What is a Purchase Price Allocation?

A Purchase Price Allocation (“PPA”) is frequently required for tax and financial reporting following a merger or acquisition . However, a PPA can be much more than just an accounting exercise.

THE BASICS

What is a Purchase Price Allocation?

The acquisition of a business generally means the purchase of some combination of assets that together are able to generate value as a going concern. As businesses have commingled parts, most acquisitions are viewed on the entirety of the business as opposed to the individual components and their intricate relationship to each other and to the buyer. A Purchase Price Allocation (“PPA”) is an exercise intended to identify what was actually purchased -- all of the assets, both tangible and intangible, as well as any liabilities -- and assigning a Fair (or Fair Market) Value to these various components. Note that the Fair Value of any asset is the value that a hypothetical market participant would pay for the assets (and not necessarily the value that any one specific acquirer would be willing to pay).

The purchase price paid for the business is then allocated among the Fair Values of the identifiable assets (and liabilities, if any). So in the simplest example where you’re buying a building and the land on which it sits, you’d be allocating sales price between land and building. Obviously buying a business with many assets is a bit more complex than that, but allocating the purchase price works the same way.

Once the allocation of purchase price to each asset (and liability) in a business sale has been accomplished, the residual is known as goodwill. Goodwill in accounting represents the amount an acquirer has paid above the Fair Value of the identifiable assets -- and in some cases, goodwill will include buyer-specific synergies expected to be realized by the acquisition of the purchased business.

As a simple example, if a valuation finds that all of a company’s assets, both tangible and (identifiable) intangible, total to $8M, and a buyer acquired that company for $10M, that means the buyer has paid $2M above the Fair Value of these tangible and intangible assets.  This excess (goodwill) may relate to many factors, including the prospect of new customers, new technologies and other assets of economic value the company expects to realize in the future.  It could also be due to the buyer’s presumption that there is some strategic synergy in acquiring the company. Conversely, if you had a company in bankruptcy eager to sell, there might be no goodwill at all, and the purchase price could be less than the Fair Value of the assets when valued under the assumption they are being utilized as part of a going concern.

Why is a Purchase Price Allocation necessary?

The main reason purchase accounting is necessary is for financial reporting purposes. The goal of the accountant for the transaction is to reflect the proper values of the assets and liabilities on the opening balance sheet.  Investors also appreciate the performance of a purchase price allocation in order to understand the transaction and its implications (perhaps on earnings per share) more fully.

So is a Purchase Price Allocation just another compliance hoop for me to jump through?

Far from it.

Yes, it is required for compliance with the accounting standards and it does take some time. But you should view a PPA valuation exercise less as a burden and more an opportunity. Doing a PPA is going to provide insight into many aspects of the business that you might otherwise not have had, thus providing a buyer with an understanding of the value drivers behind the purchased business and not just the expected total cash flows. It’s going to show you all the pieces to the puzzle that are producing those cash flows and the potential for upsides/downsides to those cash flows as the tangible and identifiable intangible assets appreciate/depreciate.

A PPA is helpful to get the parties to understand not only the rationale behind why one might consummate a deal, but also the long-term implications from having made that decision. As an example, let’s take Facebook’s acquisition of Instagram. Purely on a cash flow basis, the justification for the price paid may not seem obvious. You might say, “Okay, they’re paying for customers, but what else would make this acquisition sensible?”  The benefit of a PPA valuation, which seeks to identify all the (asset and liability) pieces of the puzzle, is that it allows the realization that there’s a lot more going on that isn’t as obvious at a cursory glance, and it’s those less obvious details that make the billion-dollar deals happen.

When do we need to do a Purchase Price Allocation?

The most essential reasons for a PPA are to report the results of the transaction to investors looking at financial reports, and to take depreciation and amortization into account when calculating taxes (for which IRS form 8594 may have been completed) or cash flow statements. For these reasons, a PPA is generally done soon after the close of the transaction while management of the target company and information related to the historical and prospective prospects of the business are fresh and still readily accessible.

Waiting too long after the close of the transaction increases the difficulty of obtaining the information, especially as personnel leave, management shifts and records are no longer available. You definitely want to finish your Purchase Price Allocation well in advance of the buyer’s quarterly (or annual) financial statements being issued, so as to not complicate the issuance of this financial information.

However, there is also a strong argument for starting your Purchase Price Allocation even earlier, before the transaction.

Why would anyone want a Purchase Price Allocation pre-transaction?

From the sell side, it can be very useful to perform a hypothetical purchase price allocation as a way of dressing the company up for sale. By getting a PPA and being able to identify and place value on your company’s key tangible and intangible assets, you can put together a pitch book that aids in attracting a prospective buyer. It’s one thing to fill a pitch book with marketing language and discussion of your valuable intellectual property. It’s another thing to have an independent view of the value of the key underlying intellectual property, demonstrating that your business offers identifiable assets to be leveraged by a specific buyer.

From the buy side, it’s likewise helpful to have an objective third party offer an independent assessment of the value of the individual components of a business. This is a sensible part of early due diligence that is favored by a forward-thinking corporate development team looking to determine, and support, a probable purchase price and highlight the potential impact on earnings from amortization of the acquired assets. It’s also a good way to avoid issues down the road, as a PPA valuation exercise can help highlight any disparity between assumptions and reality which might eventually derail the transaction.

So it can certainly be well advised to do a Purchase Price Allocation before the transaction. But once the transaction is complete, a PPA valuation goes from smart to essential for two main reasons: Reporting for investors and accounting and tax purposes.

Why do investors demand a Purchase Price Allocation?

The short answer is to understand the answer to the question “What did we just buy?”.

Investors are going to want a clear understanding of what you are doing with their money.  Simply saying “Hey, I’m Facebook and I bought Instagram for $1B, which we will leverage by doing XYZ” isn't enough (great move, by the way).  However, a savvy investor would expect to see that Facebook has been able to ascertain that the price that it paid to acquire current assets and liabilities, technology, customers, trademarks, etc. made sense.  And at the end of the day, an investor wants to know, after allocating the purchase price, how much goodwill was left over, something that they hope is not going to be subject to impairment down the road.

This is a very important concept as if the goodwill is buyer-specific synergy related, this synergistic value has the highest risk of being realized. The greater the relative goodwill booked in any acquisition, the higher the probability that such value won’t be realized. Investors want to have an understanding of this risk when management is using cash that it could otherwise invest in another opportunity or distribute to its shareholders (whereby they can then re-allocate their capital).

Why do accounting and taxes require a Purchase Price Allocation?

While the financial accounting for an acquisition requires a PPA, you may also require a purchase price allocation for tax purposes. Specifically, IRS form 8594 requires completion and signatures by both buyer and seller as to the allocation of the purchase price among various classes of assets.  The PPA may often be used for both financial and tax reporting, and in the latter case, essential for both sides.

Keeping with our Facebook example, if it had purchased a technology asset that will yield benefits for a period of five more years before it becomes obsolete, the cost of that technology asset needs to be amortized over a five year period. This means that in the $1B acquisition of Instagram, if the proper allocation to the value of its technology was $200M, Facebook can’t expense $200M in year 1. It needs to amortize the value of the technology asset over a five year period. Alternatively, in a "build versus buy scenario" had Facebook needed to make significant investments in the development of the technology (instead of buying the technology), it would have had a hit to cash flow during the time cash was scarce. By way of the acquisition, it will now spread the impact of the purchase over time (There’s a big difference between having a $200M expense in year 1, or an annual $40M expense in years 1 - 5).

From an accounting perspective, this kind of impact is important, especially for a private company that may have designs on going public some day. Understanding the potential impact on earnings per share as those assets get amortized requires gathering the data immediately after the transaction, while it’s still available.

Can we do the Purchase Price Allocation ourselves? We know best what we’re buying.

It’s absolutely true that management will have the best gut feeling as to why it wants to pursue a transaction, which is why we work very closely with the development team to understand the nuances and outlook for the transaction. However, PPAs need to be recorded and performed in accordance with the guidelines of Accounting Standard Codification (“ASC”) 805 - Business Combinations, which governs the accounting for all transactions in which the acquirer obtains control of another business. Given the complexity of such analyses, and the time required to prepare them, most management teams will work with an outside valuation consultant to prepare a PPA.

When do I need to start and complete a Purchase Price Allocation?

While we sometimes advise doing a PPA valuation even before the close of the transaction for reasons detailed above, you should not wait long after the close of the transaction to begin the process. There is a limited window of access to management of the acquired business and prospective financial information, which can be essential. You’ll also want to leave plenty of time to complete the PPA before the buyer’s quarterly (or annual) financial statements are issued.


PROCESS

Who will we need to get involved in this process?

Seller’s management (to get an understanding of what drives the business)

Buyer’s management (to discuss what the buyer thinks it is acquiring)

Buyer’s external accountants and/or tax advisors (often, but not always)

Other relevant parties (as required)

How long is the Purchase Price Allocation good for? Can I just get one report and be done with this?

Once the PPA is finalized, there is generally a need for annual impairment testing of goodwill. This is a function of the status of the company. Please reach out and we can better guide you.

How long does it take and how much does it cost?

Every deal is different. Some are far more complex than others. Some acquired business have much better documentation/financial controls in place than others. Additionally, some executives are much more willing to provide input in order to complete such an exercise. Depending on where an acquired business falls on this spectrum, it could take anywhere from 1-4 weeks to to complete such an exercise (initial on-boarding/due-diligence through final report). The cost of a purchase price allocation will typically scale with this timeline and complexity of a deal.

Generally, a fee structure which provides for a given number of intangible assets to be valued is quoted. This would also include a reasonable number of hours for Q&A with a client's management team and external auditors. Anything that arises that is not included in the original quote is typically assessed at an hourly services rate. Happy to chat in more detail if you like. You can pick a time that works for you using the link here.

What steps do you take in performing a Purchase Price Allocation?

The acquisition of a business requires an allocation of the purchase price for tax and/or financial reporting purposes. This means that the process consists of three main steps:

Calculating the purchase price (total consideration paid)

Identifying the correct assets acquired and liabilities assumed

Calculating the Fair Value of those assets and liabilities

Once those three steps are done, the purchase price paid for the business is then allocated among the fair values of the identifiable assets (and liabilities).  The amount of the purchase price and the values of the identifiable assets is then recorded on the financial statements as goodwill.  If the transaction is also being reported for use by the buyer and seller for tax reporting, then IRS form 8594 is completed by both parties.  As noted above, IRS form 8594 allocates the purchase price among various tax classes of assets and for the most part, follows the work done for financial reporting on the acquisition.  We can also assist in helping to fill out this form.

How do you figure out the purchase price? What steps are taken to identify the total consideration paid?

Total consideration is equal to the cash paid for the business, plus liabilities assumed. (In other words, if you pay $5M for the stock of a business, and in doing so assume $1M of liabilities, your total consideration paid for the assets is $6M.)

If consideration paid includes anything other than cash -- such as stock, debt, or cryptocurrency -- it may be necessary to value the currency used.

Similarly, when determining the value of the liabilities assumed, it may be necessary to value the real and contingent liabilities on the seller’s balance sheet.

Finally, if there is contingent consideration involved, such as in an earn-out, analysis must be taken to calculate the value of such contingent consideration and include it in determining the total consideration paid.

What steps are taken to identify the assets acquired?

Interviews with management (both buyer and seller) are a crucial first step to understand the value drivers of the target business and which assets are important to its success (whether the market participant is a financial or strategic buyer may weigh on the relative significance of these assets.) The types of assets which will require valuation in any PPA are frequently similar and include customer relationships, business relationships, software & technology, and trade names/trademarks. A list of probable relevant asset types is presented to management to discuss and identify which ones are applicable and the most feasible methods for valuation.


METHODOLOGY

What valuation methodologies are selected?

The short answer is, it depends.

Generally, assets that may be linked to a prospective income stream are valued by a form of the Income Approach to evaluate their likely effect on income. Contributory assets, which may not have a direct income stream attributable to them, are more typically valued by a cost or market approach. A more detailed discussion of generally accepted methods are below.

What is a Replacement Cost New method?

The premise of the Cost Approach holds that a prudent investor would pay no more for an asset than the amount for which the asset could be replaced. Replacement Cost New, which refers to the cost to replace the property with like utility using current material and labor rates, establishes the highest amount a prudent investor would pay. To the extent that the subject asset will provide less utility than a new one, the value of the subject asset is less. Accordingly, replacement cost new is adjusted for loss in value due to physical deterioration, functional obsolescence, and economic obsolescence.

What is a Relief from Royalty Method?

In estimating the Fair Value of certain intangible assets, a variation of the Income Approach called the Relief from Royalty Method may be applied. In the Relief from Royalty Method, the Fair Value of the intangible asset is estimated to be the present value of the royalties saved because the company owns the intangible asset. In other words, the owner of the intangible asset realizes a benefit from owning the intangible asset rather than paying a rent or royalty for the use of the intangible asset.

What is an Excess Earnings Method?

The Excess Earnings Method, another variation of the Income Approach, is useful in valuing assets for which measuring direct economic benefit is difficult. This method measures the value of an intangible asset by calculating the residual profit after subtracting the appropriate returns for all other complementary assets that benefit the business. Additionally, other adjustments may be warranted to reflect specific characteristics of the subject asset. Essentially, this is valuation by process of elimination, but consequently the accuracy of results using this method relies on the reasonableness of the underlying cash flow projections.

What is a tax step-up?

For any intangible asset valued, the future tax savings from the amortization of the intangible asset, over a 15-year period, is calculated.  The present value of the amortization benefit is added to the value of the intangible asset to derive its total allocable basis.

What is a WARA analysis?

The Weighted Average Return on Assets analysis is designed to demonstrate that when the required rate of return on each acquired asset is multiplied by the indicated value of the respective asset, the overall return on all assets acquired is equal to the required return on the enterprise. In effect, this shows that the risk/return of some assets (e.g. software & technology) should be significantly higher than others (e.g. fixed-tangible goods).

What is a contributory asset charge?

In valuing an individual intangible asset by the income approach, it is necessary to recognize that other assets may be employed in generating the cash flows.  For example in the valuation of a customer relationship, contributory asset charges are needed to account for use of the net working capital, fixed assets, and various other intangible assets such as a trade name and assembled workforce. Contributory asset charges are determined by calculating the after-tax cost to “rent” these assets and subtracting this expense from the projected cash flows.

What assets are required to be bifurcated?

All assets apart from goodwill need to be identified and separately allocated a purchase price.  There are technically exceptions to this for private companies (e.g. the need to value customer relationships is excluded), but given that a future requirement to identify all acquired assets may arise (if the company is planning an IPO, for example), it is recommended that all identifiable assets be valued as part of this process.


SPECIAL CIRCUMSTANCES

What is an Asset Deal?

An asset deal means you’re basically just buying the left-hand side of the balance sheet. As we discussed above, a business consists of assets and liabilities, and normally when you acquire a business you acquire all of that, both assets and liabilities. In an asset deal, you’re only acquiring the assets, and it is still the seller’s responsibility to discharge all liabilities to creditors and banks and so forth.  The acquisition of assets is often also associated with a transaction in which the buyer and seller will need to complete IRS form 8594.

What is an Stock Deal?

In a stock deal, you’re exchanging some form of security (cash and/or equity) for equity. Note this this is not the same as an asset deal, because you are still generally responsible for the assumption of liabilities, which means that they should be added to your cost (as a liability) when calculating total consideration paid.  Additionally, stock deals usually do not result in a step-up in basis in the assets for tax purposes.  Accordingly, IRS Form 8594 is likely not needed here.

Should I be worried about a relatively high Goodwill?

When Company A acquires Company B (and Company B’s assets), it will then become part of a “segment” (as it’s called in the SEC filings) or a “reporting unit” (as it's referred to in the accounting literature).  You are required to test it at least annually for “impairment of long-lived assets” -- and that includes goodwill. You’re basically trying to see if the assets that you acquired can continue to be carried on the books at their reported amount, or whether they have become impaired and lost their value.

One strategic option, if it applies, is to take the assets that are being acquired (including goodwill) and combine them with the operations of a reporting unit that was not acquired, but was grown from the ground up. The result is that your new combined holding should not only have a lower overall cost basis (since some of it you didn’t pay to acquire), but also a high value proposition (since some of it may have been acquired specifically for the synergies expected). This gives you some wiggle room with regard to potential for goodwill impairment (in case of a downturn in the financial performance of the acquired entity), since the overall holding still may not be impaired.

How do Non-Competes work in a Purchase Price Allocation?

Non-Competes are payments for protection to the buyer from activities of the seller which may detract from the value of the acquired business.

Technically speaking, if no separate consideration is called out in the purchase agreement, analysis is still required to determine if there is value embedded in the non-competition agreement as it must be carved out of the purchase price. Documentation is required for the process by which the value of the non-compete is determined.

Practically speaking, non-competes often have negligible value. Usually there are significant financial disincentives to the seller should competition occur, rendering the non-compete largely economically symbolic, but still legally important.

However, if it’s determined that a non-compete does have value, it’s important to note that this can be viewed as ordinary income to the seller(s) by the IRS. In effect, the buyer had paid an additional amount above and beyond the value of the business for the seller(s) to not compete.

What is a remaining useful life and why do I need to know it?

Most acquired assets, except goodwill, are usually finite lived. In some cases, the life may be limited by physical wear and tear, in others, by obsolescence either functional or economic.  It is important to determine the remaining useful life in order to calculate the period of time over which the asset will be depreciated or amortized on the buyer’s financial statements. Note, the life of the asset here is the remaining useful life at the time of purchase, assuming no additional upkeep on the asset. In practice, the buyer would likely invest in the maintenance of such assets, however such expenses are generally not capitalized and amortized, but rather expensed as incurred.

About Preferred Return

At Preferred Return we’ve provided 4,000 audit-defensible valuations to over 2,500 clients since 2011. Our team works with companies of all kinds, taking a tailored approach to ensure every detail through every chapter of growth. If there’s something that we can help you with, let’s talk.

Pondering an acquisition? We can help allocate the purchase price.

What is a Purchase Price Allocation?