Video Tutorial: Purchase Price Allocation Example and Walkthrough
In this lesson, you’ll learn how purchase price allocation works in M&A deals, ranging from simple examples with only Goodwill up through more complex examples with Stock vs. Asset vs. 338(h)(10) deals.
Purchase Price Allocation Definition: In M&A deals, Purchase Price Allocation is the process of assigning a “value” to each of the acquired company’s Assets and Liabilities and then creating new items, such as Other Intangible Assets and Goodwill, such that the combined Balance Sheet balances after the acquired company’s Common Shareholders’ Equity is written down.
Purchase Price Allocation, Step 1: Goodwill and Why It Exists
To understand purchase price allocation, you first must understand how to calculate Goodwill and why Goodwill is necessary in M&A deals.
We have a separate article about Goodwill, linked to above, but here’s the short version:
Goodwill is an accounting construct that exists because Buyers often pay more than the Common Shareholders’ Equity on Seller’s Balance Sheets when acquiring them in M&A deals, which causes the Combined Balance Sheet to go out of balance.
By creating Goodwill, we ensure that Assets = Liabilities + Equity, i.e., that the Balance Sheet remains in balance.
For example, if a Buyer pays $1000 for a Seller, and the Seller has $1500 in Assets, $600 in Liabilities, and $900 in Equity, the Balance Sheet will go out of balance immediately after the deal closes.
If the Buyer spends $1000 in Cash, its Assets side will increase by $500 total ($1500 increase in Assets from the Seller, and $1000 decrease from the Cash usage), and its L&E side will increase by $600 due to the Seller’s Liabilities.
The L&E side increases by only $600 because the Seller’s Common Shareholders’ Equity is written down when the deal closes since the Seller no longer exists as an independent entity.
As a result of these changes, the Balance Sheet goes out of balance by $100, as shown below:
We fix this problem by creating $100 of Goodwill on the Assets side.
The basic calculation is:
Goodwill = Equity Purchase Price – Seller’s Common Shareholders’ Equity + Seller’s Existing Goodwill +/- Other Adjustments to Seller’s Balance Sheet.
The Seller’s existing Goodwill is always written down to $0 because its fair market value is $0.
Since it is written down, the Seller’s Total Assets decrease, which means we need more Goodwill to make the Balance Sheet balance – which is why it’s an addition in the formula above.
The Seller’s Common Shareholders’ Equity is also written down in “control acquisitions” (i.e., ones where over 50% of the Seller is acquired) because it no longer exists as an independent entity after the deal closes.
This write-down reduces the Seller’s Liabilities + Equity, so less Goodwill is needed, which is why we subtract it in the formula above.
From Goodwill to the Full Purchase Price Allocation
In all M&A deals, under both IFRS and U.S. GAAP, Buyers are required to re-value everything on Sellers’ Balance Sheets.
So, if a Seller’s factories, land, inventory, and other assets are worth more or less than their Balance Sheet values, they must be adjusted – and those adjustments will also factor into the Goodwill calculation.
Many items that represent timing differences, such as Deferred Rent, Deferred Tax Liabilities, and Deferred Tax Assets, also go away because these temporary differences are reversed and reconciled in M&A deals.
Finally, new Deferred Tax Liabilities often get created because of the write-ups of PP&E and other Fixed Assets as well as Other Intangible Assets.
The Seller’s PP&E is written up in deals because its market value often exceeds its book value, as buildings and land tend to become more valuable over time.
Other Intangible Assets represent the values of items such as trademarks, brand names, and customer relationships that are worth something despite not having a “physical presence.”
Just as normal PP&E and Intangible Assets depreciate or amortize over time, these write-ups or additions also depreciate or amortize over time.
But unlike the normal items, the Depreciation & Amortization on these write-ups is not cash-tax deductible.
That means the company will pay higher Cash Taxes than Book Taxes in the future.
Since there’s an expectation of Cash Taxes exceeding Book Taxes, this DTL gets created and gradually approaches $0 as these items are depreciated or amortized:
For a more advanced look at this topic, take a look at our tutorial on Section 382 limitations for Net Operating Losses in M&A deals.
Purchase Price Allocation in Real Life
Once you factor in all these items, a complete purchase price allocation for a real-life deal (Builders FirstSource / BMC Stock Holdings here) might look like this:
You might determine the appropriate percentages here based on similar, recent deals in the market.
For example, if recently acquired building material companies have had about 40% of their purchase price allocated to Indefinite-Lived Intangibles and 20% to Definite-Lived Intangibles, that might be a source for these numbers.
Typically, investment bankers do not create detailed assumptions for the purchase price allocation schedule; once an M&A deal closes, this is the job of the Big 4 Transaction Services team.
They complete the research and modeling process over several weeks to approximate value of each item in the schedule.
A more complete formula for Goodwill, based on the schedule above, might be:
Goodwill = Equity Purchase Price – Seller’s Common Shareholders’ Equity + Seller’s Existing Goodwill – Asset Write-Ups + Asset Write-Downs – Liability Write-Downs + Liability Write-Ups
If an item increases Assets or reduces L&E, that means less Goodwill is needed to boost Assets – so we subtract that item.
This explains why we subtract Asset Write-Ups as well as Liability Write-Downs such as the DTLs that get eliminated.
Also, note that both Definite-Lived Intangibles and Indefinite-Lived Intangibles contribute to the new Deferred Tax Liability.
How is that possible if only the Definite-Lived Intangibles amortize?
The short answer is that while Indefinite-Lived Intangibles do not amortize, they will be written down to $0 eventually; it’s just that the timing for that write-down is unknown.
When they are written down, however, that write-down will not be cash-tax deductible. Therefore, the company will pay higher Cash Taxes than Book Taxes when that write-down happens.
Since there’s an expectation of Cash Taxes exceeding Book Taxes in the future, a Deferred Tax Liability still gets created.
Added Complexities in Purchase Price Allocation: Stock Purchases, Asset Purchases, and 338(h)(10) Deals
Purchase price allocation can get more complex because there are many different deal structures.
Worldwide, there are two basic structures used to acquire other companies:
Stock Purchase: The Acquirer purchases all the Target’s Assets and assumes all its Liabilities, including off-Balance Sheet items.
Asset Purchase: The Acquirer picks and chooses specific Assets and Liabilities to acquire, and only pays for those items.
Stock Purchases are more common for the acquisitions of large, public companies, while Asset Purchases are more common for divestitures and private companies.
In a Stock Purchase, the Acquirer cannot deduct D&A on asset write-ups for cash-tax purposes, so it creates a Deferred Tax Liability for the reasons outlined above.
Also, it cannot amortize Goodwill if the Target is public, and while it may use some of the Target’s Net Operating Losses, it may have to write down a portion of them.
That write-down results in an adjustment to the Target’s Deferred Tax Asset (DTA).
Specifically, if a portion of the Target’s NOLs will go unused – such as if the Target has $250 million in NOLs with a 10-year expiration, but the Acquirer can use only $10 million per year – then the $150 million unused portion will be written down.
In an Asset Purchase, the Acquirer can deduct D&A on asset write-ups, it amortizes Goodwill for tax purposes, and it does not create a Deferred Tax Liability. Also, it must write down the Target’s entire NOL balance, so a large portion of its DTA will disappear.
Finally, in the U.S., there is also a 338(h)(10) Election, which combines the Stock Purchase mechanics (Acquire All Assets + Liabilities + Off-BS items) with the Asset Purchase tax benefits.
In the examples here, there is no real difference between an Asset Purchase and 338(h)(10) Election because the tax implications are the same, which makes the purchase price allocation the same.
However, you would see differences if the Acquirer used an Asset Purchase to acquire only selected Assets and Liabilities of the Target rather than everything.
Here’s what the purchase price allocation schedule looks like for a Stock Purchase:
And here’s the purchase price allocation schedule for the same transaction, but structured as an Asset Purchase instead:
The main difference is that with an Asset Purchase, no DTL gets created, so the Goodwill Created is much lower.
A portion of the Deferred Tax Asset corresponding to the Target’s NOLs is written down, which boosts the Goodwill, but that makes a much smaller difference than the lack of a new DTL.
Other Complexities in Purchase Price Allocation
If there’s an earnout in the deal, where the Target receives an additional payment following the deal close if it achieves certain financial goals, that could also affect this schedule.
The same goes for items such as Working Capital adjustments and any other deal terms that might alter the Target’s Balance Sheet.
Note, however, that the same logic shown above still works.
If something is written up on the Assets side, less Goodwill is needed, and if something is written down or removed, more Goodwill is needed.
And on the Liabilities & Equity side, the opposite holds true: if something is written up, more Goodwill is needed, and if something is written down or removed, less Goodwill is needed.
Remember that rule, and you won’t have any trouble with purchase price allocation.