ASC 805, business combinations

1. Current Issues in Accounting for
Business Combinations
March 23, 2010

2. 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 purposes
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 surrounding
financial reporting.
Valuation Research Corporation 2

3. 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), 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.
Valuation Research Corporation 3

4. 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 820
(SFAS157) and other emerging issues.
Valuation Research Corporation 4

5. Agenda
Discussion of Current Issues in Accounting for Business Combinations,
in a case study format. Issues to be discussed are as follows:
• Valuing Contingent Consideration
• Valuing Non-controlling Interests
• Valuing Assets and Liabilities in a Bargain Purchase
• Valuing Fixed Assets in a Capital Intensive Business
• Most Common Audit questions
• Summary of Key Issues
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6. 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 although
increasing,
the economic environment is still challenging and significant
uncertainty remains regarding the future
• Increased 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 (SFAS
157)
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7. 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
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8. Valuing Contingent Consideration
Case Study:
Company A was acquired by Company B, a strategic buyer with similar,
though more geog ap ca y d spe sed, ope a o s Key factors a e
oug o e geographically dispersed, operations. ey ac o s are
summarized below:
• Acquisition Rationale: Company A has substantial overlap with Company B.
q p y p p y
As 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
“normal” performance. A such, utilized contingent consideration to bridge
“ l” f As h tili d ti t id ti t b id
the gap.
• Contingent Consideration: 6.0x 2010 EBITDA less $125 million.
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9. 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?
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10. Valuing Contingent Consideration – Is it Consideration?
Is it consideration? ASC 805-10-55-24/25 provides guidance.
• Continuing employment
• Duration of continuing employment
• Level of compensation
• Incremental payments to employees
• Number of shares owned
• Linkage to valuation
• Formula for determining consideration
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11. 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 y
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 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).
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12. 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
consideration and then determines the present value.
Probability 2010 EBITDA Payment
2.5% 22.50 10.00
7.5% 25.00 25.00
20.0% 27.50 40.00
40.0%
40 0% 30.00
30 00 55.00
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
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13. Valuing Contingent Consideration – Determining the Fair Value
Alternate 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 the deal model projects $32 million? Is the earnout
“certain?”
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14. Valuing Contingent Consideration – Alternate Examples
Probability 2010 EBITDA Payment • Deal model implies contingent consideration
2.5% 26.00 0.00 is paid.
7.5% 28.00 0.00
20.0% 30.00 10.00
• Management assisted VRC in determining a
40.0%
40 0% 32.00
32 00 10.00
10 00 range of potential outcomes.
20.0% 34.00 10.00 • Payment is still considered fairly likely.
7.5% 36.00 10.00 • Buyer and seller were in agreement.
2.5% 38.00 10.00
Expected Value 32.00 9.00
Discount Factor (13 months @ 15%) 0.86
Present Value 7.74
Probability 2010 EBITDA Payment
2.5% 22.00 0.00
• Deal model implies no contingent consideration
consideration.
7.5% 24.00 0.00 • Management assisted VRC in determining a range
20.0% 26.00 0.00 of potential outcomes.
40.0% 28.00 0.00 • There is a modest, though finite, likelihood of
20.0% 30.00 10.00 payment.
7.5%
7 5% 32.00
32 00 10.00
10 00
2.5% 34.00 10.00
• Buyer and seller were in agreement.
Expected Value 28.00 3.00
Discount Factor (13 months @ 15%) 0.86
Present Value 2.58
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15. 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?
• Determining the range of estimates? Management expectations?
Historical observations? Market observations?
• Discount Rate
• IRR
• Industry discount rate
• WACC
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16. NCI in a Business Combination - Overview
NCI
• Non-controlling interest
• The portion of equity (
p q y (net assets) in a subsidiary not attributable, directly or
) 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%)
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17. 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
, g
Company 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 and
lack of marketability?
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18. 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 $ million for 70% ( p
p $70 (implied EV of $
$100 million) is
)
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
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19. 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?
• Can the controlling shareholder make decisions that are to the detriment of
other shareholders?
• 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?
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20. Valuing Non-Controlling Interests – Marketability Adjustment
Numerous factors affect marketability adjustments for equity
interests that are non-public or not actively traded. Factors
include,
include but are not limited to the following:
to,
• “Put” rights;
• Dividends or distributions;
• Size of potential market of buyers;
• Prospects for going public or being acquired;
• Restrictive transfer provisions;
• Size and financial strength of the subject company;
• Size of the interest in question.
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21. 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,
Alternatively value would be $30 million if NCI is publicly traded
• If deemed non-marketable, fair value of NCI is adjusted for lack of
marketability
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22. Bargain Purchase – Overview
Bargain purchase
• ASC 805 definition: Total acquisition-date fair value of the identifiable net
assets acquired exceeds th fair value of the consideration t
t i d d the f i l f th id ti transferred plus
f d l
any non-controlling interest in the acquiree.
• Presence of a bargain purchase requires the acquirer to recognize the
excess as a gain
gain.
• In contrast, SFAS 141 required appropriate reduction to the assets
acquired.
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23. 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 Topic
requires to be recognized at the acquisition date for all of the following:
a. The identifiable assets acquired and liabilities assumed
b. The non-controlling interest in the acquiree, if any
c.
c For a business combination achieved in stages the acquirer’s previously held equity interest in
stages, acquirer s
the acquiree
d. The consideration transferred.
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24. Bargain Purchase – Is it a Bargain Purchase?
Factors to Consider
• Is there a reason to believe it was a bargain purchase?
• Is th
I the purchase price significantly below th value of t
h i i ifi tl b l the l f tangible assets?
ibl t ?
• Is the purchase price significantly below working capital?
• Is the purchase price significantly below observed market 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
negative,
appropriately or was an asset/liability omitted?
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25. 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 million
• EBITDA – 2007 – $60 million, 2008 – $40 million, 2009 – $25 million
illi illi illi
• Book value of acquired working capital $20 million
• Book value of acquired PP&E $80 million
• No 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?
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26. 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 assets
• Which scenario, or combination of scenarios, reflects the fair value of
PP&E?
PP&E - Book PP&E – Value PP&E –
Account Value In-Use In-Exchange
Purchase Price $100 $100 $100
Working capital 20 20 20
PP&E 80 90 20
Trademark 0 5 5
Customer Relationships 0 10 10
Goodwill 0 (25) 45
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27. Valuing Fixed Assets – Fair Value Guidance
• Review ASC 820 for any appropriate guidance
• Basics:
• Fair 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
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28. Valuing Fixed Assets – Fair Value Guidance
The Price
820-10-35-3 A fair value measurement assumes that the asset or liability is
35 3 y
exchanged 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 participant
date,
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).
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29. Valuing Fixed Assets – Fair Value Guidance
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 considers
participants,
the assumptions that market participants would use in pricing the asset, whether
using an in-use or an in-exchange valuation premise.
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30. 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 assets
PP&E –
PP&E – PP&E – Adjusted for
Book Value In- In-Exchange economic
Account Value Use 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 0 10 10 10
Relationships
Goodwill 0 (25) 45 10
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31. 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?
If yes how was it valued?
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32. Contact Information
PJ Patel
Email: ppatel@valuationresearch.com
Direct: 609 243 7030
609.243.7030
Mobile: 609.240.1337
Ed Hamilton
Email: ehamilton@valuationresearch.com
Direct: 609.243.7018
Mobile: 609.221.8174
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33. U.S. Office Locations
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617.342.7366 414.271.8662
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1 2 1800
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Chicago, IL 60606 New York, NY 10110
, Tampa, FL 33602
813-463-8510
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Cincinnati,
Cincinnati OH 45202 Ewing, NJ 08628
513.579.9100 609.452.0900
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34. International Affiliate Office Locations
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Piso 2
so London, WC2A 1EU Colonia LTH
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Rennbahnstraße 72-74
60528 Frankfurt am Main Madrid
M d id Paris
P i
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28027 Madrid 75017 Paris
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Wanchai, Hong Kong Level 10, 470 Collins St. Rua Alvarenga 1757 Butantã
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Australia Brazil
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