The primary purpose behind a Purchase Price Allocation (PPA) valuation is to fulfill financial reporting or tax reporting requirements, generally required when one company acquires or purchases another. PPA became a regulatory requirement due to balance sheet misrepresentation and has been a requirement of companies for the past 15 years. It is vital to both your investors and auditors that you get it done right.
ONCE UPON A TIME . . . WHEN PPAs WEREN’T REQUIRED
Originally, PPAs as we know them today weren’t required. Once upon a time, when a company had to have audited financials, the assets were simply “pooled together”. Companies would put a value on what was thought to be all the identifiable assets and simply allocate the remaining to goodwill. This meant that, if a company made an acquisition, the company wouldn’t split up the purchase price among individual assets, the assets were just pooled together.
With this practice came a lack of transparency in financial reporting. Many companies, both intentionally and unintentionally, misrepresented the value of assets relative to the value of goodwill. The high amount of balance sheet fraud initiated the PPA obligation, requiring companies to distinctly identify both the intangible and tangible assets and separately value each.
WHEN IS A PPA REQUIRED?
PPAs are only technically required when a company that has audited financial statements (generally any public company) acquires another company . They are most commonly used in M&A transactions when the purchase is considered to be a material change. Many companies have a materiality threshold, making acquisitions below that threshold immaterial relative to the company size as a whole. When the transaction is a material change, and the company has audited financials, they will be required to do a PPA.
THIS IS A BIG REQUIREMENT, WHAT ABOUT THE “SMALL GUYS”?
PPAs can be costly and time-consuming. As of today, PPAs are relevant for any company that has audited financials as well as companies that are planning on going public and may require audited financials in the near future; companies may also begin PPAs proactively without meeting these natural stepping-stones. In some situations, smaller companies are required by their investors to have audited financials or have taken on a bank loan and are required to have audited financials by the lender. PPAs are required in these situations, but the PPA requirement can truly cripple a small company by imposing high fees and taking a large amount of time away from building revenue-driving business.
New PPA guidance has come to light to address the difficulties behind smaller companies meeting the PPA requirements. This PPA guidance outlines the situations in which smaller, non-public companies can take a simpler approach to the PPA requirement.
Under the traditional PPA guidance, companies are required to identify assets and assign a value to any identifiable assets (both tangible and intangible). The new PPA guidance presents a simplified approach in which companies are required to identify assets but are not required to assign a value to those separately if those assets cannot be sold off as standalone assets (most commonly non-competition agreements and customer contracts). For those assets that cannot be sold off as standalone assets, the values become a part of goodwill.
DOES THE UPDATED PPA GUIDANCE REALLY HELP SMALLER COMPANIES?
The majority of smaller companies are likely more concerned about the fees associated with PPAs than they are about the process of having to separately value intangible and tangible assets. Although simplifying the PPA process for smaller companies does save a little bit on fees, it doesn’t have much of an impact.
From the perspective of an analyst, there is little difference between valuing 1 intangible asset and valuing 5 intangible assets. In spite of the number of assets being valued, there’s still a lot of background analysis to be done. The company performing your PPA still needs to identify comparable companies, read the merger agreement, value the company as a whole, and build out projections of the company as a whole. In short, 60-70% of the analysis performed for a PPA remains constant regardless of whether 1 or 5 assets are being valued. With that in mind, the amount of fees the smaller company saves are minimal and the new PPA guidance on the process doesn’t do much to mitigate those fees or the time of the PPA provider.
All that being said, smaller companies can experience some relief when it comes to fulfilling their PPA requirements by taking this more proactive approach. During the PPA process, the PPA provider identifies the intangible assets and assigns a value to those intangible assets which is recorded on the balance sheet. Each following year when the company closes out their reporting period, each of those intangible assets on the books needs to be tested for potential impairment. Thus, there’s a separate intangible asset impairment test. This is a method to look at and determine whether the value on the balance sheet of each intangible asset is still reasonable and essentially “clean up” the assets that the PPA provider would need to look at when the next PPA is required.
Purchase Price Allocations can be expensive and time consuming, but they’ve come about for a good reason and are very applicable to companies with audited financials. To provide transparency between your company, investors, and auditors, it’s vital that the Purchase Price Allocation requirement is fulfilled with a capable and experienced firm.