M&A Viewpoint: The Value, Price and Cost of Acquisitions

(Part 2 of 3)

In the last issue we examined the importance of preparing a fair market valuation of an acquisition candidate.  The valuation provides a reference point for establishing and negotiating the purchase price and terms. 

In this issue we will examine the relationship between market value and purchase price, and explore the considerations that should go into pricing decisions.  We will also cover acquisition terms and structuring because they are inseparable from price negotiations.  This article will not deal with the tax aspects of transaction structure. 

In the first part of this series we cited the classic definition of fair market value, (FMV) which is:

“The price, in terms of cash or equivalent, that a buyer could reasonably be expected to pay, and a seller could reasonably be expected to accept, if the business were exposed for sale on the open market for a reasonable period of time, with both buyer and seller being in possession of the pertinent facts and neither being under any compulsion to act.” 

However, when it comes to the real world of negotiating purchase price and terms, there are a number of problems with the classic definition of FMV.  For one thing, the definition of FMV applies to the value of the company’s equity.  In many cases, the sale is structured as an asset sale.  In an asset sale, you need to adjust the FMV by adding back the liabilities.  Other differences include:

• Not all sales are made at cash or cash equivalent terms.  The consideration can include shares of the buyer’s stock or stock in a new company.  The value of those shares can be difficult to peg and may increase or decrease in value over relatively short intervals.  In addition, the sale of the stock may be restricted for a time.
• A privately negotiated acquisition might not be exposed for sale on the open market.  The transaction may be the result of discussions initiated by the buyer or its representative.
• An acquisition opportunity may be on the market so long it has become shopworn.  The longer the business remains on the market, the universe of prospective buyers becomes smaller, the pressure on the seller’s I-Banker to reduce asking price to generate interest increase and the seller’s expectations may decrease.
• The parties to the transaction may not be in possession of all of the pertinent facts or may exercise poor cognitive processes or judgment in their interpretation and application of the so-called “pertinent facts.”  In addition, emotions can come into play encouraging a buyer to make an offer that can’t be refused.
• It’s possible that either seller or buyer may be “under a compulsion to act.”  There are a host of reasons why a seller might want to sell.  Some are business related and others of a personal nature.  While they might not qualify as a “compulsion to act,” they can become obsessions and encourage a fast sale.  On the other hand, a buyer may have its own compulsions to act such as the need to invest a given amount of money by a certain date or commitment to meet certain business objectives.

There are a variety of factors that are going to influence the actual negotiated outcome.  These factors encourage a discount from or premium over the market valuation.

A Definition of Price
Before we venture any further, we need a working definition of price.  There are different definitions for tax and financial reporting purposes, but for purposes of this article, we use an economic definition of price:  

Price is the total amount of consideration paid in all forms in order to acquire the company or substantially all of its assets.

The Purchase Price Package
The purchase price package consists of the following four elements:

1. Purchase price.
2. Form of payment.
3. Structure of the purchase.
4. Allocation of the purchase price.

These elements work together to determine accounting and tax treatment of the transaction for both the buyer and seller.  As a buyer, you want to negotiate a purchase price package that is going to be acceptable to the seller and optimizes your Net After Tax Operating Income in excess of the cost of capital.  In other words, you want to create economic or shareholder value.

Purchase Price:  The purchase price, as previously defined, is the actual amount of consideration, in all of its forms, paid by buyer to seller to effectuate a change in ownership. 

Form of Payment:  The forms of payment include: 

• Cash paid at closing.
• Debt and other notes payable to the seller or its assignee.
• Assumption or payment of liabilities (in the case of an asset purchase).
• Stock in the buyer’s company or a new company formed to hold the acquired business.
• Convertible securities.
• Future payments on agreements.

The terms of payment in the future include:

• Interest or coupon rates.
• Number of payments and interval.
• Balloon payment.
• The form of principle repayment: amortization or direct reduction.
• Interest and principal deferral periods.
• Collateral and security.
• Provisions regarding the negotiability or transferability of payments or principal balance.
• Restrictive and affirmative covenants contained in any loan agreements.

Structure:  There are three basic structures for the purchase: 

1. An asset purchase.
2. A stock purchase.
3. A statutory merger or reorganization.

Allocation:  The purchase price has to be allocated among the different assets that are purchased.  Because the allocation of the purchase price establishes the tax treatment of the proceeds to the seller and deductions for the buyer, it is a very important part of the negotiations.  The purchase price can be allocated to:

• Stock or tangible assets.
• Customer lists.
• Covenant-not-to-compete agreements.
• Consulting agreements.
• Patents.
• Royalty agreements.
• Other identifiable intangible assets.
• Goodwill.

In addition to the negotiated purchase price package, there is the seller’s asking price, the buyer’s initial proposed price and any additional exchange of offers and counter-offers.  Each of the different prices is a stepping-stone in the process of arriving at the final negotiated price. 

General Goals of Sellers and Buyers
Each party in the negotiation is going to seek the best overall bargain given their degree of motivation, financial objectives and relative negotiating strength.

The seller is going to want to walk away from the table with the highest price s/he believes is obtainable, plus as much cash as possible, the least tax burden and no additional risk.  The seller would like to pay one level of tax, preferably at the capital gains rates. The seller wants to sell stock because it avoids any potential issues with double taxation and allows him or her to walk away from the deal with no exposure for the acts of the past (except as may be defined by the purchase agreement).  If the acquisition is structured as an asset purchase, the seller will want an allocation that avoids or minimizes the recapture of depreciation.

On the other hand, as a buyer, you want the best price, maximum deduction of the purchase price, favorable purchase terms and for the seller to have a vested interest in the future in the form of a deferred or contingent payment.   Generally, a buyer will want to purchase assets because it more specifically defines what is and what is not being purchased.  In a stock acquisition, you get everything including contingent or unforeseen liabilities.

The objective of the discipline of arriving at purchase price package is to obtain a net return on capital in excess of the return on similar business investments whether it is another acquisition or investment in your company.

Bringing It All Together
In the first part of this three-part series we stressed the importance of preparing a fair market valuation of the acquisition candidate as a foundation for arriving at a negotiated price with the seller.  The FMV should be compared to the seller’s asking price (if there is one) or the seller’s aspirations in order to arrive at the spread between the two numbers.  If the spread is significant, it’s helpful to ask the sellers how they arrived at their asking price.  This will provide additional insight into the sanity of the seller and how they are considering the value of their company. 

It’s advisable to establish a target price which is the amount you would like to pay and your walk-away price, and the amount that you are going to present in your initial offer.

If the seller does not have an asking price, then the best you can do is to have a candid conversation to probe the seller’s price aspirations and needs.  There is an old salesman’s adage: “He who states the first number loses.” 

When it comes time to present the purchase price package proposal, there are two schools of thought.  First, you can start with what appears as a generous offer so that you can tie-up the seller and move the deal along to due-diligence.  Then as negative factors emerge as a result of your due-diligence investigation, you can take these negatives back to the seller and use them to justify a reduction in the price.  You are essentially using diligence to provide the ammunition to re-trade the deal.  This approach can generate emotional repercussions and is not recommended when the seller’s continued involvement is part of the deal.

The second option is to do as much investigation and evaluation as possible prior to submitting an offer and then proceed with diligence.  Obviously, if due-diligence surfaces a finding that adversely impacts the price, then it may be necessary to discuss the issue further with the seller to obtain an appropriate adjustment.  This second approach is more likely to create a problem-solving atmosphere.

Closing Thoughts
The purchase price package is a critical factor for making a successful acquisition.  Overpayment and agreeing to terms that do not make economic sense are two of the most common reasons acquisitions fail to deliver the anticipated benefits.  In the final installment of this three-part series, we will look at the various aspects that go into the cost of an acquisition.

By Robert B. Machiz
CEO MoneySoft, Inc.
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