Maximizing the Rate of Return on Your Next Acquisition: Why the Allocation of the Purchase Price Should Be Done Before the Deal Closes

From April’s Axiom on Value:

When an acquisition (stock or asset deal) is completed, the purchase price needs to be allocated to the assets purchased.  In our experience, the allocation exercise is typically done after the deal is completed.  A typical allocation table is shown below.

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Notice that in this case the portion that is goodwill is quite large at about 30%. From a post-acquisition perspective the tax benefit (assuming an asset deal or a stock deal with a 338 election) associated with goodwill is no different than the tax benefit associated with the customer list, for example- one fifteenth is amortized for tax purposes. Hence, the usual view is that the allocation of purchase price between purchased intangible assets and goodwill has no cash flow implications. This is often not the case.

Here is the reason. Goodwill is the value the buyer expects to produce in excess of what could be produced by the assets alone. Now in most cases goodwill can be divided into two components. The first is seller goodwill or goodwill that the seller would be expected to produce if the business remained on is historical trajectory. This goodwill includes but is not limited to additions to the customer base for example and/or strategies designed to reduce historical customer loss rates. What the buyer should not pay for is buyer goodwill. Following the example used here, buyer goodwill would equate to additions to the customer base above what the selling entity would be expected to generate on its own. Hence, the minimum purchase price should include the standalone value of the assets purchased plus seller goodwill. Any increment in the purchase price above this level gives rise to buyer goodwill. While competitive conditions and capital availability may result in a market participant paying up, the only way to know the potential extent of the over-payment is to conduct an allocation of the expected purchase price to the assets purchased.

Letter to the Editor: Wall Street Journal: Auditors of Hedge and Private Funds are Not Validating NAVs

“Sophisticated institutional investors still insist on believing in the Tooth Fairy that can somehow miraculously provide market beating returns for everyone. May be that is the biggest crime of all” (Behind the High- Pressure Hedge Fund Culture” (WSJ, July 25, 2013)).   Chasing after returns is not greatest crime of all. Many hedge funds have the capacity to exploit inefficiencies in the market and do so. What is a shame is that endowments, pension funds and foundations in addition to their agents do virtually no due diligence as to whether the returns and NAVs are fraudulently reported.  Investors believe that when hedge funds provide audited financials to them that the NAVs shown have been vetted by the auditors. They have not. Hedge fund auditors “presume” the NAVs are correct and audit whether the investment process used by the manager to establish the NAVs is reasonable.  This is a very low standard.  We know this because Madoff feeder funds were blessed by reputable audit firms. The consultants offer performance evaluation services but the returns used in this analysis are self-reported and for all we know fraudulent.  The crime is that investors live under an illusion that they are covered while the auditors and consultants reinforce the fantasy since it is not in their interest to do otherwise.  The fact remains that there are analytics in place that investors can use to test whether a manager is a Madoff clone.  The fact that the SEC is currently using its data mining ABI (Aberrational Performance Initiative) to ferret out fraudulent managers should be enough of anW incentive for investors to finally wake-up.

Primer on 409A

The 409A Primer was first released in 2009. It was modified in 2010 in order to better address questions that readers frequently asked.  Originally, the document was prepared for Boards of Axiom Valuation Solution clients so they might better understand the process for and implications of establishing the fair value of common of privately-held companies. The number of downloads from our web site indicates the Primer has both been well received and achieved its intended purpose: to inform and educate Boards and management of privately-held businesses. While Board members and managements see the Primer as creating more transparency to the common stock valuation process, every once in a while we here the following frustrated refrain from a frustrated Board member.

 

“I do not get it! Why is the d– fair value of common so large relative to the issue price of the latest round of preferred stock? We are an early stage firm with so little revenue, how is it possible for the common price to be more than 10% of the latest preferred issue price?”

 

Boards naturally want to establish low common price since this sets the strike price for employee stock options. The  lower the strike, the less costly to exercise employee stock options, the better the alignment between investor interests and those of management and other optionees.  Low fair values for common are not inevitable for two reasons. The first is the central attraction for investors in a private firm: the perceived expected growth opportunity leading to a future lucrative liquidity event. Some of that expected growth will necessarily show up in the value of common. This is inevitable and the IRS expects to see evidence of this in every private common stock valuation. The second factor giving rise to common stock fair values higher than Boards often expect is that preferences of preferred stock are often not large enough.

The fair value of common will be minimized by:

  •  The higher the preferred dividend rate;
  •  The greater the liquidation preference (2x is better than 1x);
  •  The less the limit on preferred participation; and
  •  The lower the value per share at which conversion to common takes place.

The Primer has many examples of how the fair value of common is impacted by liquidation preference characteristics of  a firm’s capital structure.  The Primer is available on Amazon [Read more…]