in March 2020 were placed on hold throughout 2020, but negotiations resumed in 2021.  These transactions likely enhanced the reported level of deal activity in 2021, but this deal backlog now has likely cleared.
  • With the banking industry consolidating, fewer potential buyers exist.  Smaller banks or banks in more rural areas may face a dwindling number of potential acquirers.  Meanwhile, the remaining acquirers may seek to focus on larger transactions in strategic markets.  This could lead to a supply/demand imbalance, although non-traditional buyers—read credit unions—could fill the void.
  • After the drama over the FDIC’s leadership, many observers are expecting a more rigorous regulatory review of merger applications, such as around competition issues or fair lending compliance.  In the near term, navigating the regulatory thicket would appear most fraught for larger buyers.

Another trend to watch is M&A activity involving non-traditional buyers.  Mercer Capital’s Jay Wilson presented a session on credit union acquisitions of banks, focusing on the perspective credit unions take when evaluating potential acquisition targets.  In a reversal of roles, FinTech companies now have entered the scene as acquirers.  In February 2022, SoFi completed its acquisition of Golden Pacific Bancorp, and several other precedent transactions exist.

3. Subordinated Debt:  Act Now?

The subordinated debt market has been quite active, with bank holding companies issuing debt typically with a ten-year term, a fixed rate for the first five years and a variable rate tied to SOFR for the second five years, and a call option in favor of the issuer after five years.  Pricing tightened throughout 2021.  Through early 2022, pricing of newly-issued subordinated debt has remained stable in the 3.50% range, despite rising Treasury rates.  This implies that the spread between the fixed rate on the subordinated debt and five-year swap rates has tightened, falling to levels even below those observed in 2021.

Subordinated debt counts as Tier 2 capital at the bank holding company level but can be injected into the bank subsidiary as Tier 1 capital.  If bankers expect rising loan volume as the economy continues to recover from the pandemic, then it may behoove institutions to issue subordinated debt now and lock in a low cost source of capital.

4. The Regulatory Wild Card

Some attendees expect greater regulatory enforcement and rule making activity in certain areas, with the most likely suspect being fair lending.  However, leadership at some regulatory agencies remains in flux, such as at the OCC where President Biden’s nominee was withdrawn in the face of Senate opposition.  This would not be a constraint, though, at the CFPB, which has a Senate confirmed director who appears ready to take a more active stance on fair lending matters.  Interestingly, many larger banks have moved to limit overdraft and insufficient funds charges, even absent any actual (as opposed to hinted at) regulatory changes.  Tightening practices around overdrafts appears to be another risk to community banks, which may lack the revenue diversification that permits larger banks to absorb a loss of consumer banking fee revenue.


We sense that AOBA is moving into a new era, as it did when the Great Financial Crisis passed.  Attendees and sponsors are, to an ever greater extent, coming from outside the traditional banking industry.  This mirrors the banking industry itself, with its widening set of non-traditional competitors targeting different customer niches.  Future conferences will reveal the extent to which traditional and non-traditional competitors converge.  Regardless of what happens with the intersection of banks and FinTech companies, we can only hope that we’ve attended our last virtual conference.

  1 See Ronald Adner, Winning the Right Game, How to Disrupt, Defend, and Deliver in a Changing World, The MIT Press, 2021.

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