Common sense tells us that most acquirers pay less or more, but rarely exact Fair Value for the companies they acquire. Because M&A transactions are complex, it is hard to imagine that pure economics is the only factor that influences deal pricing. Any difference between the purchase price and the Fair Value of the acquisition must be noted or recognized on the financial statements, under both US GAAP and IFRS purchase accounting rules.
Did you know that at least half of a typical intangible valuation report is dedicated to the issue of the entity’s Fair Value? The report does not calculate Fair Value directly. Instead, it calculates the Internal Rate of Return (IRR). IRR represents the rate of return on investment the acquirer expects to obtain from the deal based on the price paid and financial performance projected. IRR is compared to the industry cost of capital, or weighted average cost of capital (WACC). Low IRR may indicate that the acquirer overpaid, while high IRR signals a potentially favorable purchase price.
Paying above or below Fair Value may impact your income statement. Accounting rules define a “bargain purchase” as a transaction with a purchase price lower than the sum of all recognized net assets, excluding goodwill. Goodwill and other intangible assets are measured based on the Fair Value of an acquired entity. However, in a bargain purchase no goodwill appears on the acquirer’s books.
Due to inherent subjectivity of valuation analysis, companies may find it hard to convince auditors that acquired entity’s Fair Value is different from its purchase price. Transactions involving private company stock, earn-outs, or equity derivative instruments are more likely to deviate from Fair Value than those completed for cash. Importantly, there has to be a strong fact pattern that qualitatively supports the notion of off-Fair Value transaction.