Purchase Price Allocation in Mergers and Acquisitions: Understanding its Value

One element that often plays a significant role during this process is Purchase Price Allocation (PPA). Let’s take a look at the critical aspects and components.

What is Purchase Price Allocation?

PPA is, simply defined, the practice of dividing the total purchase price of a target company into various components—including tangible and intangible assets, liabilities, and equity. This allocation impacts how the acquiring company accounts for the acquired assets and liabilities on its balance sheet, essential information for both financial reporting and tax purposes.

The goal of a PPA is to determine the fair market value of the assets and liabilities of the acquired company, which then helps the acquiring company account for the acquisition and report it in their financial statements.

How is the Purchase Price Calculated?

It should be noted that Purchase Agreements can differ vastly based on negotiations between parties, however there are several factors and inputs often present to take into account when calculating the initial agreed upon base purchase price amount and the amount available to sellers at closing (excluding any holdbacks or escrows that affect the closing payment):

1. Base Price (often representing Enterprise Value): Represents the initial fixed amount the acquiring company agrees upon to purchase assets or equity of the target company. It serves as the starting point for price negotiations and can be based on a set number of shares or the value of the assets acquired.

2. Rollover Value/Equity/Interest: Represents the portion of the target company's equity that existing shareholders, such as founders or management, reinvest in the acquiring company. It aligns these stakeholders’ interests with the newly combined entity's growth. This amount is deducted from the Base Price.

3. Closing Cash: Denotes the cash and cash equivalents held by the target company at the time of the deal's closing. It represents the total cash balance the acquiring company will acquire. This amount is added to the Base Price.

4. Closing Indebtedness: Encompasses the total remaining debt or debt-like items owed by the target company at the time of the deal's closing. These items are typically either paid at closing as part of the funds flow or included within indebtedness as a lever to adjust the purchase price for certain accounts (e.g., Bonus or Commission Liabilities). Specific liabilities classified as "debt" are defined within the purchase agreement. This amount is deducted from the Base Price.

5. Net Working Capital Adjustment: As part of the LOI, the deal is often negotiated where the business is bought with “normalized levels of working capital” (where the working capital accounts are defined as non-cash accounts only). Typically, the LOI outlines that the working capital target will be determined as part of the Quality of Earnings or Diligence Procedures and agreed upon by both parties. Once the Net Working Capital Target has been determined, the adjustment  accounts for the difference between the targeted and the actual net working capital as of the closing date. It aims to ensure a fair adjustment of the purchase agreement based on the working capital delivered or deficit at closing Based on whether working capital at closing exceeds or is below the target drives which direction the purchase price is adjusted.

6. Seller Transaction Fees: Includes expenses incurred by the seller in relation to the deal. Examples include advisory fees, legal fees, accounting expenses, due diligence costs, valuation fees, and transaction-related insurance. This amount is deducted from the base purchase price.

How is the Purchase Price Adjusted?

As the diligence process nears its conclusion, attention turns to the adjustment of the purchase price. The goal here is to minimize unexpected adjustments to the extent possible. This is achieved through a robust net working capital analysis used to set a “peg” (i.e., a benchmark or baseline amount of non-cash net working capital that is agreed upon by the buyer and the seller).

The adjustment to working capital aims to achieve a fair and justifiable shift in the purchase agreement.

The aim is to align the purchase price with the actual financial state of the target company at the closing date.

What is Consideration Transferred?

Consideration Transferred refers to the total value paid to acquire the target company. It represents the assets, cash, stock, liabilities, or other valuable items given by the acquiring company to the shareholders and owners of the target company in exchange for their ownership interests.

In an acquisition, consideration can take various forms, and its specific structure is negotiated and agreed upon between the parties involved in the deal. The inputs taken into account for total consideration include:

1. Contingent Consideration (Earn-Out): An “earn-out" is a contractual arrangement that allows the buyer to make additional payments to the sellers of the target company based on specific performance targets or milestones achieved after the acquisition is completed. This bridges the gap between the parties' differing views on the target company’s future performance or potential.

2. Deferred Compensation: The acquiring company and key employees or executives of the target company make agreements to pay a portion of the compensation owed at a later date, aligning their interests with the long-term success of the combined entity.

Allocating Consideration Transferred to Assets & Liabilities

Once the closing statement has been finalized and signed off by both parties, the advisor (typically a CPA) can calculate the Purchase Price Allocation. This process includes measuring assets and liabilities from their book value to the fair value, as part of the write up or down. 

Third-party valuation specialists are often engaged to perform valuation over intangible assets acquired, which should then be included within the calculation to determine the Goodwill for the opening balance sheet and the corresponding purchase price allocation.

How Do You Calculate Goodwill in a Business Combination?

Goodwill represents the excess of the purchase price over the fair value of the identifiable net assets acquired. It often arises when the acquiring company pays more for the target company than the value of its tangible and identifiable intangible assets. 

Proper allocation of the purchase price among the acquired assets and liabilities determines the amount of goodwill. Valuation experts and accounting professionals should be involved in this process to ensure compliance with accounting standards.

Final Thoughts

Understanding PPA and how the purchase price is divided among assets, liabilities, and equity is essential for both financial reporting and tax compliance. PPA ensures the acquisition process is not only financially sound, but also transparent and compliant with accounting standards. 

If you have any questions about PPA, or mergers and acquisitions in general, please reach out.