Business Acquisitions: Accounting, Tax and Due Diligence · Source: Standard & Poor’s Leveraged...

Business Acquisitions: Accounting, Tax and

September 12, 2012Chicago, IL

Due Diligence

Chicago, IL

Seminar Agenda

8:00 a.m. – 8:30 a.m.Registration and Continental Breakfast

8:30 a.m. – 8:35 a.m.Welcome and Introduction of Program

8:35 a.m. – 9:00 a.m.Capital Market UpdateCapital Market Update

9:00 a.m. – 9:30 a.m.Financial Due Diligence

9:30 a.m. – 9:45 a.m.P f IPerformance Improvement

9:45 a.m. – 10:30 a.m.Acquisition Tax Issues

10:30 a m – 10:45 a m10:30 a.m. 10:45 a.m.Break

10:45 a.m. – 11:30 p.m.Accounting and Audit for Acquisitions

11:30 p.m. – 12:30 p.m.Panel Discussion: The 100 days prior to closing a transaction

12:30 p.m. Lunch and NetworkingLunch and Networking

September 12, 2012Business Acquisitions Conference

State of the Capital Markets:M&A • Private Equity • Financing

DEBT ADVISORY GROUP

The Capital Markets Desk for the Middle Market SMthe Middle Market SM

Capital Markets Update - Themes

Supply of Capital > Demand

Financing Options are Plentiful

Basis of Current Competition is Terms Basis of Current Competition is Terms

Predictions

2

Supply > Demand

Monthly Loan Prime Fund Flows ($Bn) Volume of CLO Issuances ($Bn)

Significant Available Debt Capital in the Market

Monthly Loan Prime Fund Flows ($Bn)

$25.0

$20.0

$25.0

$30.0

Volume of CLO Issuances ($Bn)

$1.0

$3.0

$5.0

$4.1

$1.2

$4.1$2.6

$4.5

$12.4

$5.8

$12.1

$0.0

$5.0

$10.0

$15.0

-$7.0

-$5.0

-$3.0

-$1.0

2010 Q1 2011

Q2 2011

Q3 2011

Q4 2011

2011 Q1 2012

Q2 2012

2012F

Capital Raised by Existing Public BDCs in 2011 and YTD 2012

Source: Standard & Poor’s Leveraged Commentary and Data

Commentary

• Improved investor confidence and stable market conditions


Name of BDC Capital RaisedAres Capital Corporation* $1 7 billion

have resulted in more available debt capital as:

– Fund flows became positive in Q1 2012 for the first time

since July 2011 and, overall, remained positive in Q2 and

Q3 2012;

– New CLO issuances have gained traction with $17.9

Ares Capital Corporation $1.7 billionFifth Street* $435 millionGolub Capital BDC $109 millionGSV Capital Corp. $264 millionHercules* $123 millionKohlberg Capital* $60 million

S C $New CLO issuances have gained traction with $17.9

billion issued during the first two quarters;

– Public BDCs raised significant capital during Q1 2012;

however, the window for new equity raises is temporarily

closed; and

Main Street Capital $117 millionMedley Capital* $216 millionPennantPark $194 millionProspect Capital* $883 millionSolar Capital $75 millionTCP Capital $85 million

4

Source: BB&T Capital Markets, CapitalIQ, Company press releases*Issued convertible debt

– Private BDCs have continued to raise capital

• Lenders are aggressively seeking to put this capital to work

TICC Capital Corp. $65 millionTriangle Capital* $248 million

Total Follow-on Capital Raised $4.6 billion

Loan Volume Low in Response to Lackluster M&A Activity

$20.0

$25.0

Middle Market Sponsored Loan Volume ($Bn)

$5.0

$10.0

$15.0

$0.0

Source: Thomson Reuters

LTM Middle Market M&A Volume (deal count)

1,400

1,800

2,200

600

1,000

5

Source: Factset

Financing Alternatives

Debt Financing Alternatives – Structures and Providers

CommercialFinance

Companies BDCs

Hedge Funds / Credit Opportunity

Funds

InsuranceCompanies

MezzanineFundsCLOs

Traditional

BanksFunds

Revolver Term Loans

Last OutSenior

TrancheB

SecondLien Loans

Rate OnlySub Debt

TraditionalSub Debt

Unitranche(Pro Rata / First-

PrivateHigh YieldLoans Senior B Lien Loans Sub DebtSub Debt (

out Last-out)High Yield

Traditional Structures Alternative Structures

77

Debt Financing Alternatives - Detail

Asset Based LoanSenior Cash Flow

Unitranche Second Lien MezzaninePrivate Institutional Public / 144A

Asset Based LoanCredit Facility

Unitranche Second Lien MezzanineHigh Yield Term Loan B High Yield

Ratings Required

No No No No No No Yes Yes

Secured Yes Yes (unless investment grade)

Yes Yes No (or “silent” second lien)

Depends Yes (pari passuwith bank facility)

Depends

Typical Size Any Any Any Any Any Typically $100mm minimum

Typically $150mm minimum

Typically $175mm minimum

In estor Base Banks finance Banks finance Hedge and credit Hedge and credit Me anine f nds Hedge and credit Commercial Hedge and creditInvestor Base • Banks, finance companies

• Banks, finance companies

• Hedge and credit opportunity funds, BDCs

• Hedge and credit opportunity funds, insurance companies

• Mezzanine funds, BDCs, insurance companies

• Hedge and credit opportunity funds, insurance companies

• Commercial finance companies, CLOs, loan mutual funds, hedge and credit opportunity funds, insurance companies

• Hedge and credit opportunity funds, insurance companies, mutual funds, asset managers

Floating / Fixed • Floating per LIBOR • Floating per LIBOR • Floating per LIBOR • Floating per LIBOR • Fixed (cash/PIK) • Generally fixed • Floating per LIBOR • Generally fixed

Tenor • 3 5 years • 3 5 years • 5 7 years • 5+ years • 5+ years • Up to 6 8 years • 5+ years • Up to 10 yearsTenor • 3-5 years • 3-5 years • 5-7 years • 5+ years • 5+ years • Up to 6-8 years • 5+ years • Up to 10 years

Amortization • Straight line or slightly back-end loaded on term debt

• Straight line or slightly back-end loaded on term debt

• 3% to 5% p.a. • 1% to 3% p.a. • None • None • 1% p.a. • None

Prepayment Penalty

• None to 1% in yr 1 • None to 1% in yr 1 • 103 / 102 / 101 • 103 / 102 / 101 • 103 / 102 / 101 • NC 2-4 • 100 to 102 in yr 1 • NC 2-5

Benefits • Lowest cost of • Second lowest cost • Providers typically • Lower amortization • Can be maximum • No amortization • Diverse lender • Diverse lender capital

• Can fund a significant portion at close to reduce the average cost of capital

• Can have looser and / or springing covenants

of capital• ‘Relationship’

investor base• Longer-term capital

have small staffs with easy access to decision makers

• Creative lending group, able to handle tough credits

• Paydown of debt at the average cost

than senior cash flow structure

available leverage• Bullet amortization

at maturity• Often unsecured

and always subordinated to senior

• No maintenance covenants (incurrence only)

base• Longer tenor than

traditional bank debt

• Limited amortization

• More favorable prepayment than junior capital

base• Longest tenor

available• No amortization• No maintenance

covenants (incurrence only)

Considerations • Requires significant working capital assets

• Requires monthly reporting

• Field exams and audits required to put in place

• Term debt limited

• Lenders are typically very selective / cautious when evaluating credits

• Limited hold sizes results in more lenders in cap structure

• Unitranche lenders often have limited origination staffs (and can be hard to find)

• Many players seek relative value, so may not always be funding primary

• Normally only matched with ABL

• Requires stricter inter-creditor terms (such as no payment blockage)

• Most expensive debt capital

• May have high prepayment penalties

• Typically requires a market level of minimum equity value and at least

• Punitive prepayment penalties

• Liquidity premium over public high yield

• Generally only available for stable credits

• Requires ratings• More expensive

than traditional bank debt

• Less leverage than other options

• Buyers require the ability to trade out of a credit

• Requires ratings and road show

• Available leverage varies based on market conditions

• Buyers require the ability to trade out of a credit

• More volatile

8

by appraised value of fixed assets

• Market conditions can cap total size

deals $10mm of EBITDA • More volatile market, conditions can change quickly

market, conditions can change quickly

Privately Placed Broadly or Publicly Distributed

The Evolution of Unitranche

First DollarABL Revolver with

T L

ABL Revolver with First Out / Last Out

Types of Unitranche Facilities (Illustrative Examples)

ABL Revolver with First Out / Last Out

Traditional Senior / M

Revolver….........$0 Term Loan........$100

Total $100

First Dollar

Revolver………$20Term Loan……$80Total $100

Term Loan

Revolver………$20First Out ……...$20Last Out ……...$60

First Out / Last Out Term Loan

Revolver.……..$20First Out .…..…$20Last Out $60

First Out / Last Out Term Loan & Mezz

Revolver…..........$20 Sr. TL……….......$55Mezz…………….$25

Mezz

Total…………$100 Total……..….$100Total…………$100

Last Out ……...$60 Mezz…….…….$20Total…………$120

Total…………..$100

Cost of Debt = 9.0% Cost of Debt = 10.0% Cost of Debt = 8.4% Cost of Debt: 8.4% Cost of Debt: 9.3%

9

Note: Cost of Debt is calculated using the mid-point of the ranges presented on pg. 15

Current Competitive Landscape

Return Requirements For Non-Traditional Lenders Have Set a Floor on Pricing

9%

10%

Middle Market All-in Term Loan Yields (3-year)

7%

8%Avg: 7.6%

4%

5%

6%

Source: Thomson ReutersNote: 3Q12TD represents the period as of July 31, 2012

11

Non-Traditional Investors Change the Landscape of Middle Market Financing

70%

80%

90%

Investor Share of Primary Mid-Market Leveraged Loans

30%

40%

50%

60%

70%

0%

10%

20%

30%

Banks Finance Companies Institutional Securities Firms


12

Senior Debt and Total Debt Multiples

Increased Mid-Market LBO Senior Debt as a % of Total Debt

5.3x 5.3x5.5x 100%

5 0x

6.0xS

e

4.0x

4.6x 4.5x

3.9x

4.4x4.6x

4.3x4.5x

70%

80%

90%

3.0x

4.0x

5.0x

enio

r Deb

t as a % oer

age

Mu

ltip

le

2.7x 2.9x3.5x 3.7x 4.0x

2.9x 2.7x3.3x 3.6x

4.1x 3.8x

50%

60%

70%

0.0x

1.0x

2.0x

of T

otal D

ebt

Lev

e

Senior Debt Total Debt Senior Debt % of Total Debt

Source: Thomson ReutersNote: Senior debt includes unitranche facilities

13

Lincoln’s View on Pricing and Terms

Overview of U.S. Middle Market Pricing and Terms

Lincoln’s View on Pricing and Terms

Pricing Multiples

Borrowers with at least $10 - $15mm EBITDA

Multiples

Borrowers with less than $10 - $15mm EBITDA

Pricing

Asset Based Senior

• L + 175 – 250

• LIBOR Floor: none• n/a

• L + 200 – 300

• LIBOR Floor: none• n/a

Cash Flow Senior

Unitranche

• L + 550 – 700

• LIBOR Floor: 100 - 150• 3.00x – 3.50x EBITDA

• L + 750 – 850

• L + 550 – 650

• LIBOR Floor: 100 - 150• 2.00x – 3.00x EBITDA

• L + 750 – 850Unitranche

2nd Lien Loans

• LIBOR Floor: 200

• L + 900 – 1100


• Cash of 11.0% - 12.0%

• 4.00x – 5.00x EBITDA


• Unlikely

• Cash of 11.0% - 13.0%

• 3.50x – 4.50x EBITDA

Sub Debt

Equity

• PIK of 1.5% - 2.5%

• All-in of 12.5% - 14.5%

• n/a • 35% - 40%

• PIK of 2.0% - 3.0%

• All-in of 13.5% - 15.5%

• n/a • 35% - 40%

14

As regularly published in:

Terms Have Become the New Arena for Lenders to Compete

Cov-Lite Loans – Percentage of Outstanding Leveraged Loans

25%25%

30%

16%

20%

10%

15%


• Dividend recaps / Ongoing distributions to

Example Areas of Increased Competition

• Reduced fees (closing pre-payment unusedDividend recaps / Ongoing distributions to shareholders

• Reduced equity contributions

• Looser covenants / Springing covenants /

Reduced fees (closing, pre payment, unused facility)

• Equity cure provisions

• Asset sale provisions – more generous

15

p g gCov-lite

p g

Predictions

Are Borrower Fundamentals Softening?

YoY Performance by Company EBITDA Size

8%

12%

Ch

ang

e

YTD as of June 30, 2012

8%

12%

Ch

ang

e

YTD as of March 31, 2012

-4%

0%

4%

< $10 $10 - $50 > $50

YT

D ‘1

2 vs

YT

D ‘1

1 C

Revenue EBITDA-4%

0%

4%

< $10 $10 - $50 > $50

TD

‘12

vsY

TD

‘11

C

Revenue EBITDA

Loans Outstanding Under Default (Percent of Principal)

Source: Lincoln International Proprietary Database

-8%

Y

12%

-8%YT

10.8%

6%

8%

10%

12%

1.0%

0%

2%

4%

17


Aging of Portfolio Companies Suggests an Increase in M&A Activity

Private Equity Portfolio Inventory by Deal Year

16%

4.2 4.23 9

4.7 4.9

5.3

5.0

6.0

Median Holding Period of Private Equity Investments (Years)

35%

1 – 3 Yrs

8 – 12 Yrs 3.8 3.7 3.7 3.53.9 3.9

2.0

3.0

4.0

49%

4 – 7 Yrs

0.0

1.0

Source: PitchbookNote: As of June 30, 2012

Source: PitchBookNote: 2012 period as of August 31, 2012

Going Forward

Continued strong liquidity and multiple options in mid-market financing

Lenders will not be the hold up on deals

Question is will volume of deals increase ?

18

Question is will volume of deals increase…?

Lincoln International Capital Raising - Bringing Efficiency to the Middle Market

Selected assignments

Private Equity Group Ais acquiringTarget A$20,000,000

Revolving Credit Facility

PENDING Graham Partnershas acquired

which will be combined with its portfolio company

$20,000,000

Private Equity Group D

has acquiredTarget D

$70 000 000

Private Equity Group C

has refinanced portfolioCompany C

$48 500 000

Private Equity Group B

is refinancingCompany B

$100 000 000

PENDING

Private Equity Group EAcquired

T t E

Atlas Holdings has refinanced itsportfolio company

Atlas Holdings has refinanced itsportfolio company

Revolving Credit Facility$33,000,000

Unitranche Term Loan

Insight Equityhas refinanced itsportfolio company

Industrial Opportunity Partnershas acquired

$20,000,000Revolving Credit Facility

$35,000,000Term Loan

$70,000,000Unitranche Term Loan

$48,500,000Senior Secured Credit

Facilities

$100,000,000Unitranche Term Loan

Atlas Holdings

Target E$45,000,000



Industrial Opportunity P t

$45,000,000Senior Credit Facilities

$38,000,000Senior Subordinated Notes

$10,000,000Preferred Equity

$70,000,000Senior Credit Facility

Gridiron CapitalExponent Private

$135,000,000Revolving Credit Facility

$5,000,000Junior Capital



Private Equity G F

ghas refinanced itsportfolio company

$50,000,000Senior Credit Facility

Partners has refinanced itsportfolio company



phas acquired

and

Senior Credit Facilities

pEquity

has financed the U.S. subsidiary of its

portfolio company

Senior Credit Facility

Group FAcquired

Target F$20,000,000


Unitranche Term LoanSenior Credit Facility

Marlin Equity Partners

has acquired

Revolving Credit Facility

Junior Capital

Bayside Capital has refinanced itsportfolio company


Platinum Equityhas refinanced itsportfolio company

Senior Credit Facility

Shareholdershave refinanced


Sun Capitalhas refinanced itsaffiliate company

19

Revolving Credit Facilityand






$28,000,000Second Lien Facilities


Lincoln’s Debt Advisory Group adds the following value to each assignment:

• Robust process ensures best available pricing and terms• Strong relationships with over 300 capital sources throughout the worldg p p g• Multiple capital structure alternatives are generated which enhances certainty of closing• Provides clients with transparency and control over financing process• Lincoln’s independence assures there is no conflict of interest• Maximum leverage of time and resources for management team and financial sponsor

DEBT ADVISORY GROUP

Lincoln International U.S. DAG Team International DAG Heads

Ron KahnManaging Director

Robert HorakManaging Director

Christine TiseoDirector

Jonathan BroomeManaging Director – U KManaging Director

(312) [email protected]

Managing Director(312) 580-2804

[email protected]

Director(312) 580-6287

[email protected]

Managing Director U.K.+44 (0) 20 7632 [email protected]

Natalie MarjancikVice President(312) 506-2729

David GrahamAssociate

(312) 506-2757

Jon ParisAssociate

(312) 506-2725

Serge PalleauManaging Director - France

+33 (1) 53 53 18 [email protected] [email protected] [email protected] [email protected]

Dylan LyonsAnalyst


Justin MalinaAnalyst


Steve YanAnalyst


Dominik SpanierManaging Director - Germany

+49 (69) [email protected]

Business AcquisitionsBusiness AcquisitionsAccounting, Tax and Due DiligenceSeptember 12, 2012

© 2012 McGladrey LLP. All Rights Reserved.© 2012 McGladrey LLP. All Rights Reserved.

Financial Due Diligence

Andy Jenkins, Director - McGladrey

© 2012 McGladrey LLP. All Rights Reserved.

y , yLLP

Agenda

Due diligence overviewg

Focus areas

Other diligence items

Dead deals and other deal issues


2

Due Diligence Overview

What is it: Review of a target company’s financial, operational, customers and markets, legal, tax, HR and IT functions prior to the completion of a transaction.

Note due diligence is different than a financial statement audit

Who needs it: Buyers, outside investors, lending institutions, Sellers

Why is it done: to ensure a target company is “as advertised”


3

Due Diligence Overview

Due Diligence Timeline

1 - 60 days 61 90 days 60 - 90 days 1-3 years

LOI signed

DD f indings and reports

communicated to interested

ClosingPost-closing

NWCadjustmentVarious due

diligencePost closing working capital Earn-outs

Earn-outsand escrow

items settledQ of E rollforward;purchase agreement

1 - 60 dayspost LOI

61 - 90 days post LOI

60 - 90 days post closing

1-3 years post closing

to interested parties

submitteddiligence performed

working capitaladjustment computed, roll-forward of Q of E

computed (if applicable)

items settledpurchase agreement terms negotiated and Target NWC set


4

Focus Area - Quality of Earnings

Adjusted EBITDA drives Quality of Earnings

valuation

EBITDA adjustment types:

Management adjustments

US$ in thousands FY10 FY11 LTM12

Net sales 22,000$ 24,000$ 26,000$

EBITDA, as reported 4,000 3,600 4,600 EBITDA %, as reported 18.2% 15.0% 17.7%

Total management adjustments 140 590 445

Due diligence adjustments

Pro forma adjustments

Other cash flow considerations

Management adjusted EBITDA 4,140 4,190 5,045 Management adjusted EBITDA % 18.8% 17.5% 19.4%

Total due diligence adjustments (575) (500) (1,050)

Adjusted EBITDA 3,565 3,690 3,995

EBITDA approximates cash flow – however a free cash flow analysis may yield different

Adjusted EBITDA % 16.2% 15.4% 15.4%

Total Buyer pro forma adjustments 225 350 400

Pro forma EBITDA 3,790$ 4,040$ 4,395$ Pro forma EBITDA % 17.2% 16.8% 16.9%Other cash flow considerations

results 1. Capital expenditures (1,500) (1,000) (300)$


5


Management Adjustments: Quality of EarningsUS$ in thousands FY10 FY11 LTM12

Owner / executive compensation

Personal expenses

Transaction / legal / accounting fees

Net sales 22,000$ 24,000$ 26,000$


Management's adjustments1. Excess compensation 200 500 250 2 T ti f 50 20

Closed / opened branch costs

Legal settlements

Revenue deferrals for tax purposes

2. Transaction fees - 50 20 3. Personal expenses 15 25 20 4. EBITDA from closed branch (75) 15 155


Management adjusted EBITDA 4,140 4,190 5,045 Management adjusted EBITDA % 18 8% 17 5% 19 4%

Typically, the valuation in the LOI takes management adjustments into consideration

Management adjusted EBITDA % 18.8% 17.5% 19.4%


Adjusted EBITDA 3,565 3,690 3,995 Adjusted EBITDA % 16.2% 15.4% 15.4%


Due diligence should substantiate these adjustments


Pro forma EBITDA 3,790$ 4,040$ 4,395$ Pro forma EBITDA % 17.2% 16.8% 16.9%Other cash flow considerations1. Capital expenditures (1,500) (1,000) (300)$


6


Due diligence adjustments: Quality of EarningsUS$ in thousands FY10 FY11 LTM12

Accounting oriented:

Interim true-ups (bonuses, reserves, etc.)

Inventory valuation

Net sales 22,000$ 24,000$ 26,000$



M t dj t d EBITDA 4 140 4 190 5 045 Accrual / reserve reversals

Revenue recognition

Adjustments to management adjustments

Management adjusted EBITDA 4,140 4,190 5,045 Management adjusted EBITDA % 18.8% 17.5% 19.4%

Due diligence adjustments1. Bonus accrual - - (100) 2. Bad debts (50) - (125) 3 Unsustainable margins w/top customer (250) (300) (350)

Business related

Lost customers

Unsustainable margins or cost cuts

3. Unsustainable margins w/top customer (250) (300) (350) 4. Capitalized inventory variances (200) - (200) 5. Drop ship revenue recognition (75) (100) (150) 6. Adjust excess comp for owner draws - (150) (75) 7. R&M improperly expensed - 50 (50)




Pro forma EBITDA 3,790$ 4,040$ 4,395$ Pro forma EBITDA % 17.2% 16.8% 16.9%


7

Other cash flow considerations1. Capital expenditures (1,500) (1,000) (300)$


Quality of EarningsUS$ in thousands FY10 FY11 LTM12 Buyer / pro forma adjustments:Net sales 22,000$ 24,000$ 26,000$



M t dj t d EBITDA 4 140 4 190 5 045

Synergies

Scaled pricing

Eliminated positions or facilitiesManagement adjusted EBITDA 4,140 4,190 5,045 Management adjusted EBITDA % 18.8% 17.5% 19.4%



Identified during diligence

New / lost major customer

Audit and tax fees

Buyer pro forma adjustments1. Buyer material pricing 100 150 175 2. Eliminated positions 125 200 225 3. Buyer EE benefits NQ NQ NQ


$ $ $

Open positions

Known cost increases (insurance e.g.)

Pro forma EBITDA 3,790$ 4,040$ 4,395$ Pro forma EBITDA % 17.2% 16.8% 16.9%Other cash flow considerations1. Capital expenditures (1,500) (1,000) (300)$


8

Focus Area - Net Working Capital

Net working capital due diligence Quality of Working CapitalUS$ in thousands 12/31/11 6/30/12

consists of the following:

Understanding normalized working capital needs and monthly trends

Identifying adjustments to reported working

Current assets 9,769$ 12,750$ Current liabilities 3,664 5,916 Rounding difference - - Working capital, unadjusted 6,105 6,834

AdditionsLine of credit 1,269 1,000 Identifying adjustments to reported working

capital (Quality of Net Working Capital)

Assistance with setting a net working capital target or peg

Shareholder loans payable 1,500 1,500 Income taxes payable 123 338 Accrued interest 2 20

DeductionsCash (119) (183) Deferred income tax (126) (126)

What is a NWC peg?

When should the peg be established?

How is peg established?

Working capital, as defined per LOI 8,754 9,383

Due diligence adjustments:1. Bonus accrual - (300) 2. Bad debt reserve - (125) 3. Capitalized inventory variances - (100) 4. Drop ship revenue recognition (300) (225)

Why is it important? Total due diligence adjustments** (300) (750)

Net working capital, as adjusted** 8,454$ 8,633$


9

Focus Area - Net Working Capital

Monthly Trade Working Capital (Excluding Cash and Interest-Bearing Debt)US$ in thousands Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 6-m 12-m

Current assetsAcco nts recei able 1 364$ 1 651$ 1 386$ 1 353$ 1 607$ 1 294$ 1 595$ 1 925$ 1 617$ 1 528$ 1 607$ 1 294$ 1 594$ 1 437$

Averages

Accounts receivable 1,364$ 1,651$ 1,386$ 1,353$ 1,607$ 1,294$ 1,595$ 1,925$ 1,617$ 1,528$ 1,607$ 1,294$ 1,594$ 1,437$ Inventory 3,176 3,038 3,254 3,589 3,754 3,870 3,756 3,877 4,016 4,014 3,754 3,870 3,881 3,523 Prepaid & other assets 74 55 33 31 47 54 62 65 77 73 47 54 63 65

Total 4,614 4,744 4,673 4,974 5,408 5,217 5,412 5,867 5,710 5,615 5,408 5,217 5,538 5,025

Current liabilitiesAccounts payable 886 539 761 975 852 679 654 616 753 631 852 679 697.4 705

T d W ki C it l A l i

Accounts payable 886 539 761 975 852 679 654 616 753 631 852 679 697.4 705 Accrued expenses & other 262 274 182 156 176 177 189 175 145 157 176 177 169.8 194

Total 1,148 813 943 1,131 1,027 856 843 791 899 788 1,027 856 867 899

Trade working capital 3,467$ 3,930$ 3,731$ 3,843$ 4,381$ 4,361$ 4,569$ 5,076$ 4,812$ 4,827$ 4,381$ 4,361$ 4,671$ 4,126$

$1,000

$1,200

$1,400

$1,600

$4,000

$5,000

$6,000

Re

ven

ue

(Ung

Ca

pita

l (U

S$

in

ou

san

ds)

Trade Working Capital Analysis

Net sales Trade working capital

$-

$200

$400

$600

$800

$-

$1,000

$2,000

$3,000

Jul 10 Aug 10 Sep 10 Oct 10 Nov 10 Dec 10 Jan 11 Feb 11 Mar 11 Apr 11 May 11 Jun 11 Jul 11 Aug 11 Sep 11 Oct 11 Nov 11 Dec 11 Jan 12 Feb 12 Mar 12 Apr 12

US

$ in

tho

usa

nd

s)T

rad

e W

ork

ith

o


10

Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12

Focus Area – Debt Like Items

Proper identification of debt-like items has a cash impact on a cash-free debt-free deal

Debt-like items often buried in accounts payable and accrued expenses

Liabilities are either working capital items or debt (not both)

Cacluation of Net Proceeds

US$ in thousands W/O debt like W/ debt like

Liabilities are either working capital items or debt (not both)

Purchase price 30,000$ 30,000$ Less Seller rollover - 10% (3,000) (3,000) Less reported debt (1,900) (1,900) Estimated delivered NWC 1 500 3 000Estimated delivered NWC 1,500 3,000 Less NWC Peg (1,400) (2,900) Identified debt-like items - (1,500) Cash on hand at closing 1,000 1,000 Net Seller proceeds 26,200$ 24,700$


et Se e p oceeds 6, 00$ , 00$

11

Focus Area – Debt Like Items

Common debt-like items: Debt and Debt-Like ItemsUS$ in thousands 6/30/12

Compensation (shareholder bonuses, accrued severance, deferred compensation, and others)

Legal settlements

US$ in thousands 6/30/12

Line of credit 950$ Term notes payable 300 Deferred compensation 600 Accrued interest 50 Legal settlements

Tax related liabilities

Termed accounts payable (including credit card debt in excess of 30 days)

Total debt, reported 1,900

Debt like items:1) Deferred comp. included in accrued bonuses 270 2) Shareholder notes included in accrued CAM 800

Shareholder payables

Certain royalty liabilities

Liabilities associated with certain cash transactions (customer deposits e g )

3) Sublessee rent deposit 50 4) Selling expenses included in accounts payable 30 5) Accrued audit fees in excess of one year 25 6) Facility closure liabilities 225 7) Accrued severance included in accrued wages 100 8) Open litigation claim NQtransactions (customer deposits e.g.) 8) Open litigation claim NQ

Total debt like items 1,500

Total adjusted debt 3,400

Cash, reported 1,000

$


12

Adjusted net debt 2,400$

Focus Area – Tax

Federal taxation

Review of tax assets / liabilities acquired / sold

Structuring

Step-up and 338(h)(10) calculations

Review of compliance procedures

Identification of potential tax liabilities of Target

State and local taxation

Review of state, local, payroll, and sales and use tax compliance procedures

High level nexus assessment

Identification of potential tax liabilities of Target

International

Transfer pricing


13

Focus Area – Reps and Warranties

Purchase agreements typically contain a standard representation on the financial statements and standard indemnification for pre-closing tax liabilities

Other rep and warranty needs may be identified:

No personal guaranties or liabilities reside with related parties

Carve-out financials

Indemnification for pending litigation

Representation on equipment available for use

Representation on unreported on contingent liabilities

Environmental representation

Government filing compliance


14

Other Diligence Items

Sell-side diligence

IT diligence

Operations

f Performance improvement

Human Resources

Customer / Vendor diligenceCustomer / Vendor diligence

Environmental

Insurance


15

Dead deals and other deal issues

Dead deals: Other deal issues:

Q of E (adjusted EBITDA)

Tax liabilities and issues

Customer and vendor contract

Inventory build

Deferred revenue and customerdeposits Customer and vendor contract

issues

Seller or Buyer cold feet

Investment committee decision

Cash left in business

Natural disaster implications

Net working capital and earn-out Investment committee decision Net working capital and earn-out settlements

Cash basis accounting

Carve-outsCarve-outs


16

Questions?

For more information please contact:p

Andy [email protected]

312.634.3178


17

Experience the power of being understoodsm

About McGladrey

McGladrey LLP is the fifth largest U.S. provider of assurance, tax and consulting services, with nearly 6,500 professionals and associates in more than 70 offices nationwide. McGladrey is a licensed CPA firm.

It is the U.S. member of RSM International (“RSMI”), the sixth largest network of i d d t ti t d lti fi ld id ith ffi iindependent accounting, tax and consulting firms worldwide, with offices in more than 85 countries and more than 32,000 people to serve clients’ business needs. The member firms of RSMI collaborate to provide services to global clients, but are separate and distinct legal entities which cannot obligate each other. Each member firm is responsible only for its own acts and omissions, and not those of any other partyparty.

Our practice areas include:- Assurance- Tax- Consulting- Wealth Management- International Business Follow us on:


18

McGladrey LLP is the U.S. member of the RSM International (“RSMI”) network of independent accounting, tax and consulting firms The member firms of RSMI collaborate to provide services to global clients but are separate and

McGladrey LLPconsulting firms. The member firms of RSMI collaborate to provide services to global clients, but are separate and distinct legal entities which cannot obligate each other. Each member firm is responsible only for its own acts and omissions, and not those of any other party.

McGladrey, the McGladrey signature, The McGladrey Classic logo, The power of being understood, Power comes from being understood and Experience the power of being understood are trademarks of McGladrey LLP.


One South Wacker Drive, Ste. 8o00Chicago, Illinois

312.634.3400

800.274.3978www.mcgladrey.com


Performance Improvement Solutions

S t b 12 2012

Performance Improvement SolutionsPresented by Tom Byrne

September 12, 2012


Pre-AcquisitionO ti d dili- Operations due diligence• Independent high-level review of functional areas

• Detailed review of specific areas of concern or opportunity

• Preliminary post-closing operational improvement opportunities


Post–Acquisition: Maximizing Portfolio Value R id A t- Rapid Assessment• “Quick hit” diagnostic identifying issues and

opportunities

• Industry outlook

• Financial performance

• High-level processesg p

• IT

• Organizational structure

• Business risks and controls• Business risks and controls


Post–Acquisition: Maximizing Portfolio Value O ti l I t A i t- Operational Improvement Assistance• Finance and accounting transformation

• Working capital management

• Purchasing and cost management

• Production and distribution

• Sales and marketingSales and marketing

• Specialized industry services


Post–Acquisition: Maximizing Portfolio Value O ti l d Fi i l R ti- Operational and Financial Reporting• Daily, weekly, monthly metrics

• Financial reporting enhancements

• Benchmarking analysis

• Customer and product profitability analysis

• Cost accounting and analysisCost accounting and analysis


Post–Acquisition: Maximizing Portfolio Value B i I t ti- Business Integration• Scenarios

o Merger integration of add-on acquisition

o Corporate carve-out support

o Consolidation of functional activities

• Areas of SupportAreas of Support

o Synergy identification and implementation

o Project management support

T iti l i d t i io Transition planning and training

o Business process transformation

o IT planning, implementation, and transition support


Capabilities- 100+ performance improvement professionals100 performance improvement professionals- Finance, integration, operations and industry

specialists- Experienced operating executives with relevant- Experienced operating executives with relevant

industry experience- Multi-disciplinary integration teams and project

managers with proven methodologiesmanagers with proven methodologies- Deep middle-market industry experience

• HealthcareBusiness services• Business services

• Financial services• Manufacturing• Distribution• Distribution


Representative transactions- $30 million distributor with shrinking profits

• Operational assessment identified issues with product location, cycle count errors and procedure non-compliance

• Recommended changes reduced operating expenses $800K+ per year

PE d d f i h d h ll ith- PE owned defense services company had challenges with month-end financial close and reporting• Assessed process, identified solutions and oversaw

implementation• Reduced cycle time of monthly close to 7 days

- PE owned $40 million company acquired $40 million carve out of Fortune 500 company• IT infrastructure design and implementation, communication g p ,

plan and business process redesign• Allowed both companies to run autonomously with minimal

disruption to ongoing business

Contact the PI Team

Tom Byrne – Director, Performance Improvement ConsultingImprovement Consulting- Chicago Office

- Direct: 312-634-4734Direct: 312 634 4734

- Mobile: 312-519-1316

- Email: [email protected] @ g y

McGladrey is the brand under which McGladrey LLP serves clients’ business needs M Gl d LLPMcGladrey is the brand under which McGladrey LLP serves clients business needs.

McGladrey LLP is the U.S. member of the RSM International (“RSMI”) network of independent accounting, tax and consulting firms. The member firms of RSMI collaborate to provide services to global clients, but are separate and distinct legal entities which cannot obligate each other. Each member firm is responsible only for its own acts and omissions, and not those of any other party.

McGladrey, the McGladrey signatures, The McGladrey Classic logo, The power of being understood, Power comes from being understood and Experience the power of being understood are trademarks of McGladrey LLP

McGladrey LLP

3600 American Blvd WBloomington, MN 55431

952.921.7700

www.mcgladrey.comfrom being understood and Experience the power of being understood are trademarks of McGladrey LLP.


Business Acquisitions: Accounting, Tax and Due DiligenceA i iti T I

S t b 12 2012

Acquisition Tax IssuesPresented by: David Sterling, Federal Tax

John Wozniczka, State & Local Tax

September 12, 2012

Assurance ■Tax ■ Consulting

Acquisition Tax Issues

Step-Up In Tax Basis Section 338(h)(10) Election( )( ) Transaction Costs Golden Parachute Payments Net Operating Loss CarryforwardsNet Operating Loss Carryforwards Nexus Sales and Use Tax Exemption for Sale of

Business AssetsBusiness Assets Entity Level Taxes Structuring Debt for State and Local Income Tax Treatment of Gain or Loss from Installment Sale Treatment of Gain or Loss from Installment Sale Successor Liability Indemnification

2

Step-Up In Tax Basis

Depreciation and amortization on a step-up in tax basis minimizes income taxes

Step-up in tax basis transactions:- Asset purchase- Purchase of limited liability company orPurchase of limited liability company or

partnership interests- Purchase of stock of a subsidiary of a

consolidated group or an S Corporation with a g p pSection 338(h)(10) Election

Disallowance of goodwill amortization in rollover transactions where the goodwill was owned by the g yselling company before August 10, 1993, and owners of the selling company own more than 20 percent of the acquiring company

3

Section 338(h)(10) Election

Validity of S Election Built-In Gains TaxBuilt In Gains Tax Corporate Level State Taxes (e.g., California,

Illinois) St t I T Withh ldi State Income Tax Withholding Reimbursement for state taxes triggered by the

election- Ordinary Income (e.g., Depreciation Recapture,

Inventory)- Additional state income taxes if shareholderAdditional state income taxes if shareholder

resident state tax rates are lower than the tax rates of the states that the corporation files in

4

Transaction Costs

In an asset purchase, transaction costs are added to the basis of assets acquiredadded to the basis of assets acquired In a stock acquisition, expenses incurred by

an acquired corporation for due diligence q p gservices rendered before the letter of intent date may be deductible St k h t l Stock purchase agreements commonly

require the buyer to pay any income tax savings realized by the acquired corporation g y q pfor the deduction of its transaction costs to the seller

5

Investment Banking Fees

An investment banking fee which is contingent on the successful closing of acontingent on the successful closing of a transaction is a “success-based fee” Documentation must be completed on or p

before the due date of the taxpayer's timely filed original federal income tax return (including extensions) for the taxable year(including extensions) for the taxable year during which the transaction closes to establish that a portion of a success-based fee is allocable to activities that do not facilitate the transaction

6


A letter from the investment banking firm which documents the percentage of time spent on

f ilit ti ti iti b f th l tt f i t tnonfacilitative activities before the letter of intent date (e.g., preparation of the offering memorandum, identification and qualification of potential buyers, evaluation of offers) is normally used to meet thisevaluation of offers) is normally used to meet this documentation requirement

However, documentation should be accumulated and retained to support an investment banker’sand retained to support an investment banker s letter (e.g., investment banker presentations, the investment banker’s engagement letter, transaction timeline, correspondence, minutes of meetings,timeline, correspondence, minutes of meetings, documentation of discussions with investment bankers)

7


Normally, approximately 70 percent of investment banking activities are nonfacilitative and, hence, d d tibldeductible

Under Revenue Procedure 2011-29, which is effective for success-based fees paid or incurred in taxable years ending on or after April 8, 2011, a taxpayer may make a safe harbor election to treat 70 percent of success-based fees as nonfacilitative and hence deductibleand, hence, deductible.

A taxpayer must attach a statement to its original federal income tax return for the taxable year the

b d f i id i d t ti th tsuccess-based fee is paid or incurred, stating that the taxpayer is electing the safe harbor, identifying the transaction, and stating the success-based fee amounts that are deducted and capitalizedamounts that are deducted and capitalized.

8

Golden Parachute Payments

Section 280G disallows a corporation’s deduction and Section 4999 imposes a 20%deduction and Section 4999 imposes a 20% excise tax [a combined 100% tax rate] on Excess Parachute PaymentsExcess Parachute Payments Excess Parachute Payments must be:

- CompensationCompensation- Paid to a disqualified individual- Contingent on a change in control- More than three times the base amount [3 X the

individual five-year average compensation]

9

Golden Parachute Payments

Exceptions:R bl ti- Reasonable compensation

- Payments from qualified plans- Payments from a corporation which qualifies toPayments from a corporation which qualifies to

elect S Corporation status- Payments from a privately held corporation

which are approved by shareholders who possess more than 75 percent of the corporation’s voting powercorporation s voting power

10

Net Operating Loss Carryforwards

Section 382 imposes an annual limitation on the use of an acquired corporation’s net operatinguse of an acquired corporation s net operating loss carryforwards (NOLs) after certain more-than-50% changes in its ownership which occur over a three-year period The annual limit is equal to the long-term tax-

t b d t ti th f i k t l fexempt bond rate times the fair market value of the acquired corporation’s stock immediately before the ownership change (but after anybefore the ownership change (but after any redemption connected with the ownership change) plus any recognized built-in gains

11

Net Operating Loss Carryforwards

If an acquired corporation’s business enterprise is not continued for two yearsenterprise is not continued for two years after the ownership change, its NOLs are disallowed except for recognized built-indisallowed except for recognized built in gains The same set of rules applies to ownership pp p

changes resulting from both stock purchases and tax-free reorganizations

12

Nexus

Nexus You have to have it!You have to have it! - The ultimate state and local tax issue When do I have it?

- Income tax and sales/use tax nexus standards are different

What is “substantial nexus”?What is substantial nexus ? - Expanding definitions for nexus standards

• Economic nexus, affiliate nexus, agency nexus, etc

Wh t th ? What are the consequences?

13

Asset Sale

Sales and Use Tax Exemption for Sale of Business Assets Many states provide for an “occasional sale”

sales tax exemption for the sale of operating assetsassets Occasional sale exemption does not apply to

inventory or automobilesinventory or automobiles Inventory can qualify for a sales tax exemption

if a resale certificate is provided at the time ofif a resale certificate is provided at the time of sale

14

Sales Tax Exemption for Inventory

State registration number is required in order t i l tifi tto issue a resale certificate Registration process normally takes 4-6

k h t t hweeks; however, some states have more expedient means of registration A corporation acquiring inventory should A corporation acquiring inventory should

begin the registration process as soon as possible to avoid delaying the transactionpossible to avoid delaying the transaction

15

Entity Level Taxes

Gross Receipts Taxes- In recent years some statesstarted to abandon the traditional income taxstructures and impose tax on the gross receipts ofthe entity. Such taxes apply to all entities, includingcorporations, S corporation, partnerships, etc. As

h t fili i th i t t t tsuch, not filing in the appropriate states can createliabilities even if the target does not have anytaxable income.

F hi T P t i iti f hi t Franchise Taxes- Post-acquisition franchise taxes(privilege taxes) should be considered as a result ofGAAP purchase price accounting. Purchase priceaccounting causes the book net worth of the targetaccounting causes the book net worth of the targetto increase and, therefore, increases the basesubject to tax.

16

Structuring Debt for State and Local Income Tax

Placing the debt in the operating entity will i i i t t i t i t t th tminimize state income tax in states that

require separate company income tax filings C ti i d ti t Converting an acquired corporation to a

single member limited liability company owned by a debt holding parent can result inowned by a debt holding parent can result in reduced state income tax expense

17

State Dividend Received Deduction

Some states provide limited dividend received deductions (e g Massachusetts Mississippideductions (e.g., Massachusetts, Mississippi, Oregon) which makes dividends paid to a parent corporation to pay debt service partially taxable

Debt incurred by the acquired corporation to pay its parent’s purchase obligation results in a deemedparent s purchase obligation results in a deemed dividend of the debt which is taxable in California if it is not paid from the new unitary group’s earnings and profits

18

Treatment of Gain or Loss from Installment Sale

Used to reduce certain state tax liability of flowUsed to reduce certain state tax liability of flow through entities− 1st Year – Gain recognized at entity level− Subsequent Years – Gain recognized at

owner level (if entity is properly liquidated)

Caution: Not Treated Consistently in All States− Example: IL – Same as federalExample: IL Same as federal− Example: CA – All gain included in final entity

return

19

Successor Liabilities

Stock Purchases− Tax liabilities transfer to Buyera ab t es t a s e to uye− Use indemnities/escrow to recover from the seller

Asset Purchases− All trust taxes (i.e., sales/use, withholding, etc.)

transfer to Buyer− Other taxes (e.g., income tax) can transfer in certain

states (e g Illinois)states (e.g., Illinois)

Ways to Limit Liability− Comply with bulk sale reporting requirementsp y p g q− Request tax clearance certificate(s)− Withhold outstanding liabilities from purchase price

20

Successor Liabilities

Indemnification− General− Specific (e.g., sales tax)− Consideration inclusion of compliance costs− Time period for indemnification

Escrow− Identify needIdentify need− Determine reasonable amount

21

Questions????Questions????

Thank you

22

Business Acquisitions – Smart Accounting and

Presented by: Steven Koltun Partner

Business Acquisitions Smart Accounting and an Efficient Audit in Year of the Deal

Presented by: Steven Koltun, Partner, McGladrey LLP

© 2012 McGladrey LLP. All Rights Reserved.© 2012 McGladrey LLP. All Rights Reserved.

Agenda

• Acquisition set to close – To-Do’s!• Acquisition accounting under ASC 805 (formerly

FAS 141R)• Key current issues• Key current issues

− Transaction expenses− Contingent consideration− Equity rollover/Non-controlling interests− Working capital adjustments− Provisional amounts/Measurement period adjustmentsProvisional amounts/Measurement period adjustments− Bargain purchases


1

Acquisition Set to Close: Accounting To-Do’s!

• Verify a “business combination” as defined by GAAP has occurredhas occurred

• Determine audit needs • Coordinate inventory observationsy• Hard cutoff (close the period) as of effective deal

date• Download sub ledgers details as of deal date• Download sub-ledgers, details, as of deal date• Obtain CD of all deal documents• Revisit credit agreement definition of EBITDA g


2

Acquisition Set to Close: Accounting To-Do’s! (Continued)

• Determine approach to valuing intangible assets andDetermine approach to valuing intangible assets and other valuation matters; engage valuation specialists if needed

• Categorize and summarize deal costs• Categorize and summarize deal costs• Complete working capital adjustment calculations • Recognize entries to reflect opening balance sheet at g p g

fair value • Account for share based compensation awards (i.e.

stock options, warrants)stock options, warrants)


3

Has a Business Combination Occurred?

• Business - “An integrated set of activities and gassets that is capable of being conducted and managed for the purpose of providing a return or economic benefit to investors owners oreconomic benefit to investors, owners or participants.”

• Business combination - “A Transaction or other event in which an entity obtains control of one or more businesses.”− Control measured by having over 50% of voting sharesControl measured by having over 50% of voting shares− Transactions between entities under common control are

not business combinations


4

Determine Audit Needs and Reporting Needsp g

• For add-on acquisitions:− Often no audit report issued as of the deal date− Often no audit report issued as of the deal date− Company’s consolidated year-end report includes

operations of the newly acquired entity from deal date through year-end

− Working capital calculation assistance needed? − Opening balance sheet audit procedures performed

• For platform acquisitions:− Which entity to be reported on? Parent holding company or

operating company? − Closing balance sheet to be audited?− Closing balance sheet- to be audited?− Working capital calculation assistance needed?− Opening balance sheet – report needed?


5

Reporting Needs for Platform Acquisitions

• Financial statement presentation in the year of the p yacquisition− Audited financial statements typically for the period of

acquisition date through year-endacquisition date through year end− If 12 month income statement requested, supplementary

section at back of report is an option − Can also present “predecessor” basis column in the main− Can also present predecessor basis column in the main

financial statements; requires additional audit work as of deal date


6

Inventory Observationsy

• If inventory is significant to the financial statements, then key locations to be counted

• If perpetual is highly accurate, can be relied upon


7

Cutoff as of Effective Deal Date

• Operations of acquired entity (P&L) start over as of effective date

• Download sub-ledgers and details:− Accounts receivableAccounts receivable− Property and equipment - (if not appraised)− Inventories

A bl− Accounts payable− Accrued expenses− Other


8

Closing Documents and Agreementsg g

• Obtain a CD of all deal documents and provide to auditorsauditors

• Should include the following:− Purchase agreement− Credit agreement, including any mezzanine credit

agreements− Operating agreements, Articles of Incorporation, etc.− Funds flow− Capitalization table− Management services agreementsManagement services agreements− Key employee agreements (i.e., stock options)


9

Revisit Credit Agreement Definition of EBITDA

• Consider potential impacts on EBITDA that will p presult from the acquisition- Transaction expenses

Expense related to future increase/decrease in earn out- Expense related to future increase/decrease in earn-out liability

- Expense related to “compensation” to Sellers, that is not considered to be “purchase price”considered to be purchase price


10

Engage a Valuation Specialistg g p

An outside specialist may be necessary to value: p y y• Intangible assets

− Company can potentially do internally prepared valuation of intangibles, heavily dependent upon on certain factors including:◦ Significance of acquisition value ◦ Add-on versus platform deal

C l it f i t ibl i l d◦ Complexity of intangibles involved◦ Expertise of individuals preparing the valuations

• Property and equipment• Contingent consideration (earn-outs)• Equity rollovers• Derivatives


11

Engage a Valuation Specialist (Continued)g g p ( )

• Ensure the valuation scope is sufficientp• Ensure methodologies being utilized are

appropriate• Up front communication between the Company, the

valuation specialist and audit team


12

Remaining To-Do’sg

• Acquisition cost break-out• Working capital adjustment calculations• Recognize entries on OBS at fair value• Account for share based compensation


13

Acquisition Accounting

• Accounting - Four Basic Steps1. Identify acquirer2. Determine acquisition date3. Recognize and measure, at FV:3. Recognize and measure, at FV:

• Assets acquired• Liabilities assumed

Non controlling interest if an• Non-controlling interest, if any4. Recognizing goodwill

• Or gain from bargain purchase


14

Step 1 - Identify the Acquirerp y q

• An acquirer must be identified for all purchase transactions

• Which entity is acquirer? Not always readily apparentapparent

• If purchase price is paid by cash or assuming liabilities……identification usually easy- Entity that distributes cash or incurs liabilities = acquirer


15

Step 2 - Determine Acquisition Datep q

• Acquisition date is the date the acquirer obtains control

• Generally, control is obtained on the closing dateAcquirer legally transfers consideration and- Acquirer legally transfers consideration, and

- Acquires assets and assumes liabilities of acquiree


16

Determine Acquisition Dateq

• The acquisition date is important because on this date:- FV of the acquired business is measured- FV of the acquirer’s equity securities issued to the seller isFV of the acquirer s equity securities issued to the seller is

measured- FV value of the assets acquired and liabilities assumed is

measuredmeasured- The acquirer begins consolidating the acquired entity’s

financial position, results of operations, and cash flows


17

Step 3 - Recognize Assets Acquired, Liabilities Assumed

• Acquirer must recognize the fair value on the acquisition date of the business as a whole- Regardless of whether purchasing some (or all) of

acquiree’s equity interestsq q y

• All of the goodwill of the acquiree’s business, not just the acquirer’s share, is recognized


18

Definition of Fair Value

The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date• Market participants include all potential buyers, financial or

strategic• Fair value assumes the transaction to sell the asset occursFair value assumes the transaction to sell the asset occurs

in the principal market for the asset or, in the absence of a principal market, the most advantageous market for the asset


19

Recognize Assets Acquired and Liabilities Assumed

• Tangible assets- Financial assets such as accounts receivable- Inventory, equipment, real estate

• Intangible assets- Customer lists trademarks non competes- Customer lists, trademarks, non-competes

• Liabilities assumed- Accounts payable

A d- Accrued expenses- Debt- Deferred income taxes

• Goodwill- A residual calculation, remainder to goodwill


20

Recognize Assets Acquired and Liabilities Assumed (Continued)(Continued)

• Certain accounts may carry-forward at their existing l th l i b l h t if th ivalue on the closing balance sheet if there is no

difference or immaterial difference between book value and fair value, including:- Accounts Receivable, Prepaid Expenses, Accounts Payable

and Accrued Expenses• Typical Liabilities that aren’t “assumed” by acquiring

CCompany- Deferred gains- Straight Line Rent Accrual

• These items do not obligate the acquiring company to provide future services or goods nor do they represent a call on the acquiring company’s assets


p q g p y

21

Recognize Assets Acquired and Liabilities Assumed (Continued)

• Typical “Step-ups” to Fair Valueyp p p- Identifiable Intangibles- Property and Equipment- Finished Goods Inventories- Finished Goods Inventories- Deferred income taxes


22

Recognizing Fair Value of Intangiblesg g g

• Identifiable intangible assetsA i t ibl t i i d t t f- An intangible asset is recognized as an asset apart from goodwill if:

- It arises from contractual or other legal rightsR dl f h h h i h f bl◦ Regardless of whether those rights are transferable or separable from the acquired entity

- If no contractual or legal right, there may still be an asset◦ Must be capable of being separable from the entity and

sold or otherwise transferred◦ Workforce is not considered a separate intangible from

goodwill


23

Intangibles

• Marketing-related- Trademarks internet domain names non-competeTrademarks, internet domain names, non compete

agreements

• Customer-relatedC− Customer relationships, backlog, customer contracts

• Contract-based- License agreements, lease agreements, franchiseLicense agreements, lease agreements, franchise

agreements

• Technology-basedP t t t ft t d t t t d- Patents, computer software, trade secrets, unpatented technology


24

Intangibles (Continued)g ( )

• How to value? - Engage a experienced third-party specialist to perform a

valuation of intangibles- These intangibles will typically be amortized over their g yp y

useful life- Useful life is the period over which the asset is expected to

contribute to future cash flows of the entityy


25

Recognizing Fair Value of Plant and Equipmentg g q p

• Plant and equipment - valued at current replacement cost for similar capacity

• Obtain third party appraisal of property and equipment if significant to the financial statementsequipment if significant to the financial statements

• Appraiser to be engaged to value the assets at replacement cost

• Accumulated depreciation reset to zero


26

Recognizing Fair Value of Inventories g g

Inventories(1) Fi i h d d d h di t ti t d lli i l(1) Finished goods and merchandise at estimated selling prices less the sum of (a) costs of disposal and (b) a reasonable profit allowance for the selling effort of the acquiring entity(2) Work in process at estimated selling prices of finished goods less(2) Work in process at estimated selling prices of finished goods less the sum of (a) costs to complete, (b) costs of disposal, and (c) a reasonable profit allowance for the completing and selling effort of the acquiring entity based on profit for similar finished goods(3) Raw materials at current replacement costs

• LIFO reserve resets to zero


27

Allocate Purchase Price - Deferred Taxes

• Business combination may either be a taxable or a nontaxable transaction:- Taxable business combinations:

◦ Purchase price is allocated to assets acquired andPurchase price is allocated to assets acquired and liabilities assumed for both GAAP and tax records

◦ Results in stepped-up basis for both book and tax◦ Generally the values assigned are same for book and◦ Generally, the values assigned are same for book and

tax- Therefore, result is few (or no) deferred taxes

◦ But may have different allocation results in deferred◦ But may have different allocation – results in deferred tax items


28

Allocate Purchase Price - Deferred Taxes (Continued)

• Nontaxable business combinations- Generally results in significant deferred tax items

◦ Because acquired company’s net assets retain their historic tax-basis carrying values for tax purposesy g p p

- Difference between the new fair-value basis for GAAP and the historic carryover-basis for tax will create “new” deferred taxes ◦ Recorded as part of the business combination◦ Will affect amount of goodwill


29

Step 4 - Goodwillp

• Goodwill is a residual amount• Goodwill = FV of entity as a whole - FV of

identifiable net assets acquired • If “negative goodwill” then bargain purchase gain• If negative goodwill then bargain purchase gain

recognized on income statement


30

Example – Bargain Purchase

• Acquirer pays $180M in cash to acquire 100% of Target. The fair value of current assets acquired is $100M and the fair value of acquired long-lived assets (PP&E, identifiable intangible assets) isassets (PP&E, identifiable intangible assets) is $150M.

• Bargain purchase gain is $70M; however the t d d i “th h lf i ”standard requires a “thorough self review” - Focus on the accuracy of the fair value of intangible assets- Bargain purchase gain is not an extraordinary item on g p g y

income statement and disclosure required in footnotes as to why bargain purchase gain occurred


31

Key Current Issues: Transaction Costs

• Transaction costs are recognized separately from a business combination and accounted for accordinglyaccordingly- Generally, expensed as incurred, except financing fees- Financing fees continue to be capitalized and amortized

lif f th lover life of the loan - Consider the impact on debt covenants, credit agreement

considerations, EBITDA definition, etcC id i li i i- Consider presenting as a separate line in income statement, if material


32

Transaction Costs - Expected Restructuring

• The following do not qualify as liabilities at the g q yacquisition date:- Expected future costs to exit an activity of Target- Expected future costs to terminate or relocate employeesExpected future costs to terminate or relocate employees

of Target• These costs do not meet the definition of a

liability or the requirements for recognition of anliability or the requirements for recognition of anexit or disposal cost obligation (i.e., restructuringliability)y)

• Recognize separately, most likely expensed as incurred in the future


33

Contingent Consideration vs. Compensation

• Determination of Contingent Consideration (i.e. additional purchase price) versus Compensation (i eadditional purchase price) versus Compensation (i.e. expense) for future services

• Answer is based on the facts and circumstances of the arrangements with employees and sellers of Target

• Is payment to employee forfeited upon termination ofIs payment to employee forfeited upon termination of employment (i.e., payment is contingent upon employment)?− If so, it’s indicative of compensation expense− If not (if payment is made regardless of employment status

with the buyer), then it’s indicative of “Consideration”


34

Contingent Consideration

• Recognized and measured at its acquisition-date g qfair value

• Subsequent changes in FV depends on l ifi ti f th ti t id ticlassification of the contingent consideration- If equity, will not be re-measured- If not equity, likely will recognize a liability and then re-

measure the liability each period at its fair value with the offset to earnings


35

Contingent Consideration (Continued)g ( )

• Determining the acquisition-date FV of future g qpayouts will require discounting those future payouts

Even if no other changes in value accretion of discounted- Even if no other changes in value, accretion of discounted value will need to be reflected as expense each year

• Failure to meet targets will result in income, which is counter-intuitive

• Valuation techniques will be required to measure FVFV- At the acquisition date and in future periods

• Increased need for ongoing monitoring of estimates


36

Contingent Consideration ExampleContingent Consideration Example

Probability-

Facts:• Buyer agrees to pay $10 million cash

for 100% of Target Company. Buyer Likelihood

Probability-Weighted Average

Discounted Amount

g p y yalso agrees it will pay additional $2 million to seller if EBITDA from Target company increases by 10% per year for each of the next three years. Buyer has estimated the following (using

Scenario 1: Payout is triggered

60% $1,200,000[$2 million

x 60%]

$840,000

g ( gdiscount rate of 12%):

1. What is the liability to recognize at the date of the transaction?

2 H i th it t d f i ]

Scenario 2: Payout is

not40% - -

2. How is the item accounted for in years two and three?

3. In three years, what is the amount of additional consideration Buyer would recognize, assuming the not

triggeredg , g

sales target is met?


37

Answer

Answer:

1. $840,0002 Th li bilit i dj t d t it f i l h2. The liability is adjusted to its fair value each

reporting period. The change in fair value is recorded as income or expense.

3. At the three-year benchmark date, the Buyer will record no additional investment in Target. However, will need to record payment of $2 million yin satisfaction of the liability. Any difference between the recorded liability and the final payment is charged to income or expense.


38

p y g p

Non-Controlling Interests/Equity Rollover

• Company A acquires 70% interest in theCompany A acquires 70% interest in the common stock of Company B

• Company A did not previously own any of Company B’s common stock

• As a result of Company A’s acquisition:Th i 30% NCI i C B- There is a 30% NCI in Company B

- Company A accounts for acquisition of Company B as a business combination

- In the accounting for the business combination, Company A recognizes the 30% NCI at its fair value


39

Non-Controlling Interests/Equity Rollover (Continued)(Continued)

• Measured at fair value on acquisition dateq• How do you determine fair value?

- Is there an active market price for shares not held by Buyer?Buyer?

- If so, multiply active market price by number of shares held by NCI

- If not use one or more other valuation techniques (e gIf not, use one or more other valuation techniques (e.g., market and (or) income approaches)

• Is there a need to apply a discount factor to the minority shares?minority shares?

• How should control premiums factor into theseother valuation techniques?


40

Non-Controlling Interest/Equity Rollover (Continued)(Continued)

• Control premiums - Amount Buyer would be willing p y gto pay to obtain a controlling interest in Target (vs. a NCI in Target)

• Generally, Buyer is willing to pay more for aGenerally, Buyer is willing to pay more for a controlling interest (more than 50% interest) than a NCI (less than 50% interest) on a per-share basis

• Should also look to the price paid by any• Should also look to the price paid by any contemporaneous minority investors who paid cash for their shares

If th id i th t lli t kh ld th t- If they paid same price as the controlling stockholder, that may be evidence that there is no need to discount the non-controlling interest


41

Working Capital Adjustmentsg p j

• Typical purchase agreement clause - purchase yp p g pprice is increased/decreased once final working capital is known I /d l l t d b i th• Increase/decrease calculated by comparing the “targeted working capital” per agreement to the actual final working capital

• These typically are measurement period adjustments that will increase/decrease the purchase price and won’t impact P&L as long aspurchase price and won t impact P&L – as long as direct link between the working capital adjustment clause and the consideration transferred


42

Working Capital Adjustments (Continued)g p j ( )

• Definition of working capital to be assessed.g p• What is included? Often not just total current assets

less total current liabilities. C t t iti f l t d bt?- Current maturities of long-term debt?

- Income tax receivable? - Cash?


43

Provisional Amounts

• What is a provisional amount?p- Preliminary estimate as of the acquisition date- Expected to be adjusted to a “final” amount during the

“measurement period”measurement period - May exist because financial reporting period ends before

the measurement period Example is a fixed asset appraisal or intangible asset- Example is a fixed asset appraisal or intangible asset valuation in process

• How long is the measurement period?- Begins on acquisition date and ends no longer than one

year from the acquisition date


44

Measurement Period Adjustments

• Measurement period adjustments (MPA):Measurement period adjustments (MPA):- Occur during the measurement period;- Result from Buyer obtaining additional information

about facts and circumstances as of the acquisition date; AND

- Result from Buyer concluding it would have reflected theResult from Buyer concluding it would have reflected the additional information in the accounting for the business combination as of the acquisition date if it had been known


45

Measurement Period Adjustments (Continued)

• Recording a MPAg- Adjustment is made as of the acquisition date- Acquisition date accounting is adjusted

When financial information for the period including the- When financial information for the period including the acquisition date is re-presented, the adjustment is reflected in that financial information


46

Questions?

• Questions? Q

Steven [email protected]


47

Business Acquisitions: Accounting, Tax and Due Diligence · Source: Standard & Poor’s Leveraged...

Documents

Transcript of Business Acquisitions: Accounting, Tax and Due Diligence · Source: Standard & Poor’s Leveraged...