When considering an acquisition, management teams need accurate valuations of the target company’s assets and liabilities. This is most commonly done to determine the accretion or dilution impact on earnings, to plan for contingent components of the purchase, such as earnouts, any entity or asset valuations for statutory or tax purposes, and any needed allocations of values by business unit – most commonly on a multinational basis.

In this article, we’ll touch on valuing intangibles in the pre-acquisition process, as well as another common pre-acquisition need, an analysis of any contingent consideration.

Recent Pre-Deal Valuation Trends

We find that more and more companies are performing pre-acquisition valuations, and larger company and multinational company acquisitions are engaging with their valuation firm one to three months in advance of any deal announcement. This includes due diligence support, working alongside the QOE, tax and technical due diligence teams.

Public companies often request pre-acquisition support as they evaluate potential acquisitions. For one multinational public company, this included the planned purchases of three targets: a provider of software tools for drug discovery; an employee management solutions company; and a European e-learning company. Other recent pre-deal valuations included:

• The acquisition of a $600 million glass manufacturer by a private equity sponsor
• A public worldwide aviation manufacturing and services company’s tuck-in acquisition
• All three acquisitions in 2014 by a leading public cloud-based web access and transactions solutions company
• Intangible asset values for public, global consumer branded personal care products company

In each of these transactions—as is the case for most acquisitions today—a preliminary valuation of intangible assets was especially important to assist with accretion-dilution modeling and to offer a quicker start (if the project moved forward) for the post-transaction purchase price allocation. Support can also include the appraisal of fixed assets as collateral for acquisition-date deal financing.

Valuing Intangible Assets and Deferred Revenue

The Financial Accounting Standards Board (FASB) created categories of intangible assets (customer-based, contract-based, etc.) and mandates recognition of these apart from goodwill in ASC 805. Identifying and valuing intangible assets, as well as deferred revenue, in advance of a purchase has become a valuable step in the due diligence process.

Consideration of the effect amortization will have on future earnings has become a critical element of the due diligence process. For this reason, acquirers often ask for preparation of pre-acquisition valuation “snapshots.” In several instances, the knowledge gained from valuation support in the due diligence phase results in modifications or cancellations of transactions.

The amortization of intangible assets will also be a concern to the buyer if, for example, there are profitability or balance sheet benchmarks the company is required to meet under the terms of a loan agreement. Understanding the value and amortization of the intangible assets prior to the close of the transaction can eliminate these types of unforeseen problems.

Case Studies

The following provides an overview of situations where VRC’s valuations of intangibles and deferred revenue helped management determine whether an acquisition would be accretive to earnings:

• A global public company was considering the acquisition of an early-stage value-added supplier of biotechnology products. We were asked to value the material intangible assets of the target company. In its initial review of the target, the client believed the technology and IPR&D would encompass a significant portion of the purchase price. Our analysis found the value of the technology and IPR&D comprised only a small percentage of the purchase price because of the rapid rate at which the technology was evolving. Based on our (lower) value and asset life conclusions, our client concluded the acquisition would be accretive to earnings.
• A U.S. public company was considering the acquisition of a privately-held UK company. We were asked to value the material intangible assets of the target. The intangible assets included trademarks, technology and customer relationships. In the course of our work, we found the target had fully expensed its recently installed ERP software. In our pre-acquisition allocation, we valued the software and determined the expected remaining useful life, enabling our client to get a true estimate of the amortization resulting from the acquisition. Based on our (higher) value and asset life conclusions, our client concluded the acquisition would still be accretive.
• A public U.S. company acquired a software company – a type of business they did not usually acquire. The acquirer’s internal models expected material revenue from existing software licenses to be reported in future years. However, a fair value analysis showed that as the product had been delivered and there was very little in the way of future obligation by the seller, the deferred revenue showed a nearly 100% haircut, and no future revenue relating to these contracts. The acquisition closed — but models and company forecasts had to be revised.
• A multinational public company in the pharmaceutical industry needed pre-acquisition support relating to its roughly $100 million purchase of a pharmaceutical company. Our valuation support helped them model and plan for the transaction. The purchase involved cash, company stock, and contingent consideration payments of up to $15 million, which would be paid in the event-specific performance metrics were reached.

About Contingent Consideration

Contingent consideration is a common component of acquisitions. Generally speaking, it is an amount that may be paid, depending on the resolution of certain future events. The most common form of contingent consideration is an earn-out agreement. Contingent consideration must be recorded at fair value as of the acquisition date. Earnouts are first reviewed to determine whether they meet the criteria to be contingent consideration, or if they should be expensed – as a reflection of future services to be provided. If determined to be contingent consideration, the accounting treatment will depend on whether it is classified as liability or equity. Earnouts, generally classified as liabilities, are to be measured at fair value at each reporting date until the contingency is resolved. On the other hand, if the contingent consideration is classified as equity, it is not re-measured at fair value and the settlement is accounted for within the equity.

The requirement to re-measure the liability at each balance sheet date has created the potential for earnings volatility. While an increase in fair value will result in a charge to earnings, a decrease in fair value will bring about a credit to the P&L. A careful analysis of the potential contingent consideration may help reduce some of this earnings volatility – and at least any surprises.

Management teams considering an acquisition should be cognizant of the target company’s intangible values and lives, and how they will affect reported earnings, the balance sheet, and taxes, post-acquisition. Through a pre-acquisition valuation, companies can better understand and prepare for the impact of a transaction. For more information about how VRC can help, contact your VRC representative.