Accounting For Business Combinations Vrc

Current Issues in Accounting forCurrent Issues in Accounting for Business Combinations

March 23, 2010

Valuation Research Corporation

• Formed in 1975, VRC has eight U.S. offices and eight international affiliates.

• VRC provides M & A advisory services, fairness and solvency opinions in support of corporate transactions, and valuations of intellectual property and tangible assets for financial reporting and tax purposesand tangible assets for financial reporting and tax purposes.

• VRC maintains relationships with corporations, lenders, accountants, investment banks, private equity firms, and law firms.

• VRC was instrumental in forming the Appraisal Issues Task Force (AITF), a valuation industry group that meets quarterly with representatives from the FASB, the SEC, and the PCAOB to discuss valuation issues surroundingFASB, the SEC, and the PCAOB to discuss valuation issues surrounding financial reporting.

Valuation Research Corporation 2

P.J. Patel, CFA

• Mr. Patel specializes in the valuation of businesses, assets and liabilities for financial reporting purposes. In particular, he has focused on the valuation of intellectual property/intangible assets such as trademarks, technology, software, customer relationships and IPR&D.

• Mr. Patel is an active member of the AITF and is currently a member of the Appraisal Foundations Working Group, which is preparing a Practice Aid for valuing customer relationships.

• Mr. Patel is a frequent presenter on valuation issues for financial reporting purposes and has recently presented on valuation issues relating to ASC 805 (SFAS141R), ASC 350/360 (SFAS142/144), ASCrelating to ASC 805 (SFAS141R), ASC 350/360 (SFAS142/144), ASC 820 (SFAS157) and other emerging issues. In addition, Mr. Patel was on the Fair Value Panel at the 2008 AICPA SEC Conference. He has been quoted numerous times in the press regarding valuation issues.


Edward Hamilton

• Mr. Hamilton specializes in the valuation of businesses, assets and liabilities for financial reporting purposes. In particular, he has focused on the valuation of intellectual property/intangible assets such as trademarks, technology, software, customer relationships and IPR&D. He also values business interests for tax purposes.

• Mr. Hamilton is an active member of the AITF and is currently involved with the Appraisal Foundation Working Group preparing a Practice Aid for the valuation of customer relationships.

• Mr. Hamilton is a frequent presenter on valuation issues for financial reporting purposes and has recently presented on valuation issues relating to ASC 805 (SFAS141R), ASC 350/360 (SFAS142/144), ASC 820to ASC 805 (SFAS141R), ASC 350/360 (SFAS142/144), ASC 820 (SFAS157) and other emerging issues.


Agenda

Discussion of Current Issues in Accounting for Business Combinations, in a case study format. Issues to be discussed are as follows:

• Valuing Contingent ConsiderationValuing Contingent Consideration• Valuing Non-controlling Interests• Valuing Assets and Liabilities in a Bargain Purchase• Valuing Fixed Assets in a Capital Intensive BusinessValuing Fixed Assets in a Capital Intensive Business• Most Common Audit questions• Summary of Key Issues


Background

• SFAS141R (now ASC 805) issued December 2007• Low M&A activity through 2008 and 1st half of 2009• Second half of 2009 and early 2010 M&A activity increasing althoughSecond half of 2009 and early 2010 M&A activity increasing, although

the economic environment is still challenging and significant uncertainty remains regarding the future

• Increased deal activity together with economic challenges has led toIncreased deal activity together with economic challenges has led to new and sometimes difficult issues in valuing assets and liabilities in a business combination

• Evolving interpretation of the meaning of Fair Value ASC 820 (SFASEvolving interpretation of the meaning of Fair Value ASC 820 (SFAS 157)


Valuing Contingent Consideration - Overview

• Contingent consideration is generally a future obligation of the acquirer to transfer additional assets or equity to the selling shareholders.

• Contingent consideration can be structured in many ways, for example:• Revenue or earnings threshold• % of revenue or earnings• Milestones

7Valuation Research Corporation

Valuing Contingent Consideration

Case Study: Company A was acquired by Company B, a strategic buyer with similar, though more geographically dispersed, operations. Key factors are oug o e geog ap ca y d spe sed, ope a o s ey ac o s a esummarized below:

• Acquisition Rationale: Company A has substantial overlap with Company B. q p y p p yAs such, there are significant operational synergies.

• Initial consideration: $125 million. • EBITDA: 2007 – $35 million, 2008 – $34 million, 2009 – $22 million. • Buyer projects 2010 EBITDA of $30 million. Seller expects a more

significant improvement. • The buyer and seller disagreed about value as they disagreed about

“ l” f A h tili d ti t id ti t b id“normal” performance. As such, utilized contingent consideration to bridge the gap.

• Contingent Consideration: 6.0x 2010 EBITDA less $125 million.


Valuing Contingent Consideration - Issues

Issues:• Is the future payment contingent consideration or employee compensation?• What is the market participant perspective on the fair value? • What methods are used to determine the fair value?• What is the fair value?


Valuing Contingent Consideration – Is it Consideration?

Is it consideration? ASC 805-10-55-24/25 provides guidance.• Continuing employment• Duration of continuing employmentDuration of continuing employment• Level of compensation• Incremental payments to employees• Number of shares owned• Linkage to valuation• Formula for determining consideration


Valuing Contingent Consideration – Fair Value Considerations

820-10-35-3 A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market y g yparticipants to sell the asset or transfer the liability at the measurement date. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the objective of a fair value measurement is to determine the price that would be received to sell the asset or paid to transfer the liability at thereceived to sell the asset or paid to transfer the liability at the measurement date (an exit price).


Valuing Contingent Consideration – Determining the Fair Value

• Most common approach is an income approach/probability adjusted present value.

• Methodology considers expected cash flow attributable to contingent• Methodology considers expected cash flow attributable to contingent consideration and then determines the present value.

Probability 2010 EBITDA PaymentProbability 2010 EBITDA Payment2.5% 22.50 10.00 7.5% 25.00 25.00

20.0% 27.50 40.00 40 0% 30 00 55 0040.0% 30.00 55.00 20.0% 32.50 70.00 7.5% 35.00 85.00 2.5% 37.50 100.00

Expected Value 30.00 55.00 Discount Factor (13 months @ 15%) 0.86 Present Value 47.27


Valuing Contingent Consideration – Determining the Fair ValueAlternate Examples

An alternative scenario: • Earnout of $10 million if EBITDA is $30 million. • What if deal model projects $28 million? Is the fair value zero?• What if deal model projects $28 million? Is the fair value zero? • What if the deal model projects $32 million? Is the earnout

“certain?”


Valuing Contingent Consideration – Alternate Examples

• Deal model implies contingent considerationis paid.

• Management assisted VRC in determining a range of potential outcomes.

Probability 2010 EBITDA Payment2.5% 26.00 0.00 7.5% 28.00 0.00

20.0% 30.00 10.00 40 0% 32 00 10 00 range of potential outcomes.

• Payment is still considered fairly likely. • Buyer and seller were in agreement.

40.0% 32.00 10.00 20.0% 34.00 10.00

7.5% 36.00 10.00 2.5% 38.00 10.00

Expected Value 32.00 9.00

• Deal model implies no contingent consideration

Discount Factor (13 months @ 15%) 0.86 Present Value 7.74

Probability 2010 EBITDA Payment • Deal model implies no contingent consideration.• Management assisted VRC in determining a rangeof potential outcomes.

• There is a modest, though finite, likelihood of payment.

2.5% 22.00 0.00 7.5% 24.00 0.00

20.0% 26.00 0.00 40.0% 28.00 0.00 20.0% 30.00 10.00

7 5% 32 00 10 00 • Buyer and seller were in agreement.7.5% 32.00 10.00 2.5% 34.00 10.00

Expected Value 28.00 3.00 Discount Factor (13 months @ 15%) 0.86 Present Value 2.58


Valuing Contingent Consideration – Additional Considerations

• Expected Contingent Consideration• Why did the transaction utilize contingent consideration?• What is the buyer’s expectation? Seller?• What is the range of potential outcomes? Does the business exhibit

stable or volatile results? • If volatile results, are there extreme values? If extreme values, are they

are on the upside or downside?are on the upside or downside? • Determining the range of estimates? Management expectations?

Historical observations? Market observations?

• Discount Rate• IRR• Industry discount rate• Industry discount rate • WACC


NCI in a Business Combination - Overview

NCI• Non-controlling interest• The portion of equity (net assets) in a subsidiary not attributable, directly or p q y ( ) y , y

indirectly, to the parent• An NCI was formerly called a minority interest• ASC 810 (SFAS 160) requires fair value of NCI to be determined and

included as part of equity or in some cases as a liability• Occurs when less than 100% of a business is acquired (i.e. control is

acquired thus consolidated but percentage is less than 100%)


Valuing Non-Controlling Interests

Case Study:Company A acquires 70% of Company B for a purchase price of $70 million. Post transaction, the selling shareholders retain 30% of , gCompany B but can “put” the shares to Company A at their Fair Market Value.

Issues:• What is the value of the 30% NCI?• Should the fair value of the NCI reflect adjustments for lack of control andShould the fair value of the NCI reflect adjustments for lack of control and

lack of marketability?


Valuing Non-Controlling Interests – What is the Fair Value?

What is the value of the NCI?• NCI is equal to is fair value at the closing date of the transaction• Purchase price of $70 million for 70% (implied EV of $100 million) is p $ ( p $ )

generally a good starting point• Need to do other calculations to substantiate that value estimate is

reasonable• DCF, guideline company and comparable transaction approaches

• Adjust for lack of control and lack of marketability, as appropriate


Valuing Non-Controlling Interests – Lack of Control Adjustment

Factors to consider in determining adjustments for lack of control, include but are not limited to the following:

• Is the shareholder disadvantaged relative to the controlling shareholder?• Do the controlling shareholders receive an inordinate share of returns?• Is the company managed inefficiently?Is the company managed inefficiently?• Can the controlling shareholder make decisions that are to the detriment of other shareholders?

• Can shareholder remove top management?Can shareholder remove top management?• Are minority shareholders involved in the management of the company?• Can a vote of minority shareholders still influence the board of directors?


Valuing Non-Controlling Interests – Marketability Adjustment

Numerous factors affect marketability adjustments for equityinterests that are non-public or not actively traded. Factors include but are not limited to the following:include, but are not limited to, the following:

• “Put” rights;• Dividends or distributions;• Dividends or distributions;• Size of potential market of buyers;• Prospects for going public or being acquired;• Restrictive transfer provisions;• Restrictive transfer provisions;• Size and financial strength of the subject company;• Size of the interest in question.


Valuing Non-Controlling Interests – Determining the Fair Value

Value of NCI• Enterprise Value was determined to be $100 million based on valuation

calculations and purchase price of $70 million for 70%• Other valuation calculations support a value an enterprise value of $100

million• Fair Value of 30% NCI determined to be $30 million, if marketable

• Value was not adjusted for a lack of control as the NCI was deemed to have the same rights as the controlling shareholders

• NCI deemed marketable due to the presence of a put option• Alternatively value would be $30 million if NCI is publicly tradedAlternatively, value would be $30 million if NCI is publicly traded

• If deemed non-marketable, fair value of NCI is adjusted for lack of marketability


Bargain Purchase – Overview

Bargain purchase• ASC 805 definition: Total acquisition-date fair value of the identifiable net

t i d d th f i l f th id ti t f d lassets acquired exceeds the fair value of the consideration transferred plus any non-controlling interest in the acquiree.

• Presence of a bargain purchase requires the acquirer to recognize the excess as a gainexcess as a gain.

• In contrast, SFAS 141 required appropriate reduction to the assets acquired.


Bargain Purchase – Is it a Bargain Purchase?

805-30-25-4 Before recognizing a gain on a bargain purchase, the acquirer shall reassess whether it has correctly identified all of the assets acquired and all of the liabilities assumed and shall recognize any additional assets or liabilities that are identified in that review. See paragraphs 805-30-30-4 through 30-6 for guidance on the review of measurement procedures in connection with a reassessment required by this paragraph.

805-30-30-5 Paragraph 805-30-25-4 requires the acquirer to reassess whether it has correctly identified all of the assets acquired and all of the liabilities assumed before recognizing a gain on a bargain purchase. As part of that required reassessment, the acquirer shall then review the procedures used to measure the amounts this Topicacquirer shall then review the procedures used to measure the amounts this Topic requires to be recognized at the acquisition date for all of the following:

a. The identifiable assets acquired and liabilities assumedb. The non-controlling interest in the acquiree, if anyc For a business combination achieved in stages the acquirer’s previously held equity interest inc. For a business combination achieved in stages, the acquirer s previously held equity interest in

the acquireed. The consideration transferred.


Bargain Purchase – Is it a Bargain Purchase?

Factors to Consider• Is there a reason to believe it was a bargain purchase?

I th h i i ifi tl b l th l f t ibl t ?• Is the purchase price significantly below the value of tangible assets? • Is the purchase price significantly below working capital?• Is the purchase price significantly below observed market multiples?

Transaction multiples?Transaction multiples? • Was the seller financially distressed? • Was the seller unaware of the value of the business? • If goodwill is modestly negative were there assets/liabilities not measured• If goodwill is modestly negative, were there assets/liabilities not measured

appropriately or was an asset/liability omitted?


Valuing Fixed Assets in a Capital Intensive Business

Case Study:Company A acquires Company B for a purchase price of $100 million. Key metrics are summarized below:

• Acquisition rationale: relatively inexpensive entry (4x EBITDA) into the market/region

• Revenues – 2007 – $350 million, 2008 – $300 million, 2009 – $250 millionEBITDA 2007 $60 illi 2008 $40 illi 2009 $25 illi• EBITDA – 2007 – $60 million, 2008 – $40 million, 2009 – $25 million

• Book value of acquired working capital $20 million• Book value of acquired PP&E $80 million• No owned real estateNo owned real estate

Issues:• What is the market participant perspective on the value of fixed assets? • Is there any value associated with the trademark and customer intangible assets?y g• Is this a bargain purchase?


Valuing Fixed Assets - Issues

• There is value to the intangible assets?• Given a purchase price of 4x EBITDA, the likelihood of a bargain purchase

seems remote, rather it appears that the buyers, implicitly or explicitly, factored in an adjustment to the value of the fixed assetsfactored in an adjustment to the value of the fixed assets

• Which scenario, or combination of scenarios, reflects the fair value of PP&E?

AccountPP&E - Book

ValuePP&E – Value

In-UsePP&E –

In-Exchange

Purchase Price $100 $100 $100

Working capital 20 20 20

PP&E 80 90 20

Trademark 0 5 5Trademark 0 5 5

Customer Relationships 0 10 10

Goodwill 0 (25) 45


Valuing Fixed Assets – Fair Value Guidance

• Review ASC 820 for any appropriate guidance• Basics:

• Fair value definitionFair value definition• The price that would be received to sell an asset or paid to transfer a liability

in an orderly transaction between market participants at the measurement date

• Establishes a framework for measuring fair value• The price• Principal/most advantageous market• Use of market participant inputs rather than company-specific inputs• Application to assets• Application to liabilities• Characteristics of the asset or liability• Characteristics of the asset or liability



The Price

820-10-35-3 A fair value measurement assumes that the asset or liability is 35 3 yexchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date considered from the perspective of a market participantmeasurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the objective of a fair value measurement is to determine the price that would be received to sell the asset or paid to transfer the liability at the measurement date (an exit price).



Application to Assets

820-10-35-11 Because the highest and best use of the asset is determined based on its use by market participants the fair value measurement considersbased on its use by market participants, the fair value measurement considers the assumptions that market participants would use in pricing the asset, whether using an in-use or an in-exchange valuation premise.


Valuing Fixed Assets – Determining the Fair Value

Conclusion• In this circumstance, the value of PP&E was based on an in-use premise and then adjusted for economic obsolescence. As such, the value in-use estimate was adjusted for the time to regain full utilization of the assetswas adjusted for the time to regain full utilization of the assets

PP&E

AccountBook Value

PP&E –Value In-

Use

PP&E –In-Exchange

PP&E –Adjusted for

economic obsolescence

Purchase Price $100 $100 $100 $100

Working capital 20 20 20 20

PP&E 80 90 20 55

Trademark 0 5 5 5

Customer Relationships

0 10 10 10

Goodwill 0 (25) 45 10


Most Common Audit Questions

• How is ASC 820 reflected in your fair value calculations?• Is the earn-out contingent consideration or compensation?• Is there a previously held equity interest in the target company?• Is there a previously held equity interest in the target company?

If yes how was it valued?


Contact Information

PJ PatelEmail: [email protected]: 609 243 7030Direct: 609.243.7030Mobile: 609.240.1337

Ed HamiltonEmail: [email protected]: 609.243.7018Mobile: 609.221.8174


U.S. Office Locations

Boston101 Federal StreetBoston, MA 02110

Milwaukee330 East Kilbourn Avenue Milwaukee, WI 53202

1 2 1 8662

San Francisco50 California Street , Suite 3050San Francisco, CA 94111

1 2 1800617.342.7366

Chicago200 W. Madison Street Chicago, IL 60606

414.271.8662

New York500 Fifth Avenue New York, NY 10110

415.277.1800

Tampa777 S. Harbour Island Blvd.Tampa, FL 33602Chicago, IL 60606

312.957.7500

Cincinnati105 East Fourth Street Cincinnati OH 45202

,212.983.3370

Princeton200 Princeton Corporate Center

813-463-8510

Cincinnati, OH 45202513.579.9100

Ewing, NJ 08628609.452.0900


International Affiliate Office Locations

Buenos Aires Vuelta de Obligado 2728Piso 2

London90 Chancery LaneLondon, WC2A 1EU

MonterreyRicardo Cantu Leal #115Colonia LTHso

Buenos Aires C1428 ADTArgentina

FrankfurtRennbahnstraße 72-74

Luxembourg31 Boulevard Marcel CahenL-1311 Luxembourg

M d id

Col. FloridaMonterrey, N.L.C.P. 64830Mexico

P i60528 Frankfurt am MainGermany

Hong Kong22nd Floor, Siu On Centre188 Lockhart Road

MadridAlcalá, 265, Edificio 228027 Madrid Spain

Melbourne

Paris127, Rue des Dames75017 ParisFrance

São Paulo188 Lockhart RoadWanchai, Hong Kong

MelbourneLevel 10, 470 Collins St.Melbourne, Victoria 3000Australia

São PauloRua Alvarenga 1757 Butantã05509-004 São Paulo SP Brazil


Documents

Accounting For Business Combinations Vrc