M&A Insights May 2012 Frequently asked questions: What strategic buyers want to know You re a strategic buyer, but at most, you do a deal every couple of years. You ve spent a little time with the new business combination rules 1, but not a lot and as you think about the possible value proposition of your current deal, you might be asking yourself What am I missing? Some, for example, might have a strong grasp on the cash aspects of the deal, but perhaps not on all of the earnings implications; while others might have a strong conceptual understanding of both cash and earnings, but are still looking for a few golden nuggets to address critical issues created by the complex deal structure. Either way, you ve come to the right place. Here, we ll address some of the questions most frequently asked by your peers as they try to structure and account for the elusive perfect deal, and highlight a few pitfalls along the way. #1 What s this about fair valuing contingent consideration and having an on-going drag on earnings? Isn t there a way to avoid earnings volatility? Yes, but it isn t easy. First, let s review the basics around the accounting for contingent consideration arrangements 2. Such arrangements initially need to be fair valued and included as part of the purchase price in every transaction no exceptions. From there, however, the arrangements will be classified in one of two ways an equity arrangement or a liability arrangement. Liability arrangements are the easier of the two to understand. Any arrangement that provides for a cash payment to the seller at the end of the contingency period will most likely be a liability arrangement. What are the implications of a liability arrangement, you ask? Well In addition to being measured at fair value at inception, all liability contingent consideration arrangements must be fair valued at each and every reporting date, with the corresponding gains/losses (the change in the liability during the period) being reflected as a component of post-acquisition operating income. If the consideration arrangement has a compensatory element as discussed in footnote 2 (e.g., is contingent upon the continued employment of the former target shareholders), there will likely be a negative impact to the effective tax rate. This occurs because the compensatory element is treated as consideration for the target shares for tax purposes, which is nondeductible, rather than additional compensation expense. Modeling Tip While a bit counter-intuitive, as the acquired business performs better than expected and the expected payout increases, the fair value of the corresponding liability also increases, decreasing overall earnings in the process. Similarly, an underperforming target might result in an earnings bump through a reduction in the fair value of the liability. In contrast to most earnings bumps which are seen as beneficial, this one only serves to highlight the underperformance of the acquired business. If, however, the arrangement qualifies for equity treatment, then no future mark to market accounting is required. The arrangement is fair valued at inception and never touched. Good news for future earnings projections and, hence, the deal s value proposition, right? So how do you get to equity treatment? Well, for starters, the contingent consideration arrangement has to be settled with an equity security. And it can t be an equity security in name only, but rather, has to be an equity security in substance as well (e.g., entitles the holder to a residual interest in the company, rights in liquidation, etc.). Structuring Tip A contingent value right (CVR) that trades in the marketplace like a security does not automatically qualify for equity treatment if it is simply a mechanism to facilitate a cash settlement at payoff (i.e., upon satisfaction of the contingency period/hurdles). 1 ASC 805, formerly SFAS 141R, Business Combinations. 2 Arrangements involving consideration that is provided to the former owners of Target must first be assessed to determine if a compensation element is present in circumstances where those owners are also employees of Target and/or the on-going combined entity. Only those not involving a compensation element would follow the prescribed contingent consideration accounting model in ASC 805.
Simply settling in equity shares, however, is not enough to guarantee equity treatment. Next, the number of shares to be issued has to be fixed. What does this mean exactly? Well there are two things to consider in this regard. First, you cannot settle a fixed dollar amount with a variable number of shares (i.e., Buyer agrees to pay $1 million settled in shares based on the then current price of Buyer shares). More specifically, when considering the settlement provisions of a contingent consideration arrangement, the number of shares to be delivered can only be adjusted by inputs to the fair value of a fixed-for-fixed forward or option on equity shares (i.e., inputs used in a Black-Scholes or other similar valuation model). For example, adjustments to the number of shares based on an entity s stock price 3, term of the instrument, expected dividends or other standard anti-dilution provisions would not jeopardize this assessment. If, however, the number of shares to be delivered is indexed to a financial statement measure (e.g., revenues, EBITDA, etc.), this feature affects the settlement amount of the contingent consideration in a manner not compliant with the fixedfor-fixed notion (i.e., because the measure is not an input into the fair value of a standard fixed for fixed forward or option on equity shares). Therefore, only an on/off contingent consideration trigger meaning there is a set number of shares and seller will receive all or none would have the possibility of achieving equity treatment. #2 The Target has some equity-based compensation plans and I really don t want to inherit an ongoing drag on earnings attributable to them. Am I stuck with those? Unless the Target has an automatic acceleration or cash settlement clause in their equity-based compensation plans, some amount of stock-based compensation charge will likely be recorded by the Buyer in the post-acquisition period. Previously, under the old rules 4, a Buyer could accelerate the awards previously given to Target s employees and record the replacement awards or cash settlement as part of the purchase price and/or as an assumed liability in purchase accounting. Under the current rules, however, generally only automatic accelerations or cash settlements can be treated in that fashion. A discretionary acceleration on the part of the Buyer will result in the Buyer recording a charge for the portion of the fair value of the award that was accelerated. Further, even if the Target undertakes the acceleration prior to the close, if the decision to do so was made in collaboration with the Buyer, the Buyer would still account for the additional compensation in its post-acquisition earnings. In fact, any new compensation award, acceleration of an old award, or new severance-type payout entered into by the Target after talks with the Buyer have commenced needs to be evaluated to determine whether it was done for the benefit of the Buyer or the Seller. If deemed to be for the benefit for the Buyer, and assuming such amount fully vests with the acquisition, such amount would be reflected as an immediate charge to the post-acquisition earnings of the combined entity. In certain acquisitions, a special tax election may be available under section 338(h)(10) to treat the stock purchase as a deemed acquisition of the underlying assets. If made, the deferred revenue balance not previously included in taxable income may be accelerated. #3 I know the Target has some revenue deferred on its books. Is there anything unusual that I need to think about with respect to those amounts in projecting or modeling future book earnings? Unfortunately, yes. Often, revenue gets deferred under current revenue recognition rules for reasons unrelated to the performance of future services. For example, collectability of the transaction fee might be uncertain, the contractual payments might be due over an extended period of time raising questions about whether the fee is fixed or determinable, or upfront non-refundable payments might be deemed to be part of an ongoing earnings process. The common thread in each of these situations, however, is that the rules result in a deferral of revenue that is likely to be in excess of the fair value of the remaining services (if any) under the contract or arrangement. In these situations, the acquisition method of accounting requires that the Buyer fair value the remaining legal obligations (i.e., services) under the contract and limit its establishment of a deferred revenue balance (i.e., liability) to that amount. This can result in a haircut to the Target s historical deferred revenue balance at closing which is often substantial and may lead to an abnormal and temporary blip or black hole in the Target s revenue trend and forecasted post-deal book earnings. Implementation Tip The adoption of ASU 2009-13 5, which modified ASC 605 and allows companies to use estimated selling prices 6 to allocate consideration to deliverables in non-software related revenue transactions, will likely lessen the amount of the haircut buyers will take as undelivered elements for which no VSOE or TPE 7 of fair value exists will no longer result in full deferral of arrangement revenues. 3 Except in those situations where the share variation is intended to produce a fixed settlement monetary amount known at inception. 4 Statement 141, Business Combinations. 5 Formerly EITF Issued 08-1. 6 Companies engaged in licensing, selling, leasing, or otherwise marketing computer software are still required to have vendor specific objective evidence of fair value (VSOE) to allocate consideration. 7 Third party evidence 2
#4 Are there other fair value adjustments that can have a substantial impact on the post-acquisition earnings of the combined entity? Yes. In fact, since fair value is the norm (not the exception) in the acquisition method of accounting, a number of Target s historical balances may be adjusted and impact future earnings. The biggest new expense, however, is likely the need to record a host of intangible assets, some of which may never have been historically recorded by the Target because they were internally developed. Items such as customer relationships, customer lists, contracts, trade names, backlog and trademarks may all result in the recording of sizable intangible assets that may require amortization over a finite, and for certain items potentially short, period of time, negatively impacting earnings. Modeling Tip The requirement to initially capitalize IPR&D and either expense it as part of the overall asset cost once it is placed in service and/or when it becomes impaired can also catch some off guard in terms of forecasting future earnings. Implementation Tip Because of the requirement to retrospectively adjust 8 prior periods for changes in the fair value of assets and liabilities acquired that are identified within the 1-year window 9, companies may consider closing deals at or around the beginning of a quarter to allow sufficient time for the comprehensive identification of tangible and intangible assets and liabilities and necessary valuation procedures to be performed and to minimize the possibility of needing to go back and recast prior periods. That said, while it is true that ASC 805 requires fair value accounting for almost everything, contingencies is an area where some exceptions do exist. First, you have to isolate the nature of the contingency. For example, an ASC 740 (formerly FIN 48) tax contingency would be dealt with differently from a non-tax contingency. Tax contingencies, for example, are not booked at fair value but rather recorded at the same amount as would be required under ASC 740 (i.e. the Target s amount may carryover, assuming the Target s historical books and records were fairly stated). If the amount is not a tax contingency, but rather a more standard contingency like a warranty or litigation item, the resulting accounting follows a two-step process. If the amount of the contingency can be fair valued, then the fair value must be recorded in connection with the acquisition method of accounting. The example often provided is a warranty reserve, which many believe can be fair valued by a valuation expert because of the large volume of transactions, availability of a number of years of data, and a company s past track record 10. If the amount cannot be fair valued, then the acquirer must record the equivalent of a ASC 450 (formerly SFAS 5) amount the amount that is probable and estimable or disclose the exposure if no amount is probable and estimable, but some amount of loss is at least reasonably possible. The fair valuing of certain types of contingencies may hold hidden surprises for the Buyer, depending on the valuation techniques utilized. For example, assume that a discounted cash flows approach is utilized to fair value a future liability. Even if the projected cash flows come in exactly as forecasted, the ultimate payout will be much higher and result in additional charges due simply to the discounting that occurs in the model. While ASC 805 is silent as to how to specifically deal with the discounting component, any accretion will find its way into the post-acquisition earnings of the combined entity. Modeling Tip While the accretion appears on the surface to be an interest item that might be excluded when disclosing or reporting EBITDA, practice has evolved to include this amount as a component of operating income, rather than as interest expense. 8 Retrospective adjustment of past periods typically requires adjusting the comparative financial information presented in subsequent filings, but could also result in a public company having to actually re-file prior financial statements in the event it files a new (or currently has an open effective) registration statement. 9 ASC 805 provides a Buyer with a measurement period (not to exceed 1-year) to obtain the information needed to identify and measure the consideration transferred, the assets acquired, the liabilities assumed, and any ncontrolling interests. Remember, however, that the 1-year measurement period is only intended to allow time to obtain information that existed at the time of the business combination, and not intended to sweep in subsequent developments. 10 Note that every situation is different and that a start-up company s warranty reserve may not have these characteristics and hence not be able to be fair valued. 3
The characterization of such an arrangement for tax purposes can be complex; for example, such a structure could be treated as a present or constructive sale of the shares by the target shareholders. As a result, it s wise to seek tax advice with respect to such structuring issues early in the transaction process. #5 The Target s shareholders want to hold onto some shares for a couple of years and then have some sort of a put/call structure around the shares several years from now. Anything in particular I need to be worried about there? These types of situations can be very complicated. The first question is whether you want to have the option to buy the shares, or the requirement to buy the shares. If, for example, you obtain control of the Target and simultaneously include a forward to buy the remaining shares, then there will be no NCI 11 recorded in connection with the original acquisition method accounting. Rather, the amount to be paid to purchase the NCI under the forward will be treated as a financing liability, and the Buyer would reflect an interest charge during the time that the forward was outstanding. If the repurchase is optional, and is structured in the form of a put/call arrangement, buyers still need to assess whether the combination of the put and the call equate to a synthetic forward, in which case the transaction would still be accounted for in a fashion similar to a financing. Situations where the put and call are exercisable on the same date at the same price typically meet this criterion. Structuring Tip A fixed price is just that a stated amount. A fixed formula is not a fixed price, as the formula (by definition) makes the price variable. Assuming that the combination of the put and call does not meet the definition of a forward, however, the instruments are evaluated separately in order to determine the Day One and future accounting 12. The issuance of a put to the Target s shareholders immediately results in mezzanine equity on the part of a public company Buyer because the shares subject to the put now represent redeemable non-controlling interest. This requires that the entire NCI balance 13 be marked to its redemption value either immediately, or, at the option of the Buyer, over the period through when the redemption becomes operational if the item is not currently redeemable. Additionally, to the extent that the mark exceeds the carrying value of the NCI as computed in accordance with ASC 860, that additional mark may be treated as a reduction of earnings available to the common stockholders for EPS purposes 14. The accounting for the call option is less transparent. Assuming that it is an embedded feature of the underlying shares, the value ascribed to the call in the original acquisition method accounting would be included in the value of the NCI recorded (i.e., it would reduce the fair value otherwise ascribed to the NCI as part of the acquisition method accounting). As the instrument does not represent a separate derivative, no mark is required. Final Thoughts The consummation of a strategic acquisition is never easy, whether you ve done it once, or a number of times. In fact, at times the complex reporting requirements of the business combination rules can make the process seem overwhelming. Getting advisers involved early, having a view as to what others are doing in the marketplace, and successfully navigating a few of the more complicated areas we ve discussed, however, can be extremely helpful in ensuring your deal meets expectations rather than falling short of its mark. 11 Non-controlling interest, formerly minority interest. 12 Since the put/call are typically on private company shares, we have assumed for purposes of this discussion that the features are embedded in the underlying shares, rather than freestanding instruments. An evaluation of whether the instruments are freestanding or embedded, however, needs to be done on a facts and circumstances basis. 13 The NCI balance would initially be recorded at fair value in accordance with ASC 805. 14 Registrants can elect to limit the amount of the dividend reflected in EPS to the amount that actually exceeds the fair value of the underlying share. This limitation is a policy choice that would need to be made by the registrant. 4
Contacts For more information, please contact: Leader Eva Seijido +1 212 436 3322 eseijido@deloitte.com Central Michael Slattery +1 312 486 3125 mslattery@deloitte.com Northeast Russell Thomson +1 212 436 4671 rthomson@deloitte.com Southeast Steve Joiner +1 404 220 1439 sjoiner@deloitte.com Mid-America Cliff Braly +1 214 840 7165 cbraly@deloitte.com West Bryan Boghosian +1 213 688 5435 bboghosian@deloitte.com Author Accounting Consultation Matthew Himmelman +1 714 436 7277 mhimmelman@deloitte.com About Deloitte Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network of member firms, each of which is a legally separate and independent entity. Please see www.deloitte.com/about for a detailed description of the legal structure of Deloitte Touche Tohmatsu Limited and its member firms. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clients under the rules and regulations of public accounting. Copyright 2012 Deloitte Development LLC. All rights reserved. Member of Deloitte Touche Tohmatsu Limited