Pre-Acquisition Valuation Key Step in Due Diligence Process

Acquirers spend a significant amount of time on financing and planning for the integration of a company when making an acquisition. Yet, buyers often wait to consider the transaction’s accounting requirements, and resulting impact on financial results, until after the deal has been completed. In order to avoid any unpleasant surprises, and in some cases, to design an efficient acquisition structure, it is beneficial to consider in the early stages of an acquisition the accounting for the intangible assets acquired as part of a transaction.

The issuance of ASC 805 and ASC 350 (previously SFAS 141 and SFAS 142 respectively) have made it critical for buyers to consider how a transaction may impact their financial reporting. For example, it is necessary to project, as accurately as possible, the future charges to expenses related to the amortization of intangible assets. Publicly traded firms are especially sensitive to reported earnings per share, which will be affected by intangible asset amortization. Consideration of the effect that the amortization of intangible assets will have on future earnings should be a critical element of the due diligence process. For this reason, acquirers often ask a valuation expert to prepare a pre-acquisition valuation.

Intangible Assets

In most acquisitions today, intangible assets are the key assets acquired. In recognition of this fact, the FASB created categories of intangible assets (customer-based, contract-based, marketing-related, etc.) and mandated recognition of these intangibles apart from goodwill in ASC 805. As a result, identifying and valuing intangible assets in advance of a purchase has become a valuable step in the due diligence process. Our pre-acquisition valuations have frequently been used as “evidence” of whether an acquisition will be accretive or not.

IPR&D

Another important factor that should be considered prior to making an acquisition is whether or not the target company has any in-process research and development (“IPR&D”). Under the prior SFAS 141, IPR&D was measured at fair value and expensed on the acquisition date. The rules changed with the advent of SFAS 141R (now ASC 805), and now require IPR&D to be measured at fair value and capitalized with an indefinite life. As is the case with other indefinite-lived assets (e.g., goodwill), IPR&D must now be tested for impairment in accordance with ASC 350. At the time the life of the IPR&D project becomes determinable (upon project completion or abandonment), IPR&D must be amortized over its expected remaining life.

Contingent Consideration

Another recent change in the accounting rules affecting transactions is the treatment of contingent consideration. Contingent consideration is an amount that may or may not be paid, depending on the resolution of certain future events. The most common form of contingent consideration is an earn-out agreement. According to ASC 805, contingent consideration must be recorded at fair value as of the acquisition date. The accounting treatment for the contingent consideration will depend on whether it is classified as a 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 remeasured 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.

Case Studies

The following examples illustrate the importance of obtaining a valuation of intangibles prior to a transaction:

  • 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 an initial review of the Company, we and the client believed the technology and IPR&D would encompass a significant portion of the purchase price. In the course of our analysis, we found that 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 value and life conclusions our client concluded that the acquisition would be accretive to earnings.
  • A U.S. public company was considering the acquisition of a privately held company based in the U.K. We were asked to value the material intangible assets of the target company. The intangible assets identified in the initial review were trademarks, technology and customer relationships. In the course of our due diligence, we found that the target had 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 better estimate of the amortization resulting from the acquisition. Based on our value and life conclusions our client concluded that the acquisition would be accretive.

In conclusion, most transactions will have intangible assets that need to be valued. Our recommendation is that the company obtain an estimate of the value of intangible assets prior to an acquisition. As a buyer, knowing the value and lives of the assets to be acquired will allow the buyer to determine whether or not a proposed acquisition will be accretive. For more information, contact your VRC representative.