EXECUTIVE
SUMMARY | CLIENTS BENEFIT FROM
USING AN INTERMEDIARY such as a
CPA/valuator to handle a merger or
acquisition. A valuator should know a
client’s industry thoroughly and have
procedural training. Even experienced
CPA/valuators may need to bring in an
outside expert for longtime clients in
order to avoid bias.
CPA/VALUATORS
GATHER, VERIFY AND ANALYZE DATA,
then prepare a report that
includes the assumptions and methodology
that underlie their conclusions. From
this they project how each business is
expected to perform in the next three to
five years and how much its client will
contribute to any resulting enterprise.
Their challenge is to find a valid
negotiation range.
IN A MERGER, THE
PARTIES NEGOTIATE how
relative value will translate into the
amount of ownership each party will have
in the new company. In an acquisition,
the parties negotiate how the relative
value contributed to the new enterprise
will translate into the purchase price.
TWO GOOD REASON FOR
PARTIES TO MERGE rather than
treat the combination as an acquisition
are that a merger does not require cash
and may in some cases be accomplished
tax-free for both businesses.
TWO ADVANTAGES OF A
STOCK ACQUISITION are that
it’s a faster and easier transaction
than an asset purchase and the buyer
does not experience the dilution of
ownership that occurs in a merger.
IN AN ASSET
PURCHASE, THE BUYER buys
explicitly detailed assets and perhaps
some liabilities. In this type of
purchase, only those assets and
liabilities that are part of the
transaction are subject to due
diligence. Asset purchases commonly
protect the buyer from unforeseen
liabilities. | NICHOLAS J. MASTRACCHIO JR.,
CPA, PhD, is associate accounting
professor of the Albany School of Business
at the State University of New York. He is
the author of Mergers and Acquisitions
of CPA Firms: A Guide to Practice
Valuation, AICPA, 1998, and of many
articles. His e-mail address is mast@nycap.rr.com
. VICTORIA M. ZUNITCH is a freelance
business writer based in New York. Her
e-mail address is VictoriaZunitch@juno.com
. |
usiness owners need valuations for
many reasons—a divorce distribution, shareholder
actions, financial and tax planning, estate and
gift tax calculations and mergers and acquisitions
(M&A), for example. Although companies that
merge with or buy another business hope to make
more money as a couple than each would have alone,
useful M&A business valuations depend on more
than just finding your client a price. M&A
differs from the other reasons for valuations in
that an actual arm’s-length negotiation (not just
a written report) takes place. This article
describes differences between merging and
acquiring for CPAs advising a client that will buy
or merge with another business. (For more
information on M&A and BV training, see “Signed,
Sealed, Delivered,” page 30.). The
differences between merging and acquiring are
important to valuing, negotiating and structuring
a client’s transaction. Acquiring another business
lets owners
Establish a base. Obtain a
going concern in a particular location.
Establish a niche. Bring
in more business of a certain type.
Increase productivity and profitability.
Increase output with unchanged fixed
costs, yielding higher profit.
Expand geographic coverage.
Obtain entry into adjacent market
areas.
Increase prestige. Drive
company value up. Merging offers the above
advantages and additional ones, such as
Succession planning. A way
to secure retirement though new ownership.
Reduced work level. A way
to share responsibility among more people.
Security of a larger organization.
A way to cope with larger
competitors.
AVOID RISK
A
CPA/valuator should know a client’s
industry well and have training in
procedures for conducting an economic
analysis of a business. It’s also
important to avoid bias, says New
York-based Stanley Person, CPA: “Be
objective. Don’t put yourself in the
position of it even being implied that
you’re too close for objectivity.” The
AICPA Code of Professional Conduct
requires that members provide only
services they can complete with
professional competence. In business
valuation they also must comply with the
professional and technical standards
under the Statement on Standards for
Consulting Services. Even experienced
CPA/valuators may need an outsider to
conduct valuations for clients they have
grown close to, especially if they have
helped build value for a longtime
client. (See “A
Nice Niche—If You Minimize Liability
Risk,” JofA , Feb.01,
page 49.) |
The “5-4-3-2-1”
Pay Plan A common
benchmark for calculating a
business valuator’s
compensation is the Lehman
formula, which suggests paying
a BV intermediary the sum of
5% of the first million
dollars of a transaction’s
value plus 4% of value between
$1 million and $2 million, 3%
of value between $2 million
and $3 million, 2% of value
between $3 million and $4
million, and 1% of value in
excess of $4 million.
Source: Gary Trugman,
CPA/ABV, Gary@TrugmanValuation.com
.
| |
Caveat: In mergers, a target often allows
the acquiring company to pay for the valuation,
but some CPA/valuators caution that it makes the
acquirer dependent on information owned by the
party on the other side of the table. Others say a
valuator that is jointly hired by merging parties
can be fair to both of them.
GATHER INFORMATION
In general, CPA/valuators will need the
target’s business history, projected and
historical financial data, ownership records,
information on products and services, sales and
marketing data, and supplementary information on
banking, legal and contractual relationships, says
Philip Hamilton, CPA/ABV, in Austin, Texas. In an
acquisition, each company hires a valuator, and
the acquirer’s valuator reviews the target’s
business history; in a merger, one valuator may
work with both parties. Before the
valuator begins work, the client(s) must compile
company data that include financial statements and
tax returns for three to five years; an accounting
of all outstanding receivables and payables; the
actual value of inventories; identification of
suppliers, vendors and key customers and the
percentage of business tied to each relationship;
equipment, including its age; industry, geographic
and market comparisons; sales and other
projections; resumes of key personnel; the most
recent business plan; published corporate
literature and press articles; and the percentage
of revenues dependent on each product line or
service. The valuator also will gather
information from other sources, including industry
and geographic comparisons, as well as a survey of
sales of comparable businesses. Cleve Gazaway,
CPA, Gazaway & Co. in Houston, says valuators
should talk to the client’s attorneys, especially
about potential litigation issues, talk to bankers
to learn background about financing arrangements
and—a key element that’s often missed—talk to
employees to get an inside view of operations.
ARRIVE AT A PRICE
After CPA/valuators gather, verify and
analyze data, they prepare a report and include
the assumptions and methodology that underlie
their conclusions. Based on historical data and
projections for the next three to five years, each
company’s expert determines how much its party
will contribute to any resulting enterprise. Their
challenge is to find a valid negotiation range by
determining the acquisition’s standalone value to
an outside investor and comparing it against the
client’s value based on the synergies their client
can achieve. Once each side’s valuations
are completed, negotiations begin. Standalone
value will be the low end of the negotiating
range, says Hamilton. The high end will be the
client’s value—that is, the standalone value plus
the expected increase in revenue, decrease in
expenses and better use of assets the company
expects to contribute to the combined enterprise.
The final determination of value will center
on how convincing each party is in its projection
of the overall performance of the combined entity.
Other factors, such as market demand or unique
assets, will influence the final price. Gazaway
ruefully remembers his valuation opinion for the
owner of a company that sold ATM machines
overseas: “I said it was worth $7 million to $8
million, but he sold it for four times that” to an
extremely motivated buyer. “Textbook valuation may
not have any relation to real-life demand.”
MERGERS VS.
ACQUISITIONS
Generally CPA/valuators use the same
procedure for calculating a standalone value
figure and the client’s value for an acquisition
and a merger. In a merger, the parties negotiate
over how relative value will translate into the
amount of ownership each party will have in the
new company. However, in an acquisition, the
parties negotiate over how the relative value
contributed to the new enterprise will translate
into the purchase price. A significant factor in
an acquisition is the terms: The seller likely
will want to structure the acquisition for cash up
front, and the buyer generally will prefer to pay
for the acquisition over time. These conflicting
structures reflect each party’s tax aims; the
seller wants a sale that will give him a capital
gain, the buyer wants a near-term writeoff or
deduction of the cost. Hamilton notes that in both
cases the parties need to forecast and support how
performance will change after the deal goes
through. CPA/valuators caution that
cultural considerations are as important to making
a transaction work as numbers. In a hypothetical
example of two CPA firms merging, one focuses on
high profitability and expects management to log
2,000 chargeable hours a year; the other has a
management team that wants a “life” and doesn’t
want anyone to log more than 1,500 hours a year.
The difference probably dictates they forgo a
combination—or agree to an acquisition, which puts
one team in charge and requires the other to
adjust. “Either of these companies can acquire the
other, but a merger—no,” says one CPA.
MERGERS
Although a merger involves a combination of
two or more entities, they are rarely equal
participants. Sometimes a merger is really an
acquisition financed by common stock. Mergers are
typically more expensive than acquisitions, with
the parties incurring higher legal costs, Hamilton
says. There are several ways to structure
a merger. In a forward merger, the target merges
into the acquirer’s company, and the selling
shareholders receive the acquirer’s stock. In a
reverse merger, the acquirer merges into the
target company and gets the target company’s
stock. (In some cases a private company uses a
reverse merger with a public one as a way to go
public at a lesser cost and with less stock
dilution than through an initial public offering.)
In a subsidiary merger, an acquirer incorporates
an acquisition subsidiary and merges it with the
target company. In a triangular merger, the target
company’s assets are conveyed to the acquirer’s
company in exchange for the acquirer’s stock. Each
of these types of mergers can have different tax
and legal consequences, and the acquirer and the
seller must seek proper tax and legal advice from
experts. There are many reasons for
parties to decide to merge rather than treat the
combination as an acquisition. Some of the more
frequently encountered reasons are
A merger does not require cash.
A merger may be accomplished tax-free
for both parties.
A merger lets the target (in effect,
the seller) realize the appreciation potential of
the merged entity, instead of being limited to
sales proceeds.
A merger allows the shareholders of
smaller entities to own a smaller piece of a
larger pie, increasing their overall net worth.
A merger of a privately held company
into a publicly held company allows the target
company shareholders to receive a public company’s
stock, despite the liquidity restrictions of SEC
Rule 144a.
A merger allows the acquirer to avoid
many of the costly and time-consuming aspects of
asset purchases, such as the assignment of leases
and bulk-sales notifications.
Of considerable importance when there
are minority stockholders is the fact that upon
obtaining the required number of votes in support
of the merger, the transaction becomes effective
and dissenting shareholders are obliged to go
along.
STOCK ACQUISITIONS
In a stock acquisition, the acquirer
purchases all or substantially all of the
common stock of the target company for a
specified price. The buyer replaces the
selling stockholders as the owner of the
target company. Advantages of a stock
acquisition are
It’s a faster and easier
transaction than an asset purchase,
where assignment of leases and
contracts, bulk-sales notices and other
legal issues must be addressed.
If the target company is
publicly traded, a tender offer to the
stockholders can preempt time-consuming
and costly negotiations.
The acquirer does not
experience the dilution of ownership
that occurs in a merger. The
main disadvantage of a stock purchase is
that the acquirer may assume actual and
contingent liabilities that can cause
significant unintended legal exposure.
Detailed due diligence is essential on
this issue, and indemnification from the
selling shareholders may be required.
Another potential problem is that
dissenting shareholders may prevent the
buyer from gaining control of all the
outstanding stock of the target company.
ASSET PURCHASES
Asset purchases are commonly used
to protect the buyer from unforeseen
liabilities. In an asset purchase, the
buyer buys specific assets and perhaps
some liabilities that are explicitly
detailed. The tax and accounting basis
of the assets, including any goodwill
being purchased, is the purchase price.
This tax treatment is attractive to an
acquirer of appreciated assets, but it
may be undesirable if the assets have
depreciated from their current book
value. In an asset purchase, the
acquirer performs due diligence on the
specific assets and liabilities to be
acquired. Only those assets and
liabilities that are expected to be part
of the transaction are subject to due
diligence. Generally, if the asset or
liability is not in the initial
contract, it will stay with the seller.
|
CASE STUDY
What Not to Do
Don’t go into a merger or
acquisition unless it’s part of
a clear, well-thought-out,
written strategic plan, warns
Nicholas J. Mastracchio, CPA,
PhD. He offers this cautionary
tale of a merger that took place
without an experienced valuator
exercising careful due
diligence. Brought in after the
fact, Mastracchio could do
little for the owner—who learned
a bruising lesson.
Situation.
A distributor of
nondurable goods had decided
to expand its business by
manufacturing some of its own
products. Then, one of the
company’s suppliers put itself
up for sale. Without
considering meeting its needs
another way, such as building
a manufacturing operation
internally, the distributor
jumped at the opportunity and
acquired the supplier.
Problems.
Conflicts soon
arose. The supplier’s former
owner had been ready to
retire. He’d had the business
a long time, and the equipment
was outdated. But the
distributor didn’t have the
manufacturing valuation
expertise that would have
helped him recognize that
important equipment would soon
have to be replaced.
Consequences.
The acquisition
never became profitable. The
supplier’s managers became
increasingly occupied with
defending themselves to the
new owners. The distributor’s
management and board were
distracted for about five
years and eventually disposed
of the business at a loss.
Mistakes.
In the absence
of a strategic plan, which
would have clarified its
goals, the acquirer failed to
research possibilities such as
building its own manufacturing
operation, and worse, it
neglected to obtain sufficient
expertise to help it make the
right decisions. Without
planning, the distributor did
not have the resources to
commit to proper due
diligence.
| |
Bulk-sales laws should be investigated if an
asset purchase is going to take place; they vary
from state to state. They require proper
notification to creditors of a business if the
majority of its inventory, materials or supplies
will be sold to a third party. The acquirer can be
held liable if it does not comply with the
bulk-sales laws. Bulk sales also may be exempted
from sales and use taxes. A financial adviser must
be familiar with the state law where the assets
are bought and sold. The fraudulent
conveyance provisions of the U.S. Bankruptcy Code
and state statutes are another important factor.
These provisions may give creditors in an asset
purchase a claim against the assets or against
sale proceeds or the ability to set aside the
transaction. There may be an issue about whether
the transaction was for an adequate amount or if
it left the seller insolvent or with insufficient
capital to meet its obligations. Asset
purchases can work for the parties when
The buyer explicitly doesn’t want to
acquire some of the assets of the target company,
such as real estate or leases.
The parties cannot agree on the value
of particular assets or liabilities and the seller
is willing to keep them.
The seller’s objective for the
overall proceeds can be met only by allowing it to
retain certain assets that can be leased to the
buyer or sold to a third party.
The buyer cannot raise enough capital
to purchase all the target company’s assets.
The buyer wants a stepped-up tax
basis for the assets.
The buyer does not want to chance the
assumption of unknown liabilities.
SHAKE HANDS AND COME OUT NEGOTIATING
Whatever type of
transaction a valuation is ultimately used for, it
is best for the client if it
Hires a seasoned valuator.
Provides a mountain of high-quality
data.
Takes the reasoned analysis of a
well-trained expert seriously. In a merger
or acquisition negotiation, motivated sellers that
feel they have few options might try to gain
leverage or create interest in their business by
sharing business projections and information such
as the standalone value calculated by its
valuator, with the other party. Most CPAs say it’s
unwise to do this. A selling client should not be
so enamored of a prospect that it gives away the
store. Similarly, a buying client should not agree
to a price over the fair-value range. A sensible,
well-informed deal is the best one. |