webinar slides: private company business combination and valuation overview
TRANSCRIPT
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CBIZ & MHM Executive Education Series™
Private Company Business Combination and Valuation Overview Mark Winiarski, Carl Schulze August 11, 2016
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About Us
• Together, CBIZ & MHM are a Top Ten accounting provider • Offices in most major markets • Tax, audit and attest* and advisory services • Over 2,900 professionals nationwide
A member of Kreston International A global network of independent accounting firms
*MHM is an independent CPA firm providing audit, review and attest services, and works closely with CBIZ, a business consulting, tax and financial services provider.
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Before We Get Started…
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CPE Credit
This webinar is eligible for CPE credit. To receive credit, you will need to answer periodic participation markers throughout the webinar. External participants will receive their CPE certificate via email immediately following the webinar.
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Disclaimer
The information in this Executive Education Series course is a brief summary and may not include all
the details relevant to your situation.
Please contact your service provider to further discuss the impact on your business.
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Presenters
Located in our Kansas City office, Mark is a member of our Professional
Standards Group (PSG). Mark's role includes instructing in our national
training program, presenting as a subject matter expert at webinars and
conferences, and preparing MHM publications on accounting and
auditing issues.
As a PSG member, Mark consults with clients and engagement teams
across the country in many areas of accounting and auditing. Mark has
served clients as an auditor, consultant and advisor in numerous
industries including manufacturing, distribution, mining, retail sales,
services and software.
816.945.5614 • [email protected] • @KCWini
MARK WINIARSKI, CPA MHM Shareholder
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Presenters
Mr. Schulze has over 20 years extensive financial advisory experience. He
specializes in the appraisal of businesses, intangible assets and
intellectual property. During his career, he has performed valuation
engagements for purchase price allocation and other financial reporting
requirements, mergers & acquisitions, financing, gift and estate tax
planning, litigation support, insurance, and other special projects.
Prior to joining CBIZ, Mr. Schulze served in the Valuation Services
Practice at Deloitte FAS, LLP and in the Audit Practice at Ernst & Young.
He holds a Bachelor of Business Administration in Accounting from The
University of Texas at Austin and a Master of Business Administration in
Finance from the Wharton School, University of Pennsylvania. Mr.
Schulze is a Certified Public accountant (CPA) in the State of Texas, a
Chartered Financial Analyst (CFA), and Accredited in Business Valuation
(ABV).
972.406.6901 • [email protected]
CARL SCHULZE, CPA, CFA, ABV Senior Manager
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Agenda
Choosing a Discount Rate
Common Intangible Assets
Accounting Issues
Common Tangible Assets
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Overview
• Business Combination (“Acquisition”) occurs when an entity obtains control of a business
• FASB Accounting Standards Codification No. 805 Requires that as of when a control is obtained, the identifiable tangible and intangible assets and liabilities should be recorded at fair value – the “acquisition method”
• Goodwill is the only asset that can be valued using a residual method. A direct valuation method must be used for all other tangible and intangible assets.
The acquisition method includes assets that do not appear on the historical balance sheet
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ACCOUNTING ISSUES
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Private Company Accounting Alternative
• Elect to not recognize customer-related intangible assets and noncompetition agreements that are not capable of being sold or licensed separately from the other assets of the business. The value of any non-recognized assets will be subsumed into
goodwill This includes the vast majority of customer-related assets
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Recent Accounting Guidance
Measurement period • US GAAP required the acquirer to retrospectively adjust the provisional
amounts recognized at the acquisition date • to reflect that information with a corresponding adjustment to goodwill,
and • revise comparative information for prior periods presented.
• The amendments require that the acquirer recognize adjustments to provisional amounts that are identified • during the measurement period in the reporting period in which the
adjustment amount is determined, • as well as the effect on earnings, if any, as a result of the change to the
provisional amounts, calculated as if the accounting had been completed at the acquisition date.
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Purchase Price or Consideration – Example Calculation
Assume that Company A acquires Company B with the following fact set:
Stock Issued 50,000 $ Cash Paid 100,000 Contingent Earnout Payments 25,000 Total Consideration Transferred (accounting) 175,000 Plus: Assumed Debt + Capital Leases 35,000 Market Value of Invested Capital (MVIC) 210,000 Plus: Assumed Debt-Free/Operating Liabilities Accounts Payable 20,000 Accrued Expenses/Other 10,000 Total 30,000 Total Consideration/Total Assets 240,000 $
Key Points to Understand
2. MVIC = net working capital + all other assets; and 3. MVIC = market value of equity + interest bearing debt + financing liabilities 4. MVIC is used with management's forecast in a DCF model to solve for the internal rate of return (IRR) of the transaction
1. Consideration Transferred = Assets transferred + Liabilities incurred + Equity interests issued
• Also referred to as “purchase price” • Used for accounting disclosure
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CHOOSING A DISCOUNT RATE
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WACC and IRR
• Weighted Average Cost of Capital • Represents the discount rate for the subject company’s assets in aggregate • For controlling interests, assumptions are based on a market participant perspective • Calculated as the cost of equity and cost of debt, each weighted according to the assumed
market participant capital structure • Is the appropriate discount rate for debt-free, free cash flows (FCF) in a DCF model
• Internal Rate of Return • Represents the discount rate that equates the net present value of future cash flows projected
for the acquired business to the invested capital used to acquire it • The compounded rate of return projected to be earned on the investment in the subject
company • Invested capital will include interest bearing debt plus equity • IRR calculation normally takes the form of a DCF model
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IRR Calculation
• Normally takes the form of a DCF model • Cash flows should include only the synergies that a market participant would assume • Buyer specific synergies are excluded • Assumes a normalized level of net working capital (market participant perspective)
• Calculation of free cash flows • Free cash flow calculated as:
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Weighted Average Return on Assets
• WARA • The blended discount rate for the subject company’s tangible and
intangible assets, including goodwill
• Calculated based on the fair value of the company’s total assets
• Rates of return (discount rates) assigned to the individual assets include the following considerations: Blend of debt and equity used to finance the asset Relative risk of the asset
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Asset Rates of Return
The Appraisal Foundation provides the following discussion on rates of return for various asset classes:
The concept underlying stratification of rates of return is that the required rate of return on a contributory asset should be estimated from market derived data reflecting the relative risk of that asset. The intuitive notion is that the perceived relative riskiness of assets reflects their liquidity/ease of transferability, their ability to be financed by debt or equity, as well as the degree of certainty of realizing future cash flows from the asset…The risk profile of each asset category should be considered when estimating the appropriate rates of return. While there are exceptions, the Working Group believes that the risk profile of an entity’s assets generally increases as you move down the balance sheet and, accordingly, the type of financing available for the assets shifts from debt to equity as the risk profile increases.
Source: The Appraisal Foundation, Best Practices For Valuations In Financial Reporting: Intangible Asset Working Group – Contributory Assets, May 31, 2010, p28.
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Weighted Average Return on Assets - Example
Percent of After-tax Weighted Fair Value Total Capital ROR Return Comment on Return
Debt-free Working Capital 2,500 $ 1.0% 4.0% 0.0% Short term borrowing rate Property, Plant, and Equipment 65,000 $ 27.1% 9.0% 2.4% Combination of debt/equity funding Other Assets 3,500 $ 1.5% 9.0% 0.1% Combination of debt/equity funding
Developed Technology 80,000 $ 33.3% 17.0% 5.7% ROR at least as great as the WACC In-process R&D 20,000 $ 8.3% 19.0% 1.6% Considered more risky Customer Relationships 30,000 $ 12.5% 17.0% 2.1% ROR at least as great as the WACC Non-compete Agreements 10,000 $ 4.2% 17.0% 0.7% ROR at least as great as the WACC Assembled Workforce 5,000 $ 2.1% 15.0% 0.3% Often see at WACC Goodwill 24,000 $ 10.0% 20.0% 2.0% Higher than identifiable intangible rates
MVIC 240,000 $ 100.0% 15.0%
Questions:
1. How do you know that the above total is MVIC and not total assets? 2. What should the WARA calculation reconcile to? 3. Do the working capital and PP&E amounts represent what happens to be on hand, or normalized levels?
Return Reconciliation
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WACC, IRR and WARA
• According to the Appraisal Foundation Monograph:
The WACC, WARA, and IRR (fully adjusted) all should be calculated and, when applicable, compared and contrasted when using the multi period excess earnings method (MPEEM) as discussed previously. The Working Group believes that the starting point for an analysis would be the derived market-based WACC for the acquired (or subject) entity. As stated above, this WACC is based on market participant assumptions specific to the entity’s cash flows. One diagnostic test would be to compare the WACC to the IRR and reconcile any differences. Another diagnostic test would be to compare the WACC/IRR to the WARA to assess the reasonableness of the stratification of rates of return.
• In other words, estimated discount rates and other inputs and assumptions in the valuation models need to be consistent with each other and represent a market participant point of view.
Source: The Appraisal Foundation, Best Practices For Valuations In Financial Reporting: Intangible Asset Working Group – Contributory Assets, May 31, 2010, 28.
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COMMON TANGIBLE ASSETS
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Most Common Tangible Assets
• Inventory
• Machinery and Equipment
• Land and Land Improvements
• Buildings
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Tangible Asset Valuation
• Inventory • Finished goods:
• Net realizable value = selling price – cost to dispose – margin on selling effort
• Retail method (downward) or wholesale method (upward)
• Work-in-process • Same concept as finished goods except consider the cost to
complete and manufacturing margin on the cost to complete
• Raw materials • Typically the price paid currently for inventory
Historical allowances for inventory and accounts receivable do not carryforward
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Tangible Asset Valuation
• Property, Plant and Equipment • Typically a market or income approach
• Current transaction prices • Lease rates
• Sometimes a cost approach
• Specialized assets • Typically cost approach = original cost + price changes –
physical deterioration and functional obsolescence
Historical allowances for inventory and accounts receivable do not carryforward
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COMMON INTANGIBLE ASSETS
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Most Common Intangible Assets
• Customer Relationships and Backlog
• Trademark/Trade Names
• Intellectual Property • Developed Technology
• Patents
• In Process Research & Development
• Contractual Assets • Non-Compete Agreements
• Leases
• Workforce
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Intangible Asset Valuation Overview
• Income Approach – used for assets that have a cash flow stream associated with them. Most common approaches. • Relief From Royalty (trademarks, patents and technology)
• Multi Period Excess Earnings Model (customer relationships, technology)
• “With and Without” analysis (non-compete agreements)
• Cost Approach – Often used for assets with no direct cash flow stream associated with them.
• Fixed assets (depreciated replacement or reproduction cost)
• Assembled workforce
• Internally developed software
• Market Approach – Some elements are routinely used
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Relief From Royalty Method - Overview
• Definition: A specific application of the discounted cash flow method (income approach)
• Based on the following principle: Ownership of the intangible asset relieves the owner of the need to pay a royalty to a third party in exchange for rights to use asset.
• Value: Equal to present value of tax-effected cost savings realized by the owner of the intangible asset as a result of not having to pay a stream of royalty payments to a third party.
• Assets Commonly Valued Under this Method:
Trademark/Trade Names Technology
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Relief From Royalty Method – Primary Assumptions
• Revenue stream • Trademark/Trade Names
Sales including use of Trademark/Trade Names
• Technology migration Core, Developed, IPR&D, Future (part of goodwill)
• Royalty Rate • Market Data • Profit Split
• Discount Rate • Normally the assets rate of return from the WARA calculation • Nature of the assets
• Useful Life • Trade names – definite or indefinite • Technology - migration
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Example – Relief From Royalty Method
FYE 2014 FYE 2015 FYE 2016 FYE 2017 FYE 2018 FYE 2019 FYE 2020
Pre-tax After-tax Total revenue 1,751,764$ 3,413,618$ 4,964,945$ 6,801,612$ 8,882,544$ 11,103,180$ 13,046,237$ Royalty Rate Royalty Rate
3.0% 1.8%
After-tax royalty cash flows 31,532$ 61,445$ 89,369$ 122,429$ 159,886$ 199,857$ 234,832$
Discount period 0.50 1.50 2.50 3.50 4.50 5.50 6.50Discount rate / PV factor 11.5% 0.9471 0.8495 0.7619 0.6834 0.6130 0.5498 0.4931
Present value of royalty stream 29,863 52,196 68,092 83,668 98,005 109,881 115,804
Present value of interim cash flows 557,509 Amortization tax benefit 130,851
Fair value of Trade Name (rounded) 688,000$
Projected
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Multi Period Excess Earnings Method (MPEEM) - Overview
• Definition: A specific application of the discounted cash flow method (income approach)
• Based on the following principle:
The value of an intangible asset is equal to the present value of the incremental after-tax cash flows attributable only to that asset.
• Value:
To quantify the cash flows attributable solely to the subject intangible asset, contributory asset charges are typically applied to account for the use of and/or required return on these assets.
• Normally applied to the dominant or primary intangible asset. Assets
Commonly Valued Under this Method: Customer Relationships Technology Operating licenses
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Excess Earnings Method – Primary Assumptions
• Revenue Stream
• Impact of technology migration • Customer relationship assets:
Revenue growth from existing customers Customer attrition – contractual and non contractual
• Adjusted operating margin (EBITDA or EBIT normally)
Adjustments for: Sales and marketing (normally for Customer Base) Research and development (normally for Technology) Favorable/unfavorable leases
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Excess Earnings Method – Primary Assumptions (Cont’d)
• Contributory asset charges
• Assets which may contribute to cash flow Net working capital Fixed assets Trade name Technology Workforce – part of goodwill
• Tax rate
• Discount rate
• Overall – Rate for identifiable intangible assets considering risk of the asset being considered
• Contributory assets - WARA
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Excess Earnings Method – Example
Existing Contributory Contributory Pre-tax After-tax PV PV Customer Annual Surviving EBIT Asset Asset Excess Excess Factor Excess
Year Revenue Renewal Revenue Margin EBIT Charge % Charges Earnings Earnings at 11.5% Earnings2014 1,464,399$ 100.0% 1,464,399$ -31.4% (459,094)$ 25.2% 368,805$ (827,899)$ (508,537)$ 0.9553 (485,829)$ 2015 2,323,799$ 90.0% 2,091,419$ 6.1% 126,695$ 24.6% 513,711$ (387,017)$ (237,725)$ 0.8644 (205,484)$ 2016 3,347,925$ 81.0% 2,711,819$ 35.8% 970,876$ 24.4% 661,251$ 309,624$ 190,187$ 0.7753 147,451$ 2017 4,751,314$ 72.9% 3,463,708$ 53.9% 1,868,655$ 24.2% 836,660$ 1,031,995$ 633,903$ 0.6954 440,814$ 2018 6,397,032$ 65.6% 4,197,092$ 65.0% 2,728,701$ 23.9% 1,005,057$ 1,723,644$ 1,058,749$ 0.6237 660,372$ 2019 6,588,943$ 59.0% 3,890,705$ 45.8% 1,783,579$ 23.9% 929,988$ 853,591$ 524,318$ 0.5594 293,329$ 2020 6,786,611$ 53.1% 3,606,683$ 42.4% 1,529,619$ 23.9% 860,496$ 669,124$ 411,009$ 0.5018 206,241$ 2021 6,990,209$ 47.8% 3,343,395$ 38.6% 1,288,964$ 23.8% 796,736$ 492,228$ 302,351$ 0.4501 136,082$ 2022 7,199,915$ 43.0% 3,099,328$ 34.4% 1,064,643$ 23.8% 737,938$ 326,706$ 200,679$ 0.4037 81,013$ 2023 7,415,913$ 38.7% 2,873,077$ 29.7% 854,717$ 23.8% 683,787$ 170,929$ 104,993$ 0.3621 38,017$ 2024 7,638,390$ 34.9% 2,663,342$ 24.4% 650,126$ 23.8% 633,719$ 16,407$ 10,078$ 0.3248 3,273$ 2025 7,867,542$ 31.4% 2,468,918$ 24.4% 602,667$ 23.8% 587,458$ 15,209$ 9,342$ 0.2913 2,721$ 2026 8,103,568$ 28.2% 2,288,687$ 24.4% 558,672$ 23.8% 544,573$ 14,099$ 8,660$ 0.2613 2,263$ 2027 8,346,675$ 25.4% 2,121,613$ 24.4% 517,889$ 23.8% 504,819$ 13,070$ 8,028$ 0.2344 1,881$ 2028 8,597,076$ 22.9% 1,966,735$ 24.4% 480,083$ 23.8% 467,968$ 12,116$ 7,442$ 0.2102 1,564$ 2029 8,854,988$ 20.6% 1,823,163$ 24.4% 445,037$ 23.8% 433,806$ 11,231$ 6,899$ 0.1885 1,301$ 2030 9,120,638$ 18.5% 1,690,073$ 24.4% 412,549$ 23.8% 402,138$ 10,411$ 6,395$ 0.1691 1,081$ 2031 9,394,257$ 16.7% 1,566,697$ 24.4% 382,433$ 23.8% 372,782$ 9,651$ 5,928$ 0.1517 899$ 2032 9,676,084$ 15.0% 1,452,328$ 24.4% 354,516$ 23.8% 345,569$ 8,947$ 5,496$ 0.1360 748$ 2033 9,966,367$ 13.5% 1,346,308$ 24.4% 328,636$ 23.8% 320,342$ 8,294$ 5,094$ 0.1220 622$ 2034 10,265,358$ 12.2% 1,248,028$ 24.4% 304,646$ 23.8% 296,957$ 7,688$ 4,722$ 0.1095 517$ 2035 10,573,319$ 10.9% 1,156,922$ 24.4% 282,406$ 23.8% 275,280$ 7,127$ 4,378$ 0.0982 430$ 2036 10,890,518$ 9.8% 1,072,467$ 24.4% 261,791$ 23.8% 255,184$ 6,607$ 4,058$ 0.0881 357$
Present value of cash flows 1,329,663$ Amortization tax benefit 312,081$
Fair value of Customer Relationships 1,642,000$
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Contributory Charges – Calculation Methodology
• Types of Returns
• Return On
Reflects the fair return for investment in the asset
Calculated as the rate of return, or discount rate for the contributory asset multiplied by its fair value
• Return Of Recovery of the investment in the asset over time
Captured through projected operating expenses or through book based depreciation
• Application of Contributory Charges Based on normalized level of the contributory asset Convert to a percentage of revenue to apply in a MPEEM Rates of return for each asset come from WARA calculation
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Common Contributory Assets
• Return Of already captured through operating expense; Charge consists only of a Return On: • Net working capital • Customer relationships • Internal use software • Assembled workforce
• Require a separate Return Of as part of the calculated charge (Return Of not captured through projected operating expenses) • Fixed assets – normally captured through economic depreciation • Non-compete agreement
• Land • Return Of is not required as asset is assumed not to waste or erode
over time
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Cost Approach Valuation Example – Assembled Workforce
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Tax Amortization Benefit
• Present value of the tax amortization benefit is added to the fair value of intangible assets that are amortizable for income tax purposes.
• Inclusion is consistent with guidance in the AICPA Practice Aid: Assets
Acquired to Be Used in Research and Development Activities (“IPR&D Guide”) issued December 6, 2013.
• The 15-year period is consistent with the statutory tax lives prescribed for intangible assets in IRC Section 197 Amortization of Goodwill and Certain Other Intangibles.
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Tax Amortization Benefit – Example Calculation
Step 1: Calculate the Present Value of the After-Tax Cash Flows Related to the Subject Intangible Asset
15.00% Discount RateKey Assumptions 40.0% Tax Rate
15.0 Amortization Period10000 Present Value of Cash Flows
Step 2: Calculate the Present Value of the Amortization Tax Benefit
Portion of Period
Applicable PV Factor
Intangible Asset
Amortization
Reduction in Tax Liability
(Tax Benefit)
Present Value of Tax
Benefit
Year1 0.50 0.9325 801 320 299Year 2 1.50 0.8109 801 320 260Year 3 2.50 0.7051 801 320 226Year 4 3.50 0.6131 801 320 196Year 5 4.50 0.5332 801 320 171Year 6 5.50 0.4636 801 320 148Year 7 6.50 0.4031 801 320 129Year 8 7.50 0.3506 801 320 112Year 9 8.50 0.3048 801 320 98Year 10 9.50 0.2651 801 320 85Year 11 10.50 0.2305 801 320 74Year 12 11.50 0.2004 801 320 64Year 13 12.50 0.1743 801 320 56Year 14 13.50 0.1516 801 320 49Year 15 14.50 0.1318 801 320 42
Totals $12,008 $4,803 $2,008
Step 3: Calculate the Fair Value of the Intangible Asset
10,000$ 2,008
12,008$
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? QUESTIONS
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