Thought Leadership on Succession Planning presented by Leonard J. Miller and Associates, Chartered.
Purchase price allocation is a critical part of the process when one business purchases another. Purchase price allocation, or PPA, is necessary when working through the execution of a transaction. Make sure you do your financial due diligence to work out assets and liabilities early so buyers can estimate what they are purchasing. They will be in earnest, as the assets (especially intangible assets) affect revenue estimations. What makes PPAs so multifaceted is that the process involves the financial understanding of both the tangible and intangible assets of a company. In this email I’d like to talk about what I’ve learned while helping clients with their business transactions.
Purchase price allocations (PPA)
When a business is merging with another, being purchased by another party, or undergoing an acquisition, a host of tax report requirements immediately go into effect. PPAs are simply an allocation of the purchase price paid to assets and liabilities that are involved in the transaction. The financial statements released must do so at the fair market value.
The fair market value for some assets are simple: they are determined by the recorded values on the seller’s financial statements. The inventory of a retail store, for instance, is valued at the price the seller paid when purchased or its current cost.
Other assets are more difficult to calculate but important to factor into the transaction since they have a direct impact on sales and the company’s potential for growth. These include:
- Employee training and experience, depth of team
- Licenses for software, technology, and equipment
- Brand name and social impression
- Customer base
- Current contracts
- Supplier connections and benefits
In exceptional cases, some buyers will pay goodwill, which is an amount included in the purchase price that exceeds the company’s fair market value of its other identifiable assets. This happens in instances where the buyer believes the owner’s earnings performance goes beyond the value of the other assets.
Mergers and acquisitions heavily affect the company’s stock price in a number of ways. The nature of the transaction usually dictates the level of risk an investor assumes when purchasing the stock. If the future of the company is uncertain, especially during aggressive takeovers, the greater the difference will be in stock and sale price.
There is another way to look at it. For example, let’s say Brady Inc. is currently worth $20 per share. Big Company announces they are purchasing Brady for $22. The question becomes, why does the stock price not automatically adjust to $22?
Uncertain variables affect this differential. If a deal begins but the buyer pulls out, the company’s stock price will plummet. During hostile takeovers, companies will sometimes try to undersell their stock value to a third party to attempt to undermine the unsolicited purchase.
Occasionally, the stock price will increase greater than the takeover if the public traders assume a third party will offer a higher bid. This can occur if the company sale drastically improves their foothold in a market or territory.
Equity is the difference between the value of a company and its debts or other financial allocations. In the simplest terms, non-stock assets are anything that is not equity. Non-stock assets include:
Tangible personal property. Items and equipment that does not fall under the real estate category qualifies as tangible personal property. This may be computers, analytical tools, testing equipment, supplies, leases, and machines.
Real property. This is the company’s real estate, like office space, shipping yards, and storage facilities.
Non-competes. Non-competes and non-solicitation agreements typically correlate with business strength. The more clients the company shares contracts with, the more revenue the company generates post-sale. Client volume and number of contracts are also important, measurable factors.
Employees. Some fields, like science and technology, require years to properly train an employee. Training programs, held certifications, and licensed patents all improve a company’s FMV.
Seller financing and equity
There are a few methods for funding acquisitions. Large acquisitions are typically funded using a combination of cash and other means. All are pretty straightforward.
Debt. The buyer may agree to assume the debt of the company in question. Debt is far more flexible than using cash, but buyers need to include interest payments into pricing.
Equity. Purchasing a business using equity is basically switching stock. Shareholders agree to trade some of their personal shares to buy company stock. Buying with equity is a fairly common practice.
Cash. This is the easiest way to purchase a company, though rarely do buyers have millions, or billions, in extra revenue sitting around.
Though all of the assets of a sale must be reported, keep in mind that many of them are deductible. Some are deducted as business expenses, while others are slowly written off over a period of several years (up to 39 years).
The IRS splits all assets into seven categories:
- Traded personal property
- Accounts receivable
- All other tangible assets including office supplies, furniture, equipment, and company-owned vehicles
- Intangible assets
The buyer and seller, along with their accountants and attorneys, will agree upon how much money is allocated into each category. Some categories have greater tax implications than others. Both parties must ultimately come to an agreement on the company’s fair market value.
This negotiation phase may take a long time, especially if any asset categories are in dispute. Large, diversified companies and corporations usually need to address one division at a time, sifting through distribution networks, office buildings, and more. Buyers of larger companies take longer, too, as they need to prepare for the restructuring phase. After agreeing upon the PPA, both parties fill out an IRS form 8594. These forms must match and be attached to the respective income tax return.
Many states have bulk transfer laws, which means the buyer needs to pay taxes on all equipment and inventory sales. For example, distribution companies with fleets of trucks are expensive to transfer.
Determining PPA and closely following finances can be a convoluted process, especially when calculating intangible assets. If you want to learn more, feel free to email me. I would be happy to answer any questions.