Financial Reporting Valuation

There’s been a great deal of interest in RIA acquisitions in recent years from a diverse group of buyers ranging from consolidators, other RIAs, banks, diversified financial services companies, and private equity. These acquirers have been drawn to RIA acquisitions due to the high margins, recurring revenue, low capital needs, and sticky client bases that RIAs often offer. Following these transactions, acquirers are generally required under accounting standards to perform what is known as a purchase price allocation, or PPA. In this whitepaper, we describe the PPA process, including attributes unique to the investment management industry.WHITEPAPERPurchase Price Allocations for RIAsDownload Whitepaper

There’s been a great deal of interest in RIA acquisitions in recent years from a diverse group of buyers ranging from consolidators, other RIAs, banks, diversified financial services companies, and private equity.These acquirers have been drawn to RIA acquisitions due to the high margins, recurring revenue, low capital needs, and sticky client bases that RIAs often offer.Following these transactions, acquirers are generally required under accounting standards to perform what is known as a purchase price allocation, or PPA.In this whitepaper, we describe the PPA process, including attributes unique to the investment management industry.

Mercer Capital is pleased to announce the release of the 2024 Energy Purchase Price Allocation Study.This study researches and observes publicly available purchase price allocation data from companies primarily contained in one of the four sub-sectors of the energy industry: (i) exploration & production; (ii) oilfield services; (iii) midstream; and (iv) downstream. This study is unlike any other in terms of energy industry specificity and depth.The 2024 Energy Purchase Price Allocation Study provides a detailed analysis and overview of valuation and accounting trends in these sub-sectors of the energy space. This study also enables key users and preparers of financial statements to better understand the asset mix, valuation methods, and useful life trends in the energy space as they pertain to business combinations under ASC 805 and GAAP fair value standards under ASC 820. We utilized transactions that reported their purchase allocation data in calendar year 2023 and not reported in previous annual filings.This study is a useful tool for management teams, investors, auditors, and even insurance underwriters as market participants grapple with ever-increasing market complexity. It provides data and analytics for readers seeking to understand undergirding economics and deal rationale for individual transactions. The study also assists in risk assessment and underwriting of assets involved in these sectors. Further, it helps readers to better comprehend financial statement impacts of business combinations.DOWNLOAD THE STUDY

Rising regulatory burdens contributed to the stunning growth in private equity the last two decades and private credit in recent years. PE investors ultimately require liquidity, however.Subdued M&A and IPO markets since mid-2022 have spurred growth for private equity secondaries, which mostly consists of GP-initiated transactions for continuation funds and LP-initiated transactions for portfolio interests.As shown in Figure 1, secondary transactions rose to $109 billion in 2023 from $102 billion in 2022 based upon data compiled by Lazard as volume soared 57% in 2H23 to $67 billion following depressed activity of about $43 billion in 2H22 and 1H23. Lazard expects secondary volume will improve further in 2024 and 2025 as the investor base for secondaries expands and buoyant markets support narrower bid-ask spreads. The need for LP liquidity also has driven the rise of NAV lending in which the GP arranges for a fund-level loan to fund distributions and/or acquisitions.Figure 1Lazard reports that LP secondaries of buyout funds realized ~88% of NAV whereas LPs realized only ~60% of NAV for interests in funds focused on early stage venture capital assuming NAV was not materially overestimated. LPs averaged 85% for interest in private credit funds, which is less than we would have guessed.LP investors can decide whether it makes sense to transact at a price that is less than NAV and thereby convey to the buyer additional return from investing in an illiquid asset. The LP investor will weigh the cost against the expected return from the current investment, the need for liquidity, and the opportunity to deploy the returned capital in new ventures.GP-led transactions for continuation funds create a corporate governance can of worms because the GP sits on both sides of the transaction as adviser to the fund that is selling an asset and as adviser to the fund that will buy it. LPs can choose liquidity on the terms offered, or they can roll their interest into the continuation fund. Whether a single asset or multi asset investment, presumably the GP is using a continuation vehicle because the exit price for an attractive asset is presently unattractive.The SEC addressed the issue through adopting Rule 211(h)(2)-2 in August 2023 which requires the GP adviser to: (a) obtain a fairness opinion or valuation from an independent valuation firm; and (b) disclose any material business relationships between the GP and opinion provider. Given the increase in GP-led secondaries to $31 billion in 2H23 from $17 billion in 1H23, the SEC governance requirement has not slowed the market.Although not mandated by law, fairness opinions for significant corporate transactions effectively have been required since 1985 when the Delaware Supreme Court ruled in Smith v. Van Gorkom, (Trans Union), (488 A. 2d Del. 1985) that directors were grossly negligent for approving a merger without sufficient inquiry. The Court suggested directors could have addressed their duty of care (informed decision making) by obtaining a fairness opinion.The SEC rule takes aim at the corporate duty of loyalty, which with the duty of care and good faith form the triad that underpins the Business Judgement Rule in which courts defer to the decision making of directors provided they have not violated one of their duties. As far as we know, there has been no widespread finger pointing that GP-led transactions have intentionally disadvantaged LPs. Nonetheless, the SEC rule is a regulatory means to address the issue of loyalty.Fairness opinions involve a review of a transaction from a financial point of view that considers value (as a range concept) and the process the board followed. Due diligence work is crucial to the development of the opinion because there is no bright line test that consideration to be received or paid is fair or not.Mercer Capital has over four decades of experience as an independent valuation and financial advisory firm in valuing illiquid equity and credit, assessing transactions and issuing fairness opinions. Please call if we can be of assistance in valuing your funds private equity and credit investments or evaluating a proposed GP-led transaction.Originally featured in Mercer Capital's Portfolio Valuation Newsletter: Summer 2025

Executive SummaryPreliminary results for 2023 show that the number of goodwill impairments is increasing for both large and middle-market public companies. Based on data through November, the number of impairments recorded by firms on the S&P 500 and Russell 2000 indices had already eclipsed 2021 and 2022 full-year figures. Interestingly, these trends materialized even as the indices themselves posted favorable total returns for the year of 25% and 14%, respectively. Public and private companies currently in the process of performing their annual/interim impairment tests should be on the alert if their peer group turns out to be the one recording impairment charges.Back in 2020, the stock market downturn stemming from pandemic shutdowns resulted in triggering events and impairment charges for many companies.This was especially evident among smaller publicly-traded companies (as tracked by the Russell 2000 versus the S&P 500).The number of charges dropped drastically in 2021 (even compared to 2019 results), suggesting that some of the 2020 impairment charges may have reflected a pull-forward of later charges.Since that time, the number and percentage of companies recording charges has steadily increased, with preliminary figures for 2023 already exceeding the numbers recorded in 2022.Total Goodwill Impairment Charges and % of companies with GW that recorded chargesThis trend held across sectors as well.In the Russell 2000, eight of eleven sectors reported an increase in number of charges to goodwill between 2019 and 2020.Charges in the consumer staples sector declined among S&P 500 companies, while increasing for Russell 2000 companies.Charges in the utilities sector declined for S&P 500 companies but remained stable for Russell 2000 companies.For both groups of companies, charges taken by the materials sector declined.Following 2020, impairment charges dropped below 2019 levels – sharply, in the case of many sectors over 2021 through 2022.More recently, the number of charges and the magnitude of total goodwill charges for the first eleven months of 2023 had already exceeded the full year of 2022.Additional impairments may be on the way as companies complete and file their year-end financials. Based on the preliminary figures for the Russell 2000, the sectors recording the most charges appear to be healthcare and industrials.Despite the increase in impairment charges taken in 2020, the number of small-cap companies reporting year-end goodwill balances increased in 2020 and continued to increase through 2022 and 2023.Approximately 60% of Russell 2000 companies carried goodwill in 2019, while over 63% did so in 2023.The percentage of S&P 500 companies reporting goodwill declined from 89% in 2019 to 86% in 2023.Percent of Companies Reporting GoodwillIt is impossible to attribute the rise in impairment charges to a single specific factor. However, it is likely that rising interest rates and higher inflation played a significant role in 2023 results. Impairment charges also tend to have a larger impact on smaller companies.Generally speaking, smaller companies tend to be less diversified in terms of product or service offerings, and their client bases may be more sensitive to external economic factors.Ultimately, the preliminary data for 2023 shows that impairments do not necessarily taper off when overall equity markets are rising. Company-specific factors, including financial performance relative to history, expectations, and peer performance, are critical when evaluating goodwill for potential impairment. Will the impairment trends seen in the large and middle-market public markets extend to private companies? Perhaps.The valuation specialists at Mercer Capital have experience in implementing both the qualitative and quantitative aspects of goodwill impairment testing under ASC 350. If you have questions, please contact a member of Mercer Capital’s Financial Statement Reporting Group.

Executive SummaryOver the past decade stock-based compensation (SBC) gained widespread popularity as a way to reward employees while conserving cash.Turmoil in the stock market during 2022 resulted in employees seeing diminishing value in SBC and investors questioning its aggressive use.In this article, we discuss how market volatility can affect employee, management, and investor perspectives on SBC.

Compensation models are the subject of significant handwringing for RIA principals—and for good reason. Out of all the decisions RIA principals need to make, compensation programs often have the single biggest impact on an RIA’s P&L and the financial lives of its employees and shareholders. The effects of an RIA’s compensation model are far-reaching, determining not only how compensation is allocated amongst employees but also how a firm’s earnings are split between shareholders and employees, what financial incentives employees have to grow the business, and what financial incentives are available to attract new employees and retain existing employees.Compensation models at RIAs tend to be idiosyncratic, reflecting each firm’s business model, ownership, and culture. In an ideal world, these compensation programs evolve purposefully over time in response to changes in the firm’s size, profitability, labor market conditions, and a variety of other factors. However, inertia is a powerful force: we often encounter compensation programs that made sense in the past but haven’t adapted to serve the firm’s changing needs as the business has grown in scale and complexity.Effective compensation programs need to change with the times, and the times have certainly changed. The RIA industry has seen tremendous growth over the last decade. As a result, firms today face increasingly complex compensation decisions that affect a growing list of stakeholders: outside shareholders, multiple generations of management, retiring partners, new partners, possible minority investors, and so on. On top of that, financial and labor market conditions have evolved dramatically over the last eighteen months, leading many RIAs to scrutinize their compensation models more than ever before.Introduction to RIA Compensation ModelsIt’s important to note at the outset what compensation models do and don’t do. Compensation models determine how the firm’s earnings are allocated; they don’t (directly) determine the amount of earnings to be allocated. When it comes to determining who gets what, it’s a fixed-sum game. The objective of an effective compensation policy is to allocate returns in such a way as to increase this sum over time.Compensation for RIAs can be broken down into three basic components, each of which serves different functions with respect to incentivizing, attracting, and retaining employees:Base Salary / Benefits. This is what an employee receives every two weeks or so. It’s fixed in nature and is paid regardless of firm or employee performance over the short term. On its own, base salary provides little incentive for employees to grow the value of the business over time.Variable Compensation / Bonus. In theory, variable compensation can be tied to specific metrics that the firm chooses or may be allocated on a discretionary basis. The amount of variable compensation paid to employees varies as a function of the chosen metric(s) or management’s qualitative analysis of an employee’s Variable compensation is also called at-risk compensation because all or part of it can be forfeited if target thresholds are not met. Variable compensation is most often paid out on an annual basis.Equity Compensation. Equity incentives serve an important function by aligning the interests of employees with those of the company and its shareholders. While base salary and annual variable compensation serve as shorter-term incentives, equity incentives serve to motivate employees to grow the value of the business over a longer period and play an important role in increasing an employee’s ties to the firm and promoting retention.Variable CompensationIn this blog post, we focus our attention on the variable compensation component (we’ll address the others in subsequent posts).Variable compensation plays an important role in incentivizing employees over the relatively short term (1-3 years). The evidence suggests that such incentives work, too. According to Schwab’s 2022 RIA Compensation Report, firms using performance-based incentive pay saw 28% greater AUM growth, 34% greater net asset flows, and 31% greater client growth over five years than firms without performance-based incentives.What Do You Want to Incentivize?As the name suggests, variable compensation changes as a function of some selected metric, typically revenue, profitability, or some other firm-level metric or individual-level metric, depending on the specific aspects that management intends to incentivize. Additionally, a qualitative assessment of employee performance across various areas may factor into variable compensation.In our experience, variable compensation pools tied to firm profitability and allocated amongst employees based on a combination of individual responsibilities and performance provide an effective incentive for most firms to grow the value of the business over time. Such structures tend to work well because linking variable comp to profitability creates a durable compensation mechanism that scales with the business and aligns the financial and risk management objectives of shareholders and management. Variable comp linked to profitability also promotes a cohesive team, rather than the individual silos that can arise out of revenue-based variable comp, which further helps to build the value of the enterprise.In market downturns, compensation mechanisms that directly link employee pay to firm profitability have the additional benefit of helping to blunt the impact of market conditions on firm profitability. Consider the example below, which shows the impact of a 10% AUM increase and a 10% AUM decrease for a hypothetical firm under two comp programs, one in which all compensation is fixed and the other in which there is a variable bonus pool equal to 20% of pre-bonus profitability.Click here to expand the image aboveIn this example, both compensation programs result in $4 million in EBITDA and an EBITDA margin of 24.6% in the base case scenario. In the downside scenario, however, the fixed comp structure leads to a high degree of operating leverage, and as a result, a 10% drop in AUM leads to a decline in EBITDA of over 40% and a decline in the EBITDA margin to 16.2%. Under the variable comp structure, the variable bonus pool helps to blunt the impact of declining AUM. In this example, a 10% decline in AUM results in a 32.5% decrease in EBITDA and a decline in the EBITDA margin to 18.5% under the variable comp program. In the upside scenario, the increase in EBITDA is greater under the fixed comp structure than under the variable comp structure (an increase of 40.6% vs 32.5%).From a shareholder perspective, a variable compensation program such as the one described above effectively transfers some of the risk equity holders bear to the firm’s employees. In downside scenarios, some of the decline in profitability that would otherwise accrue to shareholders is absorbed by employees. Similarly, some of the increase in profitability is allocated to employees in upside scenarios. The logic of such a compensation program is that employees are incentivized to grow and protect the same metric the shareholders care about—the firm’s profitability.ConclusionInvestment management is a talent business, and structuring an effective compensation program that allows the firm to attract, retain, and incentivize talent is critical to an RIA’s success. In future posts, we’ll address additional compensation considerations, such as equity compensation options and allocation processes.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.

Compensation models are the subject of a significant amount of hand-wringing for RIA principals, and for good reason. Out of all the decisions RIA principals need to make, compensation programs often have the single biggest impact on an RIA's P&L and the financial lives of its employees and shareholders.There are three basic components of compensation for investment management firms: Base salary/Benefits, Variable Compensation/Bonus, and Equity Compensation. We discuss these and more in this whitepaper.

In August 2022, the SEC adopted final rules implementing the Pay Versus Performance Disclosure required by Section 953(a) of the Dodd-Frank Act. These rules go into effect for the 2023 proxy season and introduce significant new valuation requirements related to equity-based compensation paid to company executives. What does this mean, and how does it apply to you? What are the requirements, and why might there be significant valuation challenges involved? We discuss all that and more below.Executive SummaryThe new SEC proxy disclosure rules introduce several new requirements, including that registrants calculate and disclose a new figure (Compensation Actually Paid), alongside existing executive compensation information. For most registrants, the rules will apply to upcoming 2023 proxy season.A new Pay Versus Performance table will detail the relationship between the Compensation Actually Paid, the financial performance of the registrant over the time horizon of the disclosure, and comparisons of total shareholder return.The newly introduced concept of Compensation Actually Paid will require companies to measure the period-to-period change in the fair value of all equity-based compensation awarded to named executive officers.The type of equity awards that have been granted will determine the complexity of the valuation process. Equity-based awards such as stock options might require updated Black Scholes or lattice modeling, while awards with performance or market conditions may require more complex Monte Carlo simulations.Registrants should understand that if equity awards have been granted on a consistent basis for a period of years, the new rules could require a large number of historical valuations for this initial proxy season and a significant amount of disclosure complexity.Advance planning and processes will be needed to establish the scope and complexity of complying with the new rules, including identifying how many equity-based awards will require updated valuations to measure the period-to-period changes.1. Overview and BackgroundThe new disclosures were mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act and were originally proposed by the SEC in 2015. These rules will add a new item 402(v) to Regulation S-K and are intended to provide investors with more transparent, readily comparable, and understandable disclosure of a registrant’s executive compensation. The new provisions apply to all reporting companies other than (i) foreign private issuers, (ii) registered investment companies, and (iii) emerging growth companies.The rules apply to any proxy and information statement where shareholders are voting on directors or executive compensation that is filed in respect of a fiscal year ending on or after December 16, 2022. As such, the vast majority of registrants will be required to include related disclosure for their 2023 proxy statements, though there are relaxed requirements for smaller reporting companies.The new SEC proxy disclosure rules introduce several new requirements, including that registrants calculate and disclose a new figure (Compensation Actually Paid), alongside existing executive compensation information. For most registrants, the rules will apply to upcoming 2023 proxy season.2. The Pay Versus Performance TableThe new rules require registrants to describe the relationship between the Executive Compensation Actually Paid (“CAP”) and the financial performance of the registrant over the time horizon of the disclosure. Additional items include disclosure of the cumulative Total Shareholder Return (“TSR”) of the registrant, the TSR of the registrant’s peer group, the registrant’s net income, and a company-selected measure chosen by the registrant as a measure of financial performance. These items are to be disclosed in tabular form (based on an example included in the final rule), which is replicated below.Click here to expand the table aboveThe table includes the following components:Year. The form applies to the five most recent fiscal years (or three years for smaller reporting companies)Summary Compensation Table Total for Primary Executive Officer (PEO). These are the same total compensation figures as reported under existing SEC proxy disclosure requirements. However, additional columns may need to be added if there was PEO turnover in the relevant periods.Compensation Actually Paid to PEO. For each fiscal year, registrants are required to make adjustments to the total PEO compensation reported in Item (b) for pension and equity awards that are calculated in accordance with US GAAP. This item is potentially complex and is discussed in detail below.Average Summary Compensation Table Total for Non-PEO Named Executive Officers (NEOs). These average figures would be calculated using the same compensation figures as reported under existing SEC proxy disclosure requirements for NEOs. Different individuals may be included in the average throughout the five (or three) year period. Footnote disclosure is required to list the individual NEOs.Average Compensation Actually Paid to Non-PEO NEOs. These amounts would be calculated using the same methodology as in Item (c), but then averaging the amounts in each year.Total Shareholder Return. The registrant’s TSR is to be determined in the same manner as is required by existing Regulation S-K guidance. TSR is calculated as the sum of (1) cumulative dividends (assuming dividend reinvestment) and (2) the increase or decrease in the company’s stock price for the year, divided by the share price at the beginning of the year.Peer Group Total Shareholder Return. This is calculated consistently with the methodology used for Item (f). Registrants are required to use the same peer group they use for existing performance graph disclosures or compensation discussion and analysis.Net Income. This is simply GAAP net income for the relevant period.Company Selected Measure. This item is intended to represent the most important financial performance measure the registrant uses to link compensation paid to its PEOs and other NEOs to company performance. The registrant can select a GAAP or non-GAAP financial measure.The remainder of this article focuses on the two shaded columns (c) and (e) which address Compensation Actually Paid and the valuation inputs that support these disclosures.A new Pay Versus Performance table will detail the relationship between the Compensation Actually Paid, the financial performance of the registrant over the time horizon of the disclosure, and comparisons of total shareholder return.3. What Is Compensation Actually Paid?For each fiscal year, registrants are required to adjust the total compensation reported in Columns (b) and (d) for pension and equity awards that are calculated in accordance with US GAAP. The following table describes these adjustments in detail. The pension-related adjustments should be calculated using the principles in ASC 715, Compensation – Retirement Benefits. The equity-based compensation adjustments will require registrants to disclose the fair value of equity awards in the year granted and report changes in the fair value of the awards until they vest. This means that it will be necessary to measure the year-end fair value of all outstanding and unvested equity awards for the PEO and other NEOs under a methodology consistent with what the registrant uses in its financial statements. For most registrants, this will be ASC 718, Compensation – Stock Compensation. Appropriate footnote disclosure may also be required to identify the amount of each adjustment and any valuation assumptions that materially differ from those disclosed at the time of the equity grant.The newly introduced concept of Compensation Actually Paid will require companies to measure the period-to-period change in the fair value of all equity-based compensation awarded to named executive officers.4. What Are the Different Types of Equity Awards?The procedures used to calculate fair value will vary depending on the type of equity award.For restricted stock and restricted stock units (RSUs), fair value can be calculated using observed share prices at the grant date, fiscal year-end, and the vesting date. The change in fair value would simply be the difference between these dates.For stock options and stock appreciation rights (SARs), fair value at the grant date is often calculated using a Black-Scholes or lattice model. Therefore, updated fair values at year-end and at the vesting date should be based on updated assumptions in those models, including current stock price, volatility, expected term, risk-free rate, dividend yield, and consideration of a sub-optimal exercise factor (in a lattice model). Care should be taken to ensure that expected term appropriately considers moneyness of the options at the new date. The use of historical and/or option-implied volatility should be evaluated for consistency and continued applicability.For performance shares and performance share units (PSUs), the fair value calculations may be more complex due to the presence of a performance condition (e.g., the award vests if revenues increase by 15% and EBITDA margin is at least 20%) or a market condition (e.g., the award vests if the registrant’s total shareholder return over a three-year period exceeds its peer group by at least 5%). The performance condition will require updated probability estimates at year-end and at the vesting date. Awards with market conditions are typically valued at their grant date using Monte Carlo simulation and so a reassessment at subsequent dates using a consistent simulation model with updated assumptions will be necessary.The type of equity awards that have been granted will determine the complexity of the valuation process. Equity-based awards such as stock options might require updated Black Scholes or lattice modeling, while awards with performance or market conditions may require more complex Monte Carlo simulations.5. Special Considerations for Market Condition Awards Using Monte Carlo SimulationMarket condition awards come in many different flavors. Three of the most common types of plans include:Market condition based upon performance in the registrant’s own stock. In this plan, vesting might be achieved if the registrant’s share price exceeds a certain level for a defined number of trading days or reaches an agreed-upon measure of total shareholder return.Market condition based upon relative total shareholder return. In this plan, the award vests based upon the registrant’s TSR in comparison to a similarly calculated TSR for a broad market benchmark index, an industry index, a peer company, or group of peer companies. Some plans employ a modification factor that adjusts the size of the award based upon varying levels of relative TSR performance.Market condition based upon ranked total shareholder return. In these plans, award vesting is based upon a numerical ranking of the registrant’s TSR against the TSRs of a group of peer companies or all of the companies on a particular broad market or industry index. The numerical or percentile ranking then determines the modification factor that adjusts the size of the award.Each of the above plans has inputs and assumptions that drive the Monte Carlo simulation. When performing a subsequent year-end or vesting date fair value analysis, each of the grant-date assumptions will need to be reevaluated. For example, for a relative TSR plan with a three-year term, the subsequent year-end valuations will necessarily have shorter terms (2-year and 1-year), which will require new inputs for volatility and correlation factors. Shorter terms may make the use of option-implied volatility more relevant if sufficient market data is available. For relative TSR plans that reference a group of companies or an index, some of the peers may have been acquired or merged in the subsequent periods. The plan documentation will often describe the steps to be taken when the composition of the peer group changes or there is a change in the benchmark index. A different group (or number) of companies will affect the correlation assumption as well as the percentile calculations in a ranked plan. Regardless of the type of plan, it is important for registrants to understand how even a relatively simple award, if granted consistently for a period of years, can lead to a large number of Monte Carlo simulations for this initial proxy season and a significant amount of disclosure complexity. As shown in Figure 3 below, if a company has made annual PSU grants (with a market condition) for each of the last five years, then up to eight Monte Carlo valuations could be required to calculate the CAP in each period.Click here to expand the example aboveIn the example above, the blue boxes indicate when a valuation of prior grants would be necessary to calculate the change in fair value for each period of the CAP disclosure. For the final period of a relative TSR market condition plan, the company could use the actual market performance of its stock (and the comparative index) to calculate the expected value of the award.Registrants should understand that if equity awards have been granted on a consistent basis for a period of years, the new rules could require a large number of historical valuations for this initial proxy season and a significant amount of disclosure complexity.Summary and Next StepsWhile the new SEC Pay Versus Performance disclosure rules can seem daunting, they can be managed with proper planning and a systematic approach. For the CAP disclosures, registrants need to understand the details of all equity awards that have been awarded to named executive officers (how many and what type of award). The award characteristics will determine which valuation method is most appropriate and how many valuations need to be performed.If you have questions about the valuation techniques used for the various types of equity compensation awards or would like to discuss the process, please contact a Mercer Capital professional.

Mercer Capital is pleased to announce the release of the 2022 Energy Purchase Price Allocation Study.This study researches and observes publicly available purchase price allocation data for four sub-sectors of the energy industry: (i) exploration & production; (ii) oilfield services; (iii) midstream; and (iv) downstream.  This study is unlike any other in terms of energy industry specificity and depth.The 2022 Energy Purchase Price Allocation Study provides a detailed analysis and overview of valuation and accounting trends in these sub-sectors of the energy space.  This study also enables key users and preparers of financial statements to better understand the asset mix, valuation methods, and useful life trends in the energy space as they pertain to business combinations under ASC 805 and GAAP fair value standards under ASC 820.  We utilized transactions that closed and reported their purchase allocation data in calendar year 2021.This study is a useful tool for management teams, investors, auditors, and even insurance underwriters as market participants grapple with ever-increasing market complexity.  It provides data and analytics for readers seeking to understand undergirding economics and deal rationale for individual transactions.  The study also assists in risk assessment and underwriting of assets involved in these sectors. Further, it helps readers to better comprehend financial statement impacts of business combinations.>> DOWNLOAD THE STUDY <<

This is the final article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here. Growing up an avid sports fan, I always enjoyed picking up the paper and flipping to the sports section to see the box scores from the prior day’s games. While the headline score told you who won or lost, the box score gave more information and insights into who played well and the narrative of the game. For example, the box score might tell you that even though your favorite team won, they were dominated by the other team in all the categories except turnovers, or that the team that lost actually “won” each quarter except the fourth and their star player had a bad game. In my view, a purchase price allocation is similar to a box score in that it provides greater detail from which to derive insights on a particular transaction. While a purchase price allocation (PPA) analysis is primarily an accounting (and compliance driven) exercise, it is also a window into the objectives and motivations behind the transaction. When used proactively and/or during the M&A process, the disciplines of PPA analysis can provide buyers with important perspective concerning the unique value attributes of the target’s intangible asset base, which can help rationalize strategic acquisition consideration or forewarn of potentially unstable or short-lived intangible asset value. Below we explore PPAs further with a broad overview and then a deeper look into the pitfalls and best practices related to them.Introduction to PPAsAcquirers conduct PPAs to measure the fair value of various tangible and intangible assets of the acquired business. Any excess of the total asset value implied by the transaction over the fair values of identified assets is ascribed to the residual asset, goodwill.Intangible assets commonly identified and measured as part of PPA analyses include:Trade name - Trade name intangibles may be valuable if they enhance the expected future cash flows of the firm, either through higher revenue or superior margins. The relief from royalty method, which seeks to simulate cost savings due to the ownership of the name, is frequently used to measure the value of trade names.Customer relationships - Customer relationships can be valuable because of the expectation of recurring revenue.Technology - Technologies developed by the target business are valuable because the acquirer avoids associated development or acquisition costs. Patents and other forms of intellectual property may provide legal protection from competition and help secure uniqueness and/or differentiation.IPR&D - Ongoing R&D projects can give rise to in-process research and development intangible assets, whose values are predicated on expected future cash flows.Contractual assets - Contracts that lock in pricing advantages – above market sales prices or below market costs – create value by enhancing cash flow.Employment / Non-competition agreements - Employment and non-competition agreements with key executives ensure a smooth transition following an M&A transaction, which can be vital in reducing the likelihood of employee or customer defection. The value of an enterprise is often greater than the sum of its identified parts (both tangible and intangible), and the excess is usually reflected in the residual asset, goodwill. GAAP goodwill also captures facets of the target that may be value-accretive, but do not meet certain criteria to be identified as an intangible asset. Notably, fair value measurement presumes a market participant perspective. Goodwill may also include acquirer-specific synergistic or strategic considerations that are not available to other market participants. Consequently, goodwill has tended to account for a significant portion of allocated value in truly strategic business combinations.Pitfalls and Best Practices of PPAsBelow we highlight some pitfalls and best practices gleaned from providing purchase price allocations to acquirers since the advent of fair value accounting.What are some of the pitfalls in purchase price allocations?Sometimes differences arise between expectations or estimates prior to the transaction and fair value measurements performed after the transaction. An example is contingent consideration arrangements – estimates from the deal team’s calculations could vary from the fair value of the corresponding liability measured and reported for GAAP purposes. To the extent amortization estimates are prepared prior to the transaction, any variance in the allocation of total transaction value to amortizable intangible assets and non-amortized, indefinite lived assets – be they identifiable intangible assets or goodwill – could also lead to different future EPS estimates for the acquirer.What are the benefits of looking at the allocation process early?The opportunity to think through and talk about some of the unusual elements of the more involved transactions can be enormously helpful. Similar to a coach who may look at the box score from the first half of a game during the halftime break, we view the dialogue we have with clients when we prepare a preliminary PPA estimate prior to closing as a particularly important part of the M&A project. This deliberative process results in a more robust – well-reasoned analysis that is easier for the external auditors to review, and better stands the test of time requiring fewer true-ups or other adjustments in the future. Surprises are difficult to eliminate, but as they say, forewarned is forearmed.Can goodwill be broken into different components?If so, what are the different components and how are they delineated?In the world of FASB, goodwill is not delineated into personal goodwill and corporate or enterprise goodwill. However, in the tax world, this distinction can be of critical importance and can create significant savings to the sellers of a C corporation business.Many sellers prefer that a transaction be structured as a stock sale, rather than an asset sale, thereby avoiding a built in gains issue and its related tax liability. Buyers want to do the opposite for a variety of reasons. When a C corporation’s assets are sold, the shareholders must realize the gain and face the issue of double taxation whereby the gain is taxed at both the corporate level, and again at the individual level when proceeds are distributed to the shareholders. Proceeds that can be allocated to the sale of a personal asset, such as personal goodwill, may mitigate the double taxation issue.The Internal Revenue Service defines goodwill as “the value of a trade or business based on expected continued customer patronage due to its name, reputation, or any other factor.”1 Recent Tax Court decisions have recognized a distinction between the goodwill of a business itself and the goodwill attributable to the owners/professionals of that business. This second type is typically referred to as personal (or professional) goodwill (a term used interchangeably in tax cases).Personal goodwill differs from enterprise goodwill in that personal goodwill represents the value stemming from an individual’s personal service to that business, and is an asset owned by the individual, not the business itself. This value would encompass an individual’s professional reputation, personal relationships with customers or suppliers, technical expertise, or other distinctly personal abilities which provide economic benefit to a business. This economic benefit is in excess of any normal return earned on other tangible or intangible assets of the company.What other problems/issues beyond a PPA can you help acquirers navigate?As part of our full suite of services for acquirers, we can handle a number of different kinds of special projects that corporate finance departments may be looking to outsource, completely or partially. For example, our firm helps clients think through certain financial or strategic questions – what level of cash flow reinvestment will best balance competing shareholder interests? Or, what is the appropriate hurdle rate when evaluating internal projects vs. acquisitions for capital budgeting exercises? In other instances, we perform financial due diligence and quality of earnings analyses for transactions.ConclusionAs the “box score” of transactions, PPAs can be an important tool for acquirers and provide greater insight into the motivations and narrative behind a transaction by illustrating the value of various intangible components of a business beyond the collection of tangible assets and how those compare to the purchase price being paid. Our purchase price allocations can be more robust with fewer surprises when we have also worked with the clients before the close of the transaction on elements such as financial due diligence or contingent consideration estimates, or even broader corporate finance and PPA studies.Mercer Capital has extensive experience valuing intangible assets for purchase price allocations (ASC 805), impairment testing (ASC 350), and fresh-start accounting (ASC 852) and assisting buyers during financial due diligence. Call us – we would like to help.1 IRS Publication 535: Business Expenses, Ch. 9, Cat. No. 15065Z

In recent years, there’s been a great deal of interest in RIA acquisitions from a diverse group of buyers ranging from consolidators, other RIAs, banks, diversified financial services companies, and private equity. Due to the high margins, recurring revenue, low capital needs, and sticky client bases that RIAs often offer, these acquirers have been drawn to RIA acquisitions. Following these transactions, acquirors are generally required under accounting standards to perform what is known as a purchase price allocation, or PPA.A purchase price allocation is just that—the purchase price paid for the acquired business is allocated to the acquired tangible and separately-identifiable intangible assets. As noted in the following figure, the acquired assets are measured at fair value. The excess of the purchase price over the identified tangible and intangible assets is referred to as goodwill. Transaction structures involving RIAs can be complicated, often including deal term nuances and clauses that have significant impact on fair value. Purchase agreements may include balance sheet adjustments, client consent thresholds, earnouts, and specific requirements regarding the treatment of other existing documents like buy-sell agreements. Asset and wealth management firms are unique entities with value attributed to a number of different metrics (assets under management, management fee revenue, realized fees, profit margins, etc). It is important to understand how the characteristics of the asset management industry in general and those attributable to a specific firm influence the values of the assets acquired in these transactions. Because most investment managers are not asset intensive operations, the majority of value is typically allocated to intangible assets. Common intangible assets acquired in the purchase of private asset and wealth management firms include the existing customer relationships, tradename, non-competition agreements with executives, and the assembled workforce.Customer RelationshipsGenerally, the value of existing customer relationships is based on the revenue and profitability expected to be generated by the accounts, factoring in an expectation of annual account attrition. Attrition can be estimated using analysis of historical client data or prospective characteristics of the client base.Due to their long-term nature, relatively low attrition rates, and importance as a driver of revenue in the asset and wealth management industries, customer relationships often command a relatively high portion of the allocated value. We can see this in the public filings of RIA aggregator Focus Financial. Between 2017 and 2021, Focus completed 130 acquisitions of RIAs. Of the aggregate allocated consideration for these transactions, a full 51% was allocated to customer relationships. Most of the remainder (48%) was allocated to goodwill.TradenameThe deal terms we see employ a wide range of possible treatments for the tradename acquired in the transaction. The acquiror will need to decide whether to continue using the asset or wealth manager’s name into perpetuity or only use it during a transition period as the acquired firm’s services are brought under the acquirer’s name. This decision can depend on a number of factors, including the acquired firm’s reputation within a specific market, the acquirer’s desire to bring its services under a single name, and the ease of transitioning the asset/wealth manager’s existing client base. In any event, for most relatively successful small-to-medium sized RIAs, the tradename has some positive recognition among the customer base and in the local market, but typically lacks the “brand name” recognition that would give rise to significant tradename value.In general, the value of a tradename can be derived with reference to the royalty costs avoided through ownership of the name. A royalty rate is often estimated through comparison with comparable transactions and an analysis of the characteristics of the individual firm name. The present value of cost savings achieved by owning rather than licensing the name over the future period of use is a measure of the tradename value.Noncompetition AgreementsIn many asset and wealth management firms, a few top executives or portfolio managers account for a large portion of new client generation. Deals involving such firms will typically include non-competition and non-solicitation agreements that limit the potential damage to the company’s client and employee bases if such individuals were to leave.These agreements often prohibit the covered individuals from soliciting business from existing clients or recruiting current employees of the company. In the agreements we’ve observed, a restricted period of two to five years is common. In certain situations, the agreement may also restrict the individuals from starting or working for a competing firm within the same market. The value attributable to a non-competition agreement is derived from the expected impact competition from the covered individuals would have on the firm’s cash flow and the likelihood of those individuals competing absent the agreement. Factors driving the likelihood of competition include the age of the covered individual and whether or not the covered individual has other incentives not to compete aside from the legal agreement (for example, if the individual is a beneficiary of an earn-out agreement or received equity in the acquiror as part of the deal, the probability of competition may be significantly lessened).Assembled WorkforceIn general, the value of the assembled workforce is a function of the saved hiring and assembly costs associated with finding and training new talent. However, in relationship-based industries like asset and wealth management, getting a new portfolio manager or advisor up to speed can include months of networking and building a client base, in addition to learning the operations of the firm. The ability of employees to establish and maintain these client networks can be a key factor in a firm’s ability to find, retain, and grow its business. An existing employee base with market knowledge, strong client relationships, and an existing network may often command a higher value allocation to the assembled workforce. Unlike the intangible assets previously discussed, the value of a assembled workforce is valued as a component of valuing the other assets. Under current accounting standards, the assembled workforce value is not recognized or reported separately, but rather is included as an element of goodwill.GoodwillGoodwill arises in transactions as the difference between the price paid for a company and the value of its identifiable assets (tangible and intangible). Expectations of synergies, strategic market location, and access to a certain client group are common examples of goodwill value derived from the acquisition of an asset or wealth manager. The presence of these non-separable assets and characteristics in a transaction can contribute to the allocation of value to goodwill.EarnoutsIn the purchase price allocations we do for RIA acquirors, we frequently see earnouts structured into the deal as a mechanism for bridging the gap between the price the acquirer wants to pay and the price the seller wants to receive. Earnout payments can be based on asset retention, fee revenue growth, or generation of new revenue from additional clients, assets, or product offerings. Structuring a portion of the total purchase consideration as an earnout provides some downside protection for the acquirer, while rewarding the seller for meeting or exceeding growth expectations. Earnout arrangements represent a contingent liability for the acquiror that must be recorded at fair value on the acquisition date.ConclusionThe proper allocation of value to intangible assets and the calculation of asset fair values require both valuation expertise and knowledge of the subject industry. Mercer Capital brings these together in our extensive experience providing fair value and other valuation and transaction work for the investment management industry. If your company is involved in or is contemplating a transaction, call one of our professionals to discuss your valuation needs in confidence.

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Did you miss Mercer Capital's 2021 Energy Purchase Price Allocation Study? If you did, before we move into 2022, take a look at the 2021 Study.This study researches and observes publicly available purchase price allocation data for three sub-sectors of the energy industry: (i) exploration & production; (ii) oilfield services; and (iii) midstream and downstream.  This study is unlike any other in terms of energy industry specificity and depth.The 2021 Energy Purchase Price Allocation Study provides a detailed analysis and overview of valuation and accounting trends in these sub-sectors of the energy space.  This study also enables key users and preparers of financial statements to better understand the asset mix, valuation methods, and useful life trends in the energy space as they pertain to business combinations under ASC 805 and GAAP fair value standards under ASC 820.  We utilized transactions that closed and reported their purchase allocation data in calendar year 2020.This study is a useful tool for management teams, investors, auditors, and even insurance underwriters as market participants grapple with ever-increasing market complexity.  It provides data and analytics for readers seeking to understand undergirding economics and deal rationale for individual transactions.  The study also assists in risk assessment and underwriting of assets involved in these sectors. Further, it helps readers to better comprehend financial statement impacts of business combinations.>> DOWNLOAD THE STUDY <<

There’s been a great deal of interest in RIA acquisitions in recent years from a diverse group of buyers ranging from consolidators, other RIAs, banks, diversified financial services companies, and private equity. These acquirers have been drawn to RIA acquisitions due to the high margins, recurring revenue, low capital needs, and sticky client bases that RIAs often offer. Following these transactions, acquirors are generally required under accounting standards to perform what is known as a purchase price allocation, or PPA.A purchase price allocation is just that—the purchase price paid for the acquired business is allocated to the acquired tangible and separately-identifiable intangible assets. As noted in the following figure, the acquired assets are measured at fair value. The excess of the purchase price over the identified tangible and intangible assets is referred to as goodwill.Transactions structures involving RIAs can be complicated, often including deal term nuances and clauses that have significant impact on fair value. Purchase agreements may include balance sheet adjustments, client consent thresholds, earnouts, and specific requirements regarding the treatment of other existing documents like buy-sell agreements. Asset and wealth management firms are unique entities with value attributed to a number of different metrics (assets under management, management fee revenue, realized fees, profit margins, etc). It is important to understand how the characteristics of the asset management industry in general and those attributable to a specific firm influence the values of the assets acquired in these transactions. Because most investment managers are not asset intensive operations, the majority of value is typically allocated to intangible assets. Common intangible assets acquired in the purchase of private asset and wealth management firms include the existing customer relationships, tradename, non-competition agreements with executives, and the assembled workforce. Customer RelationshipsGenerally, the value of existing customer relationships is based on the revenue and profitability expected to be generated by the accounts, factoring in an expectation of annual account attrition. Attrition can be estimated using analysis of historical client data or prospective characteristics of the client base.Due to their long-term nature, relatively low attrition rates, and importance as a driver of revenue in the asset and wealth management industries, customer relationships often command a relatively high portion of the allocated value. We can see this in the public filings of RIA aggregator Focus Financial. Between 2016 and 2020, Focus completed 106 acquisitions of RIAs. Of the aggregate allocated consideration for these transactions, a full 53% was allocated to customer relationships and 3% was allocated to other assets, with the remaining 44% comprising goodwill.Expand ChartTradenameThe deal terms we see employ a wide range of possible treatments for the tradename acquired in the transaction. The acquiror will need to decide whether to continue using the asset or wealth manager’s name into perpetuity or only use it during a transition period as the acquired firm’s services are brought under the acquirer’s name. This decision can depend on a number of factors, including the acquired firm’s reputation within a specific market, the acquirer’s desire to bring its services under a single name, and the ease of transitioning the asset/wealth manager’s existing client base. In any event, for most relatively successful small-to-medium sized RIAs, the tradename has some positive recognition among the customer base and in the local market, but typically lacks the “brand name” recognition that would give rise to significant tradename value.In general, the value of a tradename can be derived with reference to the royalty costs avoided through ownership of the name. A royalty rate is often estimated through comparison with comparable transactions and an analysis of the characteristics of the individual firm name. The present value of cost savings achieved by owning rather than licensing the name over the future period of use is a measure of the tradename value.Noncompetition AgreementsIn many asset and wealth management firms, a few top executives or portfolio managers account for a large portion of new client generation and are often being groomed for succession planning. Deals involving such firms will typically include non-competition and non-solicitation agreements that limit the potential damage to the company’s client and employee bases if such individuals were to leave.These agreements often prohibit the covered individuals from soliciting business from existing clients or recruiting current employees of the company. In the agreements we’ve observed, a restricted period of two to five years is common. In certain situations, the agreement may also restrict the individuals from starting or working for a competing firm within the same market. The value attributable to a non-competition agreement is derived from the expected impact competition from the covered individuals would have on the firm’s cash flow and the likelihood of those individuals competing absent the agreement. Factors driving the likelihood of competition include the age of the covered individual and whether or not the covered individual has other incentives not to compete aside from the legal agreement (for example, if the individual is a beneficiary of an earn-out agreement or received equity in the acquiror as part of the deal, the probability of competition may be significantly lessened).Assembled WorkforceIn general, the value of the assembled workforce is a function of the saved hiring and assembly costs associated with finding and training new talent. However, in relationship-based industries like asset and wealth management, getting a new portfolio manager or advisor up to speed can include months of networking and building a client base, in addition to learning the operations of the firm. Employees’ ability to establish and maintain these client networks can be a key factor in a firm’s ability to find, retain, and grow its business. An existing employee base with market knowledge, strong client relationships, and an existing network may often command a higher value allocation to the assembled workforce. Unlike the intangible assets previously discussed, the value of an assembled workforce is valued as a component of valuing the other assets. It is not recognized or reported separately, but rather is included as an element of goodwill.GoodwillGoodwill arises in transactions as the difference between the price paid for a company and the value of its identifiable assets (tangible and intangible). Expectations of synergies, strategic market location, and access to a certain client group are common examples of goodwill value derived from the acquisition of an asset or wealth manager. The presence of these non-separable assets and characteristics in a transaction can contribute to the allocation of value to goodwill.EarnoutsIn the purchase price allocations we do for RIA acquirors, we frequently see earnouts structured into the deal as a mechanism for bridging the gap between the price the acquirer wants to pay and the price the seller wants to receive. Earnout payments can be based on asset retention, fee revenue growth, or generation of new revenue from additional product offerings. Structuring a portion of the total purchase consideration as an earnout provides some downside protection for the acquirer, while rewarding the seller for continuity of performance or growth. Earnout arrangements represent a contingent liability that must be recorded at fair value on the acquisition date.ConclusionThe proper allocation of value to intangible assets and the calculation of asset fair values require both valuation expertise and knowledge of the subject industry. Mercer Capital brings these together in our extensive experience providing fair value and other valuation and transaction work for the investment management industry. If your company is involved in or is contemplating a transaction, call one of our professionals to discuss your valuation needs in confidence.

This article discusses important concepts of personal goodwill in divorce litigation engagements. The discussion relates directly to several divorce litigation cases involving owners of automobile dealerships. These real life examples display the depth of analysis that is critical to identifying the presence of personal goodwill and then estimating or allocating the associated value with the personal goodwill. The issues discussed here pertain specifically to considerations utilized in auto dealer valuations, but the overall concepts can be applied to most service-based industries.It is important that the appraiser understands the industry and performs a thorough analysis of all relevant industry factors. It is also important to determine how each state treats personal goodwill. Some states consider personal goodwill to be a separate asset, and some do not make a specific distinction for it and include it in the marital assets.Personal goodwill was an issue in several of our recent litigated divorce engagements. It is more prevalent in certain industries than others and varies from matter to matter. However, although there are several accepted methodologies to determine personal goodwill, there is not a textbook that discusses where it exists and where it doesn’t. Before any attempts to measure and quantify it, an important question to ask is “Does it exist?” Often with ambiguous concepts like personal goodwill, the adage “you know it when you see it” is most appropriate. In this article, we examine personal and enterprise goodwill using a specific fact pattern unique to the auto dealership industry. Beyond this illustrative example, the analyses can be applied in other industries, but must be considered carefully for the unique facts and circumstances of each matter.What Is Personal Goodwill?Personal goodwill is value stemming from an individual’s personal service to a business and is an asset that tends to be owned by the individual, not the business itself. Personal goodwill is part of the larger bucket of an intangible asset known as goodwill. The other portion of goodwill, referred to as enterprise or business goodwill, relates to the intangible asset involved and owned by the business itself.1Commercial and family law litigation cases aren’t typically governed by case law resulting from Tax Court matters and can differ by jurisdiction, but Tax Court decisions offer more insight into defining the conditions and questions that should be asked in an evaluation of personal goodwill. One seminal Tax Court case on personal goodwill is Martin Ice Cream vs. Commissioner.2 Among the Court’s discussions and questions to review were the following:Do personal relationships exist between customers/suppliers and the owner of a business?Do these relationships persist in the absence of formal contractual relationships?Does an owner’s personal reputation and/or perception in the industry provide intangible benefit to the business?Are practices of the owner innovative or distinguishable in his or her industry, such as the owner having added value to the particular industry?Another angle with which to evaluate the presence of personal goodwill, specifically to professional practices, is provided in Lopez v. Lopez.3 Lopez suggests several factors that should be considered in the valuation of professional (personal) goodwill as:The age and health of the individual;The individual’s demonstrated earning power;The individual’s reputation in the community for judgement, skill, and knowledge;The individual’s comparative professional successThe nature and duration of the professional’s practice as a sole proprietor or as a contributing member of a partnership or professional corporation.Why Is Personal Goodwill Important?Many states identify and distinguish between personal goodwill and enterprise goodwill. Further, numerous states do NOT consider the personal goodwill of a business to be a marital asset for family law cases. For example, a business could have a value of $1 million, but a certain portion of the value is attributable and allocated to personal goodwill. In this example, the value of the business would be reduced for personal goodwill for family law cases and the marital value of the business would be considered at something less than the $1 million value.How Applicable/Prevalent Is Personal Goodwill in the Auto Dealer Industry?In litigation matters, we always try to avoid the absolutes: always and never. The concept of personal goodwill is easier identified and more prevalent in service industries such as law practices, accounting firms, and smaller physician practices. Does that mean it doesn’t apply to more traditional retail and manufacturing industries? In each case, the fundamental question that should be first answered is “Is this an industry or company where personal goodwill could be present?”For the auto dealer industry, the principal product, outside of the service department, is a tangible product – new and used vehicles. In order for personal goodwill to be present in this industry, the owner/dealer principal would have to exhibit a unique set of skills that specifically translates to the heightened performance of their business.We are all familiar with regional dealerships possessing the name of the owner/dealer principal in the name of the business. However, just having the name on a business doesn’t signify the presence of personal goodwill. An examination of the customer base would be needed to justify personal goodwill. It would be more difficult to argue that customers are purchasing vehicles from a particular dealership only for the name on the door, rather than the more obvious factors of brands offered, availability of inventory, convenience, etc. An extreme example might be having a recognized celebrity as the name/face of the dealership, but even then, it would be debated how materially that affects sales and success.Auto dealers attempt to track performance and customer satisfaction through surveys, which could provide an avenue to determine this value (if, for example, factors that influenced the decision to buy listed Joe Dealer as being their primary motivation) though this is still unlikely and would be subject to debate.Another consideration of the impact of a dealer’s name on the success/value of the business would be how actively involved the owner/dealer principal is and how directly have they been involved with the customer in the selling process. Simply put, there should be higher bars to clear than just having the name in the dealership for personal goodwill to be present. In more obvious examples of personal goodwill in professional practices, the customer usually interacts directly with the owner/professional such as with the attorney or doctor in our previous examples. How often does the customer of an auto dealership come into contact or deal directly with the owner/dealer principal, or do they generally engage with the salespeople, service manager, or the general manger?Another factor that often helps identify the existence of personal goodwill is the presence of an employment agreement and/or non-compete agreement. The prevailing thought is that an owner of a business without these items would theoretically be able to exit the business and open a similar business and compete directly with the prior business. Neither of these items typically exist with an owner of an auto dealership. However, owners of auto dealerships must be approved as dealer principals by the manufacturer.The transferability of a dealer principal relationship is not guaranteed, and certainly an existing dealer principal would not be able to obtain an additional franchise to directly compete with an existing franchise location of the same manufacturer for obvious area of responsibility (AOR) constraints. So, does the fact that most dealer principals don’t have an employment or non-compete agreement signify that personal goodwill must be present? Not necessarily. Again it relates back to the central questions of whether an owner/dealer principal is directly involved in the business, has a unique set of skills that contributed to a heightened success of the business, and does that owner/dealer principal have a direct impact on attracting customers to their particular dealership that could not be replicated by another individual.ConclusionPersonal goodwill in an auto dealership, and in any industry, can become a contested item in a litigation case because it can reduce the enterprise value consideration, reduced by the amount allocated to personal goodwill. As much as the allocation, quantification, and methodology used to determine the amount of personal goodwill will come into question, several central questions should be examined and answered before simply jumping to the conclusion that personal goodwill exists. Instead of arguing whether the value of an auto dealership should be reduced by some percentage, the real debate should center around the examination of whether personal goodwill exists in the first place. The difference in reports from valuation for experts in litigation matters generally falls within the examination and support of the assumptions (that lead to differences in conclusions). If present, personal goodwill for an auto dealership, or any company in any industry for that matter, must exist beyond just having the owner’s name in the title of the business.1 In the auto dealer industry, goodwill and other intangible assets are referred to as Blue Sky value. 2 Martin Ice Cream Co. v. Commissioner, 110 T.C. 189 (1998). 3 In re Marriage of Lopez, 113 Cal. Rptr. 58 (38 Cal. App. 3d 1044 (1974).

A stress test is defined as a risk management tool that consists of estimating the bank’s financial position over a time horizon – approximately two years – under different scenarios (typically a baseline, adverse, and severe scenario).The concept of stress testing for banks and credit unions is akin to the human experience of going in for a check up and running on a treadmill so your cardiologist can measure how your heart performs under stress. Similar to stress tests performed by doctors, stress tests for financial institutions can ultimately improve the health of the bank or credit union (“CU”). The benefits of stress testing for financial institutions include: Enhancing strategic/capital planningImproving risk managementEnhancing the value and earning power of the bank or credit unionAs many public companies in other industries have pulled earnings guidance due to the uncertainty surrounding the economic outlook amid the coronavirus pandemic, community banks and CUs do not have that luxury.Key stakeholders, boards, and regulators will desire a better understanding of the ability of the bank or CU to withstand the severe economic shock of the pandemic. Fortunately, stress testing has been a part of the banking lexicon since the last global financial crisis began in 2008. We can leverage many lessons learned from the last decade or so of this annual exercise.Conducting a Stress Test It can be easy to get overwhelmed when faced with scenario and capital planning amidst the backdrop of a global pandemic with a virus whose path and duration is ultimately uncertain.However, it is important to stay grounded in established stress testing steps and techniques. Below we discuss the four primary steps that we take to help clients conduct a stress test in light of the current economic environment.Step 1: Determine the Economic Scenarios to ConsiderIt is important to determine the appropriate stress event to consider.Unfortunately, the Federal Reserve’s original 2020 scenarios published in 1Q2020 seem less relevant today since they forecast peak unemployment at 10%, versus the recent peak national unemployment rate of 14.7% (April 2020).However, the Federal Reserve supplemented the original scenario with a sensitivity analysis for the 2020 stress testing round related to coronavirus scenarios in late 2Q20, which provides helpful insights. The Federal Reserve’s sensitivity analysis had three alternative downside scenarios: A rapid V-shaped recovery that regains much of the output and employment lost by year-end 2020A slower, more U-shaped recovery in which only a small share of lost output and employment is regained in 2020A W-shaped double dip recession with a short-lived recovery followed by a severe drop in late 2020 due to a second wave of COVIDSome of the key macroeconomic variables in these scenarios are found in Table 1.In our view, these scenarios provide community banks and credit unions with economic scenarios from which to begin a sound stress testing and capital planning framework.Step 2: Segment the Loan Portfolio and Estimate Loan Portfolio Stress LossesWhile determining potential loan losses due to the uncertainty from a pandemic can be particularly daunting, we can take clues from the Federal Reserve’s release of results in late 2Q20 from some of the largest banks.While the specific loss rates for specific banks weren’t disclosed, the Fed’s U, V, and W sensitivity analysis noted that aggregate loss rates were higher than both the Global Financial Crisis (“GFC”) and the Supervisory Capital Assessment Program (“SCAP”) assumptions from the prior downturn. We note that many community banks and CUs may feel that their portfolios in aggregate will weather the COVID storm better than their larger counterparts (data provided in Table 2).We have previously notedthat community bank loan portfolios are more diverse now than during the prior downturn and cumulative charge-offs were lower for community banks as a whole than the larger banks during the GFC.For example, cumulative charge-offs for community banks over a longer distressed time period during the GFC (four years, or sixteen quarters, from June 2008 - June 2012) were 5.1%, implying an annual charge-off rate during a stressed period of 1.28% (which is ~42% of what larger banks experienced during the GFC).However, we also note that this community bank loss history is likely understated by the survivorship bias arising from community banks that failed during the GFC.Each community bank or CU’s loan portfolio is unique, and it will be important for community banks and CUs to document the composition of their portfolio and segment the portfolio appropriately. Segmentation of the loan portfolio will be particularly important.The Fed noted that certain sectors will behave differently during the COVID downturn. The leisure, hospitality, tourism, retail, and food sectors are likely to have higher credit risk during the pandemic. Proper loan segmentation should include segmentation for higher risk industry sectors during the current pandemic as well as COVID-modified/restructured loans.Once the portfolio is segmented, loss history over an extended period and a full business cycle (likely 10-12 years of history) will be important to assess. While the current pandemic is a different event, this historical loss experience can be leveraged to provide insights into future prospects and underwriting strength during a downturn and relative to peer loss experience. In certain situations, it may also be relevant to consider the correlation between those historical losses and certain economic factors such as the unemployment rate in the institution’s market areas. For example, a regression analysis can determine which variables were most significant statistically in driving historical losses during prior downturns and help determine which variables may be most relevant in the current pandemic. For those variables deemed statistically significant, the regression analysis can also provide a forecasting tool to estimate and/or test the reasonableness of future loss rates based on assumed changes in those variables that may be above and beyond historical experience. Lastly, higher risk loan portfolio segments (such as those in more economically exposed sectors) and larger loans that were modified during the pandemic may need to be supplemented by some “bottom-up” analysis of certain loans to determine how these credits may fare in the different economic scenarios previously described.To the extent losses can be modeled for each individual loan, these losses can be used to estimate losses for those particular loans and also leveraged to support assumptions for other loan portfolio segments.Step 3: Estimate the Impact of Stress on EarningsStep 3 expands the focus beyond just the loan portfolio and potential credit losses from the pandemic modeled in Step 2 and focuses on the institution’s “core” earning power and sensitivity of that over the economic scenarios modeled in Step 1. When assessing “core” earning power, it is important to consider the potential impact of the economic scenarios on the interest rate outlook and net interest margins (“NIM”). While the outlook is uncertain, Federal Reserve rate cuts have already started to crimp margins. Beyond the headwinds brought about by the pandemic, it is also important to consider any potential tailwinds in certain countercyclical areas like mortgage banking, PPP loan income, and/or efficiency brought about by greater adoption of digital technology and cost savings from branch closures.Ultimately, the earnings model over the stressed period relies on key assumptions that need to be researched, explained, and supported related to NIM, earning assets, non-interest income, expenses/efficiency, and provision expense in light of the credit losses modeled in Step 2.Step 4: Estimate the Impact of Stress on CapitalStep 4 combines all the work done in Steps 1, 2, and 3 and ultimately models capital levels and ratios over the entirety of the forecast periods (which is normally nine quarters) in the different economic scenarios. Capital at the end of the forecast period is ultimately a function of capital and reserve levels immediately prior to the stressed period plus earnings or losses generated over the stressed period (inclusive of credit losses and provisions estimated).When assessing capital ratios during the pandemic period, it is important to also consider the impact of any strategic decisions that may help to alleviate stress on capital during this period, such as raising sub-debt, eliminating distributions or share repurchases, and slowing balance sheet growth.For perspective, the results released from the Federal Reserve suggested that under the V, U, and W shaped alternative downside scenarios, the aggregate CET1 capital ratios were 9.5%, 8.1%, and 7.7%, respectively.What Should Your Bank or Credit Union Do with the Results?What your bank or credit union should do with the results depends on the institution’s specific situation.For example, assume that your stress test reveals a lower exposure to certain economically exposed sectors during the pandemic and some countercyclical strengths such as mortgage banking/asset management/ PPP revenues.This helps your bank or CU maintain relatively strong and healthy performance over the stressed period in terms of capital, asset quality, and earnings performance. This performance could allow for and support a strategic/capital plan involving the continuation of dividends and/or share repurchases, accessing capital and/or sub-debt for growth opportunities, and proactively looking at ways to grow market share both organically and through potential acquisitions during and after the pandemic-induced downturn.For those banks and CUs that include M&A in the strategic/capital plan over the next two years, improved stress testing capabilities at your institution should assist with stress testing the target’s loan portfolio during the due diligence process. Alternatively, consider a bank that is in a relatively weaker position.In this case, the results may provide key insight that leads to quantifying the potential capital shortfall, if any, relative to either regulatory minimums or internal targets.After estimating the shortfall, management can develop an action plan, which could entail seeking additional common equity,accessing sub-debt, selling branches or higher-risk loan portfolios to shrink the balance sheet, or considering potential merger partners.Integrating the stress test results with identifiable action plans to remediate any capital shortfall can demonstrate that the bank’s existing capital, including any capital enhancement actions taken, is adequate in stressed economic scenarios. How Mercer Capital Can Help A well-reasoned and documented stress test can provide regulators, directors, and management the comfort of knowing that capital levels are adequate, at a minimum, to withstand the pandemic and maintain the dividend.A stress test can also support other strategies to enhance shareholder value, such as a share buyback plan, higher dividends, a strategic acquisition, or other actions to take advantage of the disruption caused by the pandemic.The results of the stress test should also enhance your bank or credit union’s decision-making process and be incorporated into strategic planning and the management of credit risk, interest rate risk, and capital.Having successfully completed thousands of engagements for financial institutions over the last 35 years, Mercer Capital has the experience to solve complex financial issues impacting community banks and credit unions during the ups and downs of economic cycles. Mercer Capital can help scale and improve your institution’s stress testing in a variety of ways. We can provide advice and support for assumptions within your bank or credit union’s pre-existing stress test. We can also develop a unique, custom stress test that incorporates your institution’s desired level of complexity and adequately captures the unique risks you face. Regardless of the approach, the desired outcome is a stress test and capital plan that can be used by managers, directors, and regulators to monitor capital adequacy, manage risk, enhance the bank’s performance, and improve strategic decisions. For more information on Mercer Capital’s Stress Testing and Capital Planning solutions, contact Jay Wilson at wilsonj@mercercapital.com. Originally appeared in Mercer Capital's Bank Watch, July 2020.

Oil & gas producers have been forced to take steps to improve their liquidity and make production cuts as prices have fallen to the lowest in decades, primarily due to a price war between Saudi Arabia and Russia as well as a demand slump amid the coronavirus pandemic. Weakness in the equity markets at the end of Q1 and through Q2 in 2020, due to the virus outbreak and substantial decline in commodity prices, have forced public oil & gas companies to take large impairment charges in recent quarterly reports (See table below for a non-exhaustive list of companies that have taken Q1 impairment charges). Even before prices started to collapse, energy companies were cutting outlooks and planning major asset write-downs. Last fall, Schlumberger planned to take a $12.7 billion charge as shale drilling slowed, and Chevron Corp. announced a $10 billion charge related to offshore assets in the Gulf of Mexico and its Appalachia shale assets. This post is aimed at discerning whether an oil & gas company may need to make interim impairment assessments in light of recent major global events and discuss the impairment testing process. The Basics of Impairment TestingIn an earlier post from Mercer Capital titled Goodwill Impairment Testing in Uncertain Times, we cover the basics of impairments, namely when it is appropriate to assess and how to perform tests of impairment with the most notable item for testing relating to goodwill on a company’s balance sheet.In short, under ASC Topic 360 impairment tests for long-lived assets should follow a two-or three-step process:Assess Impairment IndicatorsTest for RecoverabilityMeasure the Impairment In addition to the listed indicators in the accounting guidance, an entity may identify other indicators or “triggering events” that are particular to its business or industry. Once an indicator is identified, a company then tests for recoverability. For oil & gas companies, conditions such as extreme volatility of supply, demand, and sustained periods of low commodity prices brought on by international commodity price wars, adverse global politicking, and the novel coronavirus pandemic can constitute as triggering events to necessitate interim impairment testing.Oil & Gas Reserves – Accounting MethodologyAs opposed to the vast majority of companies outside of the energy sector, oil & gas companies have reserves that are considered long-lived assets for accounting purposes. These reserves are subject to the same impairment testing rules outlined above such that they are required to be tested on a periodic basis or when triggering events occur.Before performing any impairment testing, however, the accounting methods used to account for these oil & gas reserves need to be considered. Under ASC Topic 932, companies can use one of two methods to account for their oil and gas operations: the successful efforts method or the full cost method.Under the successful efforts method, the cost of drilling an oil well cannot be capitalized unless the well is successful. Costs for unsuccessful wells (dry holes) must be charged as an expense against revenue in the matching period.Under the full cost method, companies may capitalize all operating expenses relating to searching for and producing new oil reserves. Costs are then totaled and grouped into cost pools.Impairment Considerations Related to Oil & Gas Reserves In Statement of Financial Accounting Standards No. 19, the FASB requires that oil & gas companies use the successful efforts method. However, the SEC allows companies to use the full cost method. Guidance for impairment testing of reserves under both methods differ but are available to valuation and other practitioners conducting the tests.Successful Efforts MethodOil & gas companies that use the successful efforts method apply the guidance in ASC 932-360-35 and ASC 360-10-35 to account for the impairment of their reserve assets.Timing of Impairment Testing and Impairment IndicatorsUnder the successful efforts method, an oil & gas company generally performs a traditional two-step impairment analysis in accordance with ASC 360 when assessing reserves for indications of impairment. As mentioned above, impairment assessment for reserves may be determined on an annual basis or in the case of a triggering event. To begin, we bifurcate the total reserve assets into two major groups: proved properties and unproved properties.Proved properties in an asset group should be tested for recoverability whenever triggering events or changes in circumstances indicate that the asset group’s carrying amount may not be recoverable. Generally, companies that apply the successful efforts method will perform an annual impairment assessment upon receiving their annual reserve report by preparing a cash flow analysis. Companies can consider proved (P1), probable (P2), and possible (P3) reserves and other resources since these are all included in the value of the assets. Typically, the impairment evaluation of proved properties are performed on a field-by-field basis. Property groupings may differ due to specific circumstances like shared platform infrastructure or other logical reasons.Oil & gas companies should also assess unproved properties periodically to determine whether they have been impaired. The assessment of these properties is based mostly on qualitative factors and are generally assessed on a property-by-property basis.Measurement of Impairment LossA company that applies the successful efforts method then evaluates each asset group for impairment using the two-step approach under ASC Topic 360. In step one, the company will perform a cash flow recoverability test by comparing the summation of an asset group’s undiscounted cash flows with the asset group’s carrying value. If the undiscounted cash flows are less than the asset group's carrying value, the assets are likely impaired. The company would then proceed to step two of the impairment test to compare the asset group’s determined fair value with its carrying amount. An impairment loss would be recorded and measured as the amount by which the asset group’s carrying amount exceeds this determined fair value.Recognition of Impairment LossAn impairment loss for a proved property asset group will reduce only the carrying amounts of the group’s long-lived assets. The loss should be allocated to the long-lived assets of the group on a pro rata basis by using the relative carrying amounts of those assets. However, the loss allocated to an individual long-lived asset of the group should not reduce the asset’s carrying amount to less than its fair value if that fair value is determinable without undue cost and effort.For unproved properties, if the results of the assessment indicate impairment, a loss should be recognized by providing a valuation allowance. Under the successful efforts method and consistent with U.S. GAAP, companies are prohibited from reversing write-downs.In most cases, write-downs occur when oil & gas reserves cannot be extracted economically, such as on properties where drilling has not started or where properties were expected to be developed based on higher oil prices than are currently estimated. As evidenced in recent market events, if oil prices drop too low, the cost to develop the properties may outweigh the net revenues associated with production.Full Cost MethodAlthough less common in U.S financial reporting, companies that use the full-cost method of accounting should apply the guidance in Regulation S-X, Rule 4-10; SAB Topic 12.D; and FRC Section 406.01.c.Timing of Impairment Testing and Impairment IndicatorsUnder the full-cost method, a full-cost ceiling test must be performed on proved properties each reporting period. This “ceiling” is a formulaic limitation on the net book value of capitalized costs prescribed by SEC guidance listed above. This ceiling formula is equal to: + The present value of estimated future net revenues, minus any estimated future expenditures to develop and produce proved reserves, using a discount rate of 10% + The cost of any properties not being amortized + The lower of cost or the estimated fair value of unproved properties that are included in the amortized costs - Any income tax effects associated with differences between the book and tax basis of the excluded properties and the unproven properties being amortized Similar to the successful efforts method, unproved properties must be assessed periodically for inclusion in the full-cost pool, subject to amortization.Measurement and Recognition of Impairment LossIf a full cost pool ceiling is exceeded, the excess amount must be recorded as an expense. If the cost center ceiling later increases, like the successful efforts method, write-downs may not be reversed and the amount written off may not be reinstated.Determination of Fair Value of Oil & Gas ReservesIn the event that a step two analysis needs to be performed, the determination of fair value of the reserve assets can be performed under three approaches:Income approach — Under this approach, valuation techniques are used to convert future cash flows to a single present amount using a discount rate. The measurement is based on the value indicated by current market expectations about those future amounts.Market approach — This approach requires entities to consider prices and other relevant information in market prices and transactions that involve identical or comparable assets or companies. Valuation techniques commonly used under the market approach include the guideline public company and guideline transaction methods.Asset approach —Also known as the cost approach, the value of a business, business ownership interest, or tangible or intangible asset is estimated by determining the sum of total costs required to replace the investment or asset with similar utility. When determining the fair value of oil & gas reserves, companies use various methods and approaches. The vast majority utilize a discounted cash flow (DCF) model to estimate the fair value of reserves. Depending on circumstances other approaches or a mix of approaches may be appropriate for determining fair value of a company’s reserves.Concluding ThoughtsThe oil & gas market and the energy sector as a whole have taken a beating and experienced unprecedented events due to the global impacts from the pandemic and international price wars. While the scale of the full economic effects from these events has yet to be seen, companies are having to question and consider the need for interim impairment testing on reserves.At Mercer Capital, we have experience in implementing both the qualitative and quantitative aspects of interim oil & gas reserve impairment testing. To discuss the implications and timing of triggering events, please contact a professional in Mercer Capital’s Energy Group.

Analysts and pundits are debating whether the economic recovery will be shaped like a U, V, W, swoosh, or check mark and how long it may take to fully recover. To find clues, many are following the lead of the healthcare professionals and looking to Asia for economic and market data since these economies experienced the earliest hits and recoveries from the COVID-19 pandemic.Taking a similar approach led me to take a closer look at the Japanese megabanks for clues about how U.S. banks may navigate the COVID-19 crisis. In Japan, the banking industry is grappling with similar issues as U.S. banks, including the need to further cut costs; expanding branch closures; enhancing digital efforts; bracing for a tough year as bankruptcies rise; and looking for acquisitions in faster growing markets.Another similarity is impairment charges. Two of the three Japanese megabanks recently reported impairment charges. Mitsubishi UFJ Financial Group (MUFG) reported a ¥343 billion impairment charge related to two Indonesian and Thai lenders that MUFG owned controlling interests in and whose share price had dropped ~50% since acquisition. Mizuho Financial Group incurred a ¥39 billion impairment charge.In the years since the Global Financial Crisis, there have not been many goodwill impairment charges recognized by U.S. banks. A handful of banks including PacWest (NASDAQ-PACW) and Great Western Bancorp (NYSE-GWB) announced impairment charges with the release of 1Q20 results. Both announced dividend reductions, too.Absent a rebound in bank stocks, more goodwill impairment charges likely will be recognized this year. Bank stocks remain depressed relative to year-end pricing levels despite some improvements in May and early June. For perspective, the S&P 500 Index was down ~5% from year-end 2019 through May 31, 2020 compared to a decline of ~32% for the SNL Small Cap Bank Index and ~34% for the SNL Bank Index.This sharper decline for banks reflects concerns around net interest margin compression, future credit losses, and loan growth potential. The declines in the public markets mirrored similar declines in M&A activity and several bank transactions that had previously been announced were terminated before closing with COVID-19 impacts often cited as a key factor.Price discovery from the public markets tends to be a leading indicator that impairment charges and/or more robust impairment testing is warranted. The declines in the markets led to multiple compression for most public banks and the majority have been priced at discounts to book value since late March. At May 31, 2020, ~77% of publicly traded community banks (i.e., having assets below $5B) were trading at a discount to their book value with a median of ~83%. Within the cohort of banks trading below book value at May 31, 2020, ~74% were trading below tangible book value.Do I Need an Impairment Test?Goodwill impairment testing is typically performed annually. But the unprecedented events precipitated by the COVID-19 pandemic now raise questions whether an interim goodwill impairment test is warranted.The accounting guidance in ASC 350 prescribes that interim goodwill impairment tests may be necessary in the case of certain “triggering” events. For public companies, perhaps the most easily observable triggering event is a decline in stock price, but other factors may constitute a triggering event. Further, these factors apply to both public and private companies, even those private companies that have previously elected to amortize goodwill under ASU 2017-04.For interim goodwill impairment tests, ASC 350 notes that management should assess relevant events and circumstances that might make it more likely than not that an impairment condition exists. The guidance provides several examples, several of which are relevant for the bank industry including the following:Industry and market considerations such as a deterioration in the environment in which an entity operates or an increased competitive environmentDeclines in market-dependent multiples or metrics (consider in both absolute terms and relative to peers)Overall financial performance such as negative or declining cash flows or a decline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periodsChanges in the carrying amount of assets at the reporting unit including the expectation of selling or disposing certain assetsIf applicable, a sustained decrease in share price (considered both in absolute terms and relative to peers) The guidance notes that an entity should also consider positive and mitigating events and circumstances that may affect its conclusion. If a recent impairment test has been performed, the headroom between the recent fair value measurement and carrying amount could also be a factor to consider.How Does an Impairment Test Work?Once an entity determines that an interim impairment test is appropriate, a quantitative “Step 1” impairment test is required. Under Step 1, the entity must measure the fair value of the relevant reporting units (or the entire company if the business is defined as a single reporting unit). The fair value of a reporting unit refers to “the price that would be received to sell the unit as a whole in an orderly transaction between market participants at the measurement date.”For companies that have already adopted ASU 2017-04, the legacy “Step 2” analysis has been eliminated, and the impairment charge is calculated as simply the difference between fair value and carrying amount.ASC 820 provides a framework for measuring fair value which recognizes the three traditional valuation approaches: the income approach, the market approach, and the cost approach. As with most valuation assignments, judgment is required to determine which approach or approaches are most appropriate given the facts and circumstances. In our experience, the income and market approaches are most used in goodwill impairment testing. However, the market approach is somewhat limited in the current environment given the lack of transaction activity in the banking sector post-COVID-19.In the current environment, we offer the following thoughts on some areas that are likely to draw additional scrutiny from auditors and regulators.Are the financial projections used in a discounted cash flow analysis reflective of recent market conditions? What are the model’s sensitivities to changes in key inputs?Given developments in the market, do measures of risk (discount rates) need to be updated?If market multiples from comparable companies are used to support the valuation, are those multiples still applicable and meaningful in the current environment?If precedent M&A transactions are used to support the valuation, are those multiples still relevant in the current environment?If the subject company is public, how does its current market capitalization compare to the indicated fair value of the entity (or sum of the reporting units)? What is the implied control premium and is it reasonable in light of current market conditions? At a minimum, we anticipate that additional analyses and support will be necessary to address these questions. The documentation from an impairment test at December 31, 2019 might provide a starting point, but the reality is that the economic and market landscape has changed significantly in the first half of 2020.Concluding ThoughtsWhile not all industries have been impacted in the same way from the COVID-19 pandemic and economic shutdown, the banking industry will not escape unscathed given the depressed valuations observed in the public markets. For public and private banks, it can be difficult to ignore the sustained and significant drop in publicly traded bank stock prices and the implications that this might have on fair value and the potential for goodwill impairment.At Mercer Capital, we have experience in implementing both the qualitative and quantitative aspects of interim goodwill impairment testing. To discuss the implications and timing of triggering events, please contact a professional in Mercer Capital’s Financial Institutions Group.Originally published in Bank Watch, June 2020.Request for ProposalMercer Capital is pleased to prepare a proposal for impairment testing services for your bank or bank holding company. Follow the link below to complete a submission.Bank Impairment Testing Proposal Request »

The economic impact from the COVID-19 pandemic has been swift and unexpected. Just a few short weeks ago, the S&P 500 was at an all-time high and goodwill impairments were not a serious concern for most companies. However, between mid-February and the end of March, the S&P 500 declined by 25%. The Russell 2000 fell nearly 32% over the same period, and the negative shock to certain companies and sectors has been much worse.Most financial professionals understand that goodwill impairment testing is typically performed annually, usually near the end of a Company’s fiscal year. In fact, many companies just completed an impairment test as of year-end 2019. But the unprecedented events precipitated by the COVID-19 pandemic now raise questions about whether an interim goodwill impairment test is warranted.Do I Need an Impairment Test?The accounting guidance in ASC 350 prescribes that interim goodwill impairment tests may be necessary in the case of certain “triggering” events. For public companies, perhaps the most easily observable triggering event is a decline in stock price, but other factors may constitute a triggering event. Further, these factors apply to both public and private companies, even those private companies that have previously elected to amortize goodwill under ASU 2017-04.For interim goodwill impairment tests, ASC 350 notes that entities should assess relevant events and circumstances that might make it more likely than not that an impairment condition exists. The guidance provides several examples, including the following:Changes in the macroeconomic environment, such as a deterioration in general economic conditionsLimitations on accessing capital, fluctuations in foreign exchange rates, or other developments in equity and credit marketsIndustry and market considerations such as a deterioration in the environment in which an entity operates or an increased competitive environmentDeclines in market-dependent multiples or metrics (consider in both absolute terms and relative to peers)Changes in the market for an entity’s products or services, or a regulatory or political developmentCost factor considerations such as increases in raw materials, labor, or other costs that have a negative effect on earnings and cash flowsOverall financial performance such as negative or declining cash flows or a decline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periodsEntity-specific events (changes in management or key customers, contemplation of bankruptcy, adverse litigation or regulatory events)Changes in the carrying amount of assets at the reporting unit including the expectation of selling or disposing certain assetsIf applicable, a sustained decrease in share price (considered both in absolute terms and relative to peers) The examples above are not all-inclusive and entities should consider other relevant events and circumstances that might affect the fair value or carrying amount of a reporting unit. An entity should place more weight on the events and circumstances that most affect a reporting unit’s fair value or the carrying amount of its net assets. The guidance notes that an entity should also consider positive and mitigating events and circumstances that may affect its conclusion. If a recent impairment test has been performed, the headroom between the recent fair value measurement and carrying amount could also be a factor to consider.How an Impairment Test WorksOnce an entity determines that an interim impairment test is appropriate, a quantitative “Step 1” impairment test is required. Under Step 1, the entity must measure the fair value of the relevant reporting units (or the entire company if the business is defined as a single reporting unit). The fair value of a reporting unit refers to “the price that would be received to sell the unit as a whole in an orderly transaction between market participants at the measurement date.”For companies that have already adopted ASU 2017-04, the legacy “Step 2” analysis has been eliminated, and the impairment charge is calculated as simply the difference between fair value and carrying amount. Under the old framework, an additional “Step 2” analysis was performed and the impairment charge was based on the amount by which carrying amount exceeded the implied value of goodwill.ASC 820 provides a framework for measuring fair value which recognizes the three traditional valuation approaches: the income approach, the market approach, and the cost approach. As with most valuation assignments, judgment is required to determine which approach or approaches are most appropriate given the facts and circumstances. In our experience, the income and market approaches are most commonly used in goodwill impairment testing. In the current environment, we offer the following thoughts on some areas that are likely to draw additional scrutiny from auditors and regulators.Are the financial projections used in a discounted cash flow analysis reflective of recent market conditions? What are the model’s sensitivities to changes in key inputs?Given developments in the market, do measures of risk (discount rates) need to be updated?If market multiples from comparable companies are used to support the valuation, are those multiples still applicable and meaningful in the current environment?If precedent M&A transactions are used to support the valuation, are those multiples still relevant in the current environment?If the subject company is public, how does its current market capitalization compare to the indicated fair value of the entity (or sum of the reporting units)? What is the implied control premium and is it reasonable in light of current market conditions? At a minimum, we anticipate that additional analyses and support will be necessary to address these questions. The documentation from an impairment test at December 31, 2019 might provide a starting point, but the reality is that the economic landscape has changed significantly in the last three months.Concluding ThoughtsNot all industries have been impacted in the same way and there will certainly be differences between companies. For public companies, it can be difficult to ignore the significant drop in stock prices and the implications that this might have on fair value. For private businesses, even if a triggering event has not arisen yet, the deteriorating economic environment may just push the triggering factors into the second or third quarter of the year.At Mercer Capital, we have experience in implementing both the qualitative and quantitative aspects of interim goodwill impairment testing. To discuss the implications and timing of triggering events, please contact a professional in Mercer Capital’s Financial Statement Reporting Group.

Have you downloaded Mercer Capital’s 2019 Energy Purchase Price Allocation Study yet?The study provides a detailed analysis and overview of valuation and accounting trends in these subsectors of the energy space.  It enables key users and preparers of financial statements to better understand the asset mix, valuation methods, and useful life trends in the energy space as they pertain to business combinations under ASC 805 and GAAP fair value standards under ASC 820. Download here.

Last week, Mercer Capital released its 2019 Energy Purchase Price Allocation Study.  In this post, we’ll be taking a deeper dive into the Exploration & Production transactions reviewed in the analysis.The E&P sector had the lowest average allocation to intangible assets, at just 2% of total purchase consideration.  In fact, only two of the eleven transactions analyzed had any intangible allocation at all.  Oasis Petroleum recorded a small ($1 million) intangible asset related to a non-compete agreement in connection with its acquisition of Forge Energy.  The major outlier was Concho Resources, which recorded over $2.2 billion of goodwill related to its acquisition of RSP Permian.Exploration & Production is not an intangible asset-driven business model.  These companies sell a commodity, so there is no real brand value leading to trademark or trade name allocations.  Bill Barrett and Fifth Creek rebranded as HighPoint Resources after their merger, and recently two E&P companies (Ovintiv, formerly Encana, and Battalion Oil Corporation, formerly Halcon Resources) changed names, the latter likely influenced by its emergence from bankruptcy.The commodity is generally sold at market hubs, so specific customer relationships have minimal value.  (To the extent the company has derivatives that result in above-market pricing realizations, that asset is captured separately.)And while E&P companies tout their technical prowess, few outside of the majors spend meaningfully on R&D or have protected intellectual property.  None of the transactions analyzed in this year’s study included allocations to Developed Technology or In Process Research & Development.Ultimately, the value of an E&P company is driven by its reserves, and purchase price allocations generally reflected that.  Based on the transactions reviewed in our analysis, ~90% of purchase consideration was allocated to reserves.Again, the outlier in the data is Concho’s acquisition of RSP Permian, in which over $2.2 billion was allocated to goodwill.  In its 2018 10-K filing, Concho rationalized the goodwill value as follows:Goodwill recognized is primarily attributable to the following factors: (i) operating and administrative synergies and (ii) net deferred tax liabilities arising from the differences between the purchase price allocated to RSP’s assets and liabilities based on fair value and the tax basis of these assets and liabilities. For the operating and administrative synergies, the total consideration for the RSP Acquisition included a control premium, which resulted in a higher value compared to the fair value of net assets acquired. There are also other qualitative assumptions of long-term factors that the RSP Acquisition creates for the Company’s stockholders, including additional potential for exploration and development opportunities and additional scale and efficiencies in basins in which the Company operates.Despite the headwinds faced by the E&P sector since the Concho / RSP transaction, Concho has indicated that this goodwill value has not been impaired.  The company’s most recent 10-Q indicates that quantitative impairment tests were performed as of July 1, August 29, and September 30, 2019.  (However, Concho did take an $81 million goodwill impairment charge related to certain New Mexico Shelf acreage that was divested in 2019.)In an environment of increasingly complex fair value reporting standards and burgeoning regulatory scrutiny, Mercer Capital helps clients resolve financial reporting valuation issues successfully. We have the capability to serve the full range of fair value valuation needs, providing valuation opinions that satisfy the scrutiny of auditors, the SEC, and other regulatory bodies. Contact our Energy Industry or Financial Reporting Valuation teams to discuss your valuation needs in confidence.

When performing a purchase price allocation for an oilfield services company, careful attention must be given to both the relevant accounting rules and the specific nuances of the oil and gas industry. Oilfield services companies can entail many unique characteristics that are not present in non-oilfield related businesses such as manufacturing, wholesale, non-energy related services, or retail.  Our senior professionals bring significant experience in performing purchase price allocations in the oilfield services area where knowledge of these characteristics is crucial to determining the proper allocation among the subject company’s assets.For the most part, current assets and current liabilities are relatively straight forward. The unique factors of an oilfield services company are found in the fixed assets and intangibles: specialized drilling and production equipment, service contracts, proprietary technology (patented, or unpatented), methods, or software, in-process research and development assets (IPR&D), etc.  In addition, the proper consideration of contributory asset charges in the appraisal of existing customer relationships or technology in the context of oilfield services companies requires a thorough understanding of how such contributory assets are utilized in generating the subject company’s expected operating results.  We will explore the unique factors in future entries. In this blog post, we discuss the guidelines for purchase price allocations that all companies must adhere.The unique factors of an oilfield services company are found in the fixed assets and intangibles.Reviewing a purchase price allocation report can be a daunting task if you don’t do it for a living – especially if you aren’t familiar with the rules and standards governing the allocation process and the valuation methods used to determine the fair value of intangible assets. While it can be tempting as a financial manager to leave this job to your auditor and valuation specialist, it is important to stay on top of the allocation process. Too often, managers find themselves struggling to answer eleventh-hour questions from auditors or being surprised by the effect on earnings from intangible asset amortization. This guide is intended to make the report review process easier while helping to avoid these unnecessary hassles.It should be noted that a review of the valuation methods and fair value accounting standards is beyond the scope of this guide. Grappling with these issues is the responsibility of the valuation specialist, and a purchase price allocation report should explain the valuation issues relevant to your particular acquisition. Instead, this guide focuses on providing an overview of the structure and content of a properly prepared purchase price allocation report.General GuidanceWhile every acquisition will present different circumstances that will impact the purchase price allocation process, there are a few general rules common to all properly prepared reports. From a qualitative standpoint, a purchase price allocation report should satisfy three conditions:The report should be well-documented. As a general rule, the reviewer of the purchase price allocation should be able to follow the allocation process step-by-step. Supporting documentation used by the valuation specialist in the determination of value should be clearly listed and the report narrative should be sufficiently detailed so that the methods used in the allocation can be understood.The report should demonstrate that the valuation specialist is knowledgeable of all relevant facts and circumstances pertaining to the acquisition. If a valuation specialist is not aware of pertinent facts related to the company or transaction, he or she will be unable to provide a reasonable purchase price allocation. If the report does not demonstrate this knowledge, the reviewer of the report will be unable to rely on the allocation.The report should make sense. A purchase price allocation report will not make sense if it describes an unsound valuation process or if it describes a reasonable valuation process in an abbreviated, ambiguous, or dense manner. Rather, the report should be written in clear language and reflect the economic reality of the acquisition (within the bounds of fair value accounting rules). This can be particularly daunting if the reviewer of the purchase price allocation report does not have significant experience in working with oilfield services industry participants.  The oilfield services industry is particularly strong in industry-specific terminology and jargon that can lead to a lack of understanding among purchase price allocation report reviewers that lack a deep industry background.Definition of AssignmentA purchase price allocation report should include a clear definition of the valuation assignment. For a purchase price allocation, the assignment definition should include:The definition of the valuation objective should specify the client, the acquired business, and the intangible assets to be valued.The purpose explains why the valuation specialist was retained. Typically, a purchase price allocation is completed to comply with GAAP financial reporting rules.Effective Date. The effective date of the purchase price allocation is typically the closing date of the acquisition.Standard of Value. The standard of value specifies the definition of value used in the purchase price allocation. If the valuation is being conducted for financial reporting purposes, the standard of value will generally be fair value as defined in ASC 820.Statement of Scope and Limitations. Most valuation standards of practice require such statements that clearly delineate the information relied upon and specify what the valuation does and does not purport to do.Background InformationThe purchase price allocation report should demonstrate that the valuation specialist has a thorough understanding of the acquired business, the intangible assets to be valued, the company’s historical financial performance, and the transaction giving rise to the purchase price allocation.Understanding of the BusinessThe purchase price allocation report should include a discussion related to the acquired company which demonstrates that the valuation specialist is knowledgeable of the company and has conducted sufficient due diligence for the valuation. The overview should also discuss any characteristics of the company that plays a material role in the valuation process. The description should almost always include discussion related to the history and structure of the company, the competitive environment, and key operational considerations.In the case of acquisitions within the oilfield services industry, the pertinent facts include a thorough understanding as to the demand for the subject company’s services across the various basins within the target market.  Unlike many other industries, oilfield services businesses may provide services that are specific to certain basins.  Therefore, expectations regarding the specific basins served may be of much greater importance than expectations for the overall oil and gas industry.Intangible AssetsThe discussion of the subject intangible assets should both provide an overview of all relevant technical guidance related to the particular asset and detail the characteristics of the assets that are significant to the valuation. The overview of guidance demonstrates the specialist is aware of all the relevant standards and acceptable valuation methods for a given asset.Upon reading this section, the reviewer of the purchase price allocation report should have a clear understanding of how the existence of the various intangible assets contribute to the value of the enterprise (how they impact cash flow, risk, and growth).Within the oilfield services industry, in particular, one may have to spend a significant amount of time in the determination of what intangible assets were acquired, what intangible assets should recognized as a separate asset from goodwill (based on the legal/contractual rights and separability considerations) and what intangible assets are likely to have a material value.  These can differ markedly across industries and such considerations can be somewhat unique in the oilfield services industry.Past PerformanceThe historical financial performance of the acquired company provides important context to the story of what the purchasing company plans to do with its new acquisition. While prospective cash flows are most relevant to the actual valuation of intangible assets, the acquired company’s historical performance is a useful tool to substantiate the reasonableness of stated expectations for future financial performance.The historical financial performance of the acquired company provides important context to the story.This does not mean that a company that has never historically made money cannot reasonably be expected to operate profitably in the future. It does mean that management must have a compelling growth or turn-around story (which the specialist would thoroughly explain in the company overview discussion in the report).Understanding an oilfield services company’s past financial performance requires knowledge of industry-specific trends that can impact activity levels, pricing for particular services, competing service providers, and profit margins.  The oilfield services industry is subject to potentially wide fluctuations in activity that can be driven by commodity prices and technological changes.  A thorough understanding of these dynamics is necessary in order to correctly interpret past performance among industry participants.Transaction OverviewTransaction structures can be complicated and specific deal terms often have a significant impact on value. Purchase agreements may specify various terms for initial purchase consideration, include or exclude specific assets and liabilities, specify various structures of earn-out consideration, contain embedded contractual obligations, or contain other unique terms. The valuation specialist must demonstrate a thorough understanding of the deal terms and discuss the specific terms that carry significant value implications.Determination of ValueThe purchase price allocation report should provide an adequate description of the valuation approaches and methods relevant to the project. In general, the report should outline the three approaches to valuation (the cost approach, the market approach, and the income approach), regardless of the approaches selected for use in the valuation. This demonstrates that the valuation specialist is aware of and considered each of the approaches in the ultimate selection of valuation methods appropriate for the given circumstances.Any of a number of valuation methods could be appropriate for a given intangible asset depending on the specific situation. While selection of the appropriate method is the responsibility of the valuation specialist, the reasoning should be documented in the report in such a way that a report reviewer can assess the valuation specialist’s judgment.In the closing discussion related to the valuation process, the report should provide some explanation of the overall reasonableness of the allocation. This part of the purchase price allocation report should include both a qualitative assessment and quantitative analysis for support. While this support will differ depending on circumstances, the report should adequately present how the valuation “hangs together.”Within the oilfield services industry determination as to the reasonableness of the indicated allocation of value (purchase price) is often a factor of whether the subject company’s services are subject to proprietary technology, the level of fixed assets required to provide the subject company’s services and the level of personal interaction with customers.  Based on such factors, the allocation of value might be reasonably expected to be skewed to particular types of assets, with higher, or lower, expected levels of goodwill.Keep in Mind, it’s Not a BlackboxA purchase price allocation is not intended to be a black box that is fed numbers and spits out an allocation. The fair value accounting rules and valuation guidance require that it be a reliable and auditable process so that users of financial statements can have a clear understanding of the actual economics of a particular acquisition. As a result, the allocation process should be sufficiently transparent that you are able to understand it without excessive effort, and the narrative of the report is a necessary component of this transparency.

A Look at WeWork’s Failed IPOIn last quarter’s issue of Portfolio Valuation we raised the issue as to whether public market investors are more critical (or discerning) in establishing value than private equity investors.The evidence this year largely is, yes—at least for companies where there is skepticism as to whether meaningful profitability can be achieved. Lyft, SmileDirectClub and Uber are examples of unicorns that saw share prices marked sharply lower after the IPO (Lyft, SDC) or during the roadshow (Uber); and The We Company’s planned IPO never occurred due to pushback by investors. At the other extreme is Beyond Meat, which as of early October had risen about six-fold from its May IPO.The We Company’s (formerly “WeWork” and will be refered to in this article as WeWork) valuation journey is interesting (maybe even fascinating).WeWork, which was founded in 2010, is a real estate company that signs long-term leases for pricey real estate that it refurbishes then releases the space short-term. The company describes itself somewhat differently as a “community company committed to maximum global impact.” The S-1 disclosed not only massive losses, but also significant corporate governance issues.Year-to-date revenues through June 30, 2019 doubled to $1.5 billion from the comparable period in 2018, but the operating loss also doubled to $1.4 billion.EBITDA for the six months was negative $511 million, while capex totaled $1.3 billion. That is a big hole to fill every six months before factoring in rapid growth to be financed.Cash as of June 30 totaled $2.5 billion, while the capital structure entails a lot of debt and negative equity. From a valuation perspective, WeWork is problematic because operating cash flows are deep in the red with little prospect of turning positive anytime soon. Nonetheless, the increase in value private equity investors placed on the company was astounding. The company pierced the unicorn threshold in early 2014 when affiliates of JPMorgan invested $150 million in the fourth funding at a post-raise $1.5 billion valuation. T. Rowe Price and Goldman Sachs invested $434 million in late 2014, which resulted in a post raise valuation of $10 billion. The 7th and 8th funding rounds are where the valuation really gets interesting.In August 2017 SoftBank Vision Fund invested $3.1 billion, which implied a valuation of $21 billion.SoftBank Group Corp., which sponsors the Vision Fund, invested $4.0 billion in January 2019 at an implied valuation of $47 billion. When the underwriters were forced to pull the plug on the IPO the targeted post-raise valuation reportedly was $10 billion to $15 billion—a value the company apparently was willing to accept because it needs the cash.We do not know exactly how private equity investors valued the company.Presumably discounted cash flow (DCF), guideline public company and guideline transaction methods were used, perhaps overlaid with a Monte Carlo simulation.The valuation history raises an important question: how was a stupendous valuation achieved in the private markets by a cash incinerator such as WeWork? A similar question could be asked about many high-profile PE-backed investments.The short answer is that Softbank thinks the valuation increased significantly even though the company’s fundamentals argue otherwise. Prospective investors such as the public ones who were offered WeWork shares in an IPO could prepare their own DCF forecast to value the company.They also could examine past transactions in the company for relevant valuation information. Likewise, they could examine capital transactions in similar companies.Both sets of data fall under the guideline transaction method. A transaction in a privately held company infers a meaningful data point about value to investors, but there are a couple of caveats.One is an assumption that both parties are fully-informed and neither is forced to transact.Great values were realized by those willing to buy during the 2008 meltdown because there were so many forced sellers that ran the gamut from levered credit investors forced to dump bonds to the likes of Wachovia Corporation and National City Corporation. The price data was legitimate, but many sellers faced margin calls and had to dump assets into an illiquid market.Is the valuation data relevant if “normal” market conditions prevail?The second issue relates to private equity valuation generally, but especially those where start-up losses and ongoing capital requirements can be huge.The valuation issue relates to using transaction data from investments in other money losing enterprises.Is it always valid to apply multiples paid by investors in a funding round of a money-losing business to value another money-losing business? The valuation data may be factual, but it may be nonsense when weighed against the business’ operating and financial performance.One can question Softbank’s motives.Did Softbank need a higher valuation to offset losses in other parts of the portfolio in order to maintain investor and lender confidence? Was a higher valuation necessary to support upcoming capital raises? We do not know, but prospective public investors were dismissive of Softbank’s valuations and they appear to be dismissive of the prior two raises given how low the price talk had fallen by the time the IPO was pulled. We at Mercer Capital respect markets and the pricing information that is conveyed.The prices at which assets transact in private and public markets are critical observations; however, so too are a subject company’s underlying fundamentals, especially the ability to produce positive operating cash flow and a return on capital that at least approximates the cost of capital provided.Mercer Capital can assist with the valuation of your portfolio companies.We value hundreds of debt and equity securities of privately held companies every year and have been doing so for nearly four decades.Please call if we can assist in the valuation of your portfolio companies.Originally published in Mercer Capital’s Portfolio Valuation Newsletter:Third Quarter 2019

The IPO market is hot thanks to the intersection of investor enthusiasm and a new crop of venture capital-backed, and in some instances traditional private equity-backed, firms that have gone public. Unicorns (pre-IPO valuation of $1 billion or more) in particular have caught investors’ attention. There is nothing new about a hot IPO cycle in the U.S. IPO activity waxes and wanes with markets. The last massive wave occurred in 1999 when a mania swept through markets as then internet and other technology-focused companies captured investors’ imaginations.1999 vs. 2019Why has 2019 become the year of the unicorn IPO? It could be a matter of timing and monetary policy. After a nearly ten-year bull market, private equity is monetizing while the IPO window remains open after it more or less closed in the fourth quarter of 2018. Also, easy money policies the past decade arguably have incented investors to shower capital on growth-focused tech companies. With the Fed likely to begin cutting rates again in 2019, capital flows may intensify again.Nonetheless, the current IPO wave is different from 1999 and other peaks on three related counts. One is the length of time most venture-backed companies have remained private before going public. The other is the staggering amount of losses incurred even on an “adjusted” basis before going public. The link between the two differences has been the willingness of deep-pocketed investors, such as SoftBank, to fund losses through multiple capital raises. The link gives rise to the third difference: staggeringly large private market valuations for some.Looking at how several of the big name public offerings have fared this year, we can’t help but wonder:Do current losses matter to public market investors?Did the private market overvalue these unicorns?What does all of this mean for other unicorns planning to go public in 2019?The short answers are: perhaps, probably, and hurry.Sentiment Toward Recent UnicornsPublic investors seemingly have been more discerning about losses than private investors who pushed valuations higher for many companies with successive funding rounds. Price performance in the post-IPO market has been uneven as would be expected, but it points to less tolerance among public market investors to the extent big money losers such as Lyft and Uber have much lower valuations today than expected when their IPO roadshows were launched. Blue Apron is a poster child for a disaster post-IPO stock, but it is not alone.Lyft and Uber point to the more critical view public investors have taken of each company’s business model as it relates to future earnings. Lyft priced near the high end of the range targeted initially by lead underwriter JPMorgan and then saw strong first day performance; however, it now trades about 15% below the IPO price.Uber has traded down modestly from the IPO price, but lead underwriter Morgan Stanley had to sharply reduce the IPO price from when the roadshow started with price talk of a $90 billion to $100 billion post-raise valuation compared to about $73 billion presently.Uber and Lyft posted the highest revenue growth over the prior three years, but also the largest losses. The losses didn’t prohibit the companies from going public, but the uncertainty of a future path to profitability has led to disappointing performance relative to the hype that has surrounded the companies. Perhaps investors see a better outlook for Slack Technologies, which went public via a direct listing on the NYSE in mid-June. Although the company is not yet profitable, the shares rose nearly 50% on the first day of trading as either investors see a path to profitability or too few shares were floated. On the other hand, both Tradeweb and Zoom among a number of newly minted tech companies have performed well since their respective IPOs. Both were profitable in the year prior to the IPO, which is more in line with the kind of pre-offering financials that public investors are used to seeing. The market has rewarded the two companies accordingly. The next big name to test investors’ willingness to fund sizable losses is The We Company. The company confidentially filed for an IPO at the end of 2018 and is expected to begin a roadshow soon. The We Company may be the ultimate unicorn to test the market. It is minting losses. Only through the company’s defined term “community adjusted” EBITDA, which is akin to a twice-adjusted EBITDA, does the company post positive EBITDA. Also, the company has a huge $45 billion valuation based upon its last fundraising round; yet, its business model may be suspect in that it entails acquiring expensive real estate that generally is leased under short-term arrangements. Presumably, in a recession, lease rates would plummet as vacancies soar.Some have raised legitimate questions about valuation processes employed by private equity and VC firms and whether private market valuations are too high. Others have noted investors can, in effect, mark-up the value of prior investments by investing in follow-on capital raises for a given company at a higher valuation. ConclusionWe do not mean to disparage anyone with the issues raised in this article. We respect markets and the pricing information that is conveyed. The prices at which assets transact in private and public markets are critical observations; however, so too are a subject company’s underlying fundamentals, especially the ability to produce positive operating cash flow and a return on capital that at least approximates the cost of capital provided.At Mercer Capital we have been valuing private equity and private credit securities for nearly four decades and have deep experience in most industries. If we can help you establish the value of securities held in your fund or offer a second opinion, please call. We would be glad to assist. Stock Performance Since IPO (Pricing as of 6/20/19)Three Year Financial PerformancePrivate vs. Public Valuation (Pricing as of 6/20/19)Originally published in Mercer Capital’s Portfolio Valuation Newsletter: Second Quarter 2019

This guest post first appeared on Mercer Capital’s Financial Reporting Blog on January 18, 2016.  When performing a purchase price allocation for an Exploration and Production (E&P) company, careful attention must be paid to both the accounting rules and the specialty nuances of the oil and gas industry. E&P companies are unique entities compared to traditional businesses such as manufacturing, wholesale, services or retail. As unique entities, the accounting rules have both universal rules to adhere as well as industry specific. Our senior professionals bring significant experience in performing purchase price allocations in the E&P area where these two principles collide. For the most part, current assets, current liabilities are straight forward. The unique factors of an E&P are found in the fixed assets and intangibles: producing, probable and possible reserves, raw acreage rights, gathering systems, drill rigs, pipe, working interests, royalty interests, contracts, hedges, etc. Different accounting methods like the full cost method or the successful efforts method can create comparability issues between two E&P’s that utilize opposite methods. We will explore the unique factors in future entries. In this blog post, we discuss the guidelines for purchase price allocations that all companies must adhere.Reviewing a purchase price allocation report can be a daunting task if you don’t do it for a living – especially if you aren’t familiar with the rules and standards.Reviewing a purchase price allocation report can be a daunting task if you don’t do it for a living – especially if you aren’t familiar with the rules and standards governing the allocation process and the valuation methods used to determine the fair value of intangible assets. While it can be tempting as a financial manager to leave this job to your auditor and valuation specialist, it is important to stay on top of the allocation process. Too often, managers find themselves struggling to answer eleventh-hour questions from auditors or being surprised by the effect on earnings from intangible asset amortization. This guide is intended to make the report review process easier while helping to avoid these unnecessary hassles.Please note that a review of the valuation methods and fair value accounting standards is beyond the scope of this guide. Grappling with these issues is the responsibility of the valuation specialist, and a purchase price allocation report should explain the valuation issues relevant to your particular acquisition. Instead, this guide focuses on providing an overview of the structure and content of a properly prepared purchase price allocation report.General RulesWhile every acquisition will present different circumstances that will impact the purchase price allocation process, there are a few general rules common to all properly prepared reports. From a qualitative standpoint, a purchase price allocation report should satisfy three conditions:The report should be well-documented. As a general rule, the reviewer of the purchase price allocation should be able to follow the allocation process step-by-step. Supporting documentation used by the valuation specialist in the determination of value should be clearly listed and the report narrative should be sufficiently detailed so that the methods used in the allocation can be understood.The report should demonstrate that the valuation specialist is knowledgeable of all relevant facts and circumstances pertaining to the acquisition. If a valuation specialist is not aware of pertinent facts related to the company or transaction, he or she will be unable to provide a reasonable purchase price allocation. If the report does not demonstrate this knowledge, the reviewer of the report will be unable to rely on the allocation.The report should make sense. A purchase price allocation report will not make sense if it describes an unsound valuation process or if it describes a reasonable valuation process in an abbreviated, ambiguous, or dense manner. Rather, the report should be written in clear language and reflect the economic reality of the acquisition (within the bounds of fair value accounting rules).Assignment DefinitionA purchase price allocation report should include a clear definition of the valuation assignment. For a purchase price allocation, the assignment definition should include:Objective. The definition of the valuation objective should specify the client, the acquired business, and the intangible assets to be valued.Purpose. The purpose explains why the valuation specialist was retained. Typically, a purchase price allocation is completed to comply with GAAP financial reporting rules.Effective Date. The effective date of the purchase price allocation is typically the closing date of the acquisition.Standard of Value. The standard of value specifies the definition of value used in the purchase price allocation. If the valuation is being conducted for financial reporting purposes, the standard of value will generally be fair value as defined in ASC 820.Statement of Scope and Limitations. Most valuation standards of practice require such statements that clearly delineate the information relied upon and specify what the valuation does and does not purport to do.Background InformationThe purchase price allocation report should demonstrate that the valuation specialist has a thorough understanding of the acquired business, the intangible assets to be valued, the company’s historical financial performance, and the transaction giving rise to the purchase price allocation.Company OverviewDiscussion related to the acquired company should demonstrate that the valuation specialist is knowledgeable of the company and has conducted sufficient due diligence for the valuation. The overview should also discuss any characteristics of the company that play a material role in the valuation process. The description should almost always include discussion related to the history and structure of the company, the competitive environment, and key operational considerations.Intangible AssetsThe intangible assets discussion should both provide an overview of all relevant technical guidance related to the particular asset and detail the characteristics of the asset that are significant to the valuation. The overview of guidance demonstrates the specialist is aware of all the relevant standards and acceptable valuation methods for a given asset.After reading this section, the reviewer of the purchase price allocation report should have a clear understanding of how the existence of the various intangible assets contribute to the value of the enterprise (how they impact cash flow, risk, and growth).Historical Financial PerformanceThe historical financial performance of the acquired company provides important context to the story of what the purchasing company plans to do with its new acquisition. While prospective cash flows are most relevant to the actual valuation of intangible assets, the acquired company’s historical performance is a useful tool to substantiate the reasonableness of stated expectations for future financial performance.This does not mean that a company that has never historically made money cannot reasonably be expected to operate profitably in the future. It does mean that management must have a compelling growth or turn-around story (which the specialist would thoroughly explain in the company overview discussion in the report).Transaction OverviewTransaction structures can be complicated and specific deal terms often have a significant impact on value. Purchase agreements may specify various terms for initial purchase consideration, include or exclude specific assets and liabilities, specify various structures of earn-out consideration, contain embedded contractual obligations, or contain other unique terms. The valuation specialist must demonstrate a thorough understanding of the deal terms and discuss the specific terms that carry significant value implications.Fair Value DeterminationThe report should provide adequate description of the valuation approaches and methods relevant to the purchase price allocation. In general, the report should outline the three approaches to valuation (the cost approach, the market approach, and the income approach), regardless of the approaches selected for use in the valuation. This demonstrates that the valuation specialist is aware of and considered each of the approaches in the ultimate selection of valuation methods appropriate for the given circumstances.The report should outline the three approaches to valuation, regardless of the approaches selected for use in the valuation.Depending on the situation, any of a number of valuation methods could be appropriate for a given intangible asset. While selection of the appropriate method is the responsibility of the valuation specialist, the reasoning should be documented in the report in such a way that a report reviewer can assess the valuation specialist’s judgment.At the closing of the discussion related to the valuation process, the report should provide some explanation of the overall reasonableness of the allocation. This discussion should include both a qualitative assessment and quantitative analysis for support. While this support will differ depending on circumstances, the report should adequately present how the valuation “hangs together.”Something to RememberA purchase price allocation is not intended to be a black box that is fed numbers and spits out an allocation. The fair value accounting rules and valuation guidance require that it be a reliable and auditable process so that users of financial statements can have a clear understanding of the actual economics of a particular acquisition. As a result, the allocation process should be sufficiently transparent that you are able to understand it without excessive effort, and the narrative of the report is a necessary component of this transparency.

FinTech M&A continues to be top of mind for the sector as larger players seek to grow and expand while founders and early investors look to monetize their investments.This theme was evident in several larger deals already announced in 2019 including Global Payments/Total System Services (TSYS), Fidelity National Information Services, Inc./Worldpay, Inc., and Fiserv, Inc./First Data Corporation.One important aspect of FinTech M&A is the purchase price allocation and the valuation estimates for goodwill and intangible assets as many FinTech companies have minimal physical assets and a high proportion of the purchase price is accounted for via goodwill and intangible assets.The majority of value creation for the acquirer and their shareholders will come from their investment in and future utilization of the intangibles of the FinTech target.To illustrate this point, consider that the median amount of goodwill and intangible assets was ~98% of the transaction price for FinTech transactions announced in 2018.Since such a large proportion of the transaction price paid for FinTech companies typically gets carried in the form of goodwill or intangibles on the acquirer’s balance sheet, the acquirer’s future earnings, tax expenses, and capitalization will often be impacted significantly from the depreciation and amortization expenses.When preparing valuation estimates for a purchase price allocation for a FinTech company, one key step for acquirers is identifying the intangible assets that will need to be valued.In our experience, the identifiable intangible assets for FinTech acquisitions often include the tradename, technology (both developed and in-development), noncompete agreements, and customer relationships.Additionally, there may be a need to consider the value of an earn-out arrangement if a portion of transaction consideration is contingent on future performance as this may need to be recorded as a contingent liability.Since the customer relationship intangible is often one of the more significant intangible assets to be recorded in FinTech acquisitions (both in $ amounts and as a % of the purchase price), we discuss how to value FinTech customer relationships in greater detail in the remainder of the article.Valuing Customer-Related AssetsFirms devote significant human and financial resources in developing, maintaining and upgrading customer relationships. In some instances, customer contracts give rise to identifiable intangible assets. More broadly, however, customer-related intangible assets consist of the information gleaned from repeat transactions, with or without underlying contracts. Firms can and do lease, sell, buy or otherwise trade such information, which are generally organized as customer lists.Since FinTech has some relatively varied niches including payments, digital lending, WealthTech, or InsurTech, the valuation of FinTech customer relationships can vary depending on the type of company and the niche that it operates in.While we do not delve into the key attributes to consider for each FinTech niche, we provide one illustration from the Payments niche.In the Payments industry, one key aspect to understand when evaluating customer relationships is where the company is in the payment loop and whether the company operates in a B2B (business-to-business) or B2C (business-to-consumer) model.This will drive who the customer is and the economics related to valuing the cash flows from the customer relationships.For example, merchant acquirers typically have contracts with the merchants themselves and the valuable customer relationship lies with the merchant and the dollar volume of transactions processed by the merchant over time, whereas the valuable relationship with other payments companies such as a prepaid or gift card company may lie with the end-user or consumer and their spending/card usage habits over time.Valuation ApproachesValuation involves three approaches: 1) the cost approach, 2) the market approach, and 3) the income approach. Customer relationships are typically valued based upon an income approach (i.e., a discounted cash flow method) where the cash flows that the customer relationships are expected to generate in the future are forecast and then discounted to the present at a market rate of return.Cost ApproachValuation under the cost approach requires estimation of the cost to replace the subject asset, as well as opportunity costs in the form of cash flows foregone as the replacement is sought or recreated. The cost approach may not be feasible when replacement or recreation periods are long. Therefore, the cost approach is used infrequently in valuing customer-related assets.Market ApproachUse of the market approach in valuing customer-related assets is generally untenable for FinTech companies because transactional data on sufficiently comparable assets are not likely to be available.Income ApproachUnder the income approach, customer-related assets are valued most commonly using the income approach. One method within the income approach that is often used to value FinTech customer relationships is the Multi-Period Excess Earnings Method (MPEEM).MPEEM involves the estimation of the cash flow stream attributable to a particular asset. The cash flow stream is discounted to the present to obtain an indication of fair value. The most common starting point in estimating future cash flows is the prospective financial information prepared by (or in close consultation with) the management of the subject business.The key valuation inputs are often estimates of the economic benefit of the customer relationship (i.e., the cash flow stream attributable to the relationships), customer attrition rate, and the discount rate.Three key attributes that are important when using these inputs to valuing customer relationships include:Repeat Patronage. The expectation of repeat patronage creates value for customer-related intangible assets. Contractual customer relationships formally codify the expectation of future transactions. Even in the absence of contracts, firms look to build on past interactions with customers to sell products and services in the future. Two aspects of repeat patronage are important in evaluating customer relationships. First, not all customer contact leads to an expectation of repeat patronage. The quality of interaction with walk-up retail customers, for instance, is generally considered inadequate to reliably lead to expectations of recurring business. Second, even in the presence of adequate information, not all expected repeat business may be attributable to customer-related intangible assets. Some firms operate in monopolistic or near-monopolistic industries where repeat patronage is directly attributable to a dearth of acceptable alternatives available to customers. In other cases, it may be more appropriate to attribute recurring business to the strength of the trade names, software platform, or brands.Attrition. Customer-related intangible assets create value over a finite period. Without efforts geared towards continual reinforcement, customer lists dwindle over time due to customer mortality, the ravages of competition, or the emergence of alternate products and services. The mechanics of present value mathematics further erode the economic benefits of sales to current customers in the distant future. Customer relationships are wasting assets whose economic value attrite with the passage of time.Other Assets.Customer-related intangible assets depend on the existence of other assets to provide value to the firm. Most assets, including fixed assets and intellectual property, are essential in creating products or providing services. The act of selling these products and services enable firms to develop relationships and collect information from customers. In turn, the value of these relationships depends on the firms’ ability to sell additional products and services in the future. Consequently, for firms to extract value from customer-related assets, a number of other assets need to be in place.ConclusionMercer Capital has experience providing valuation and advisory services to FinTech companies and their acquirers.We have valued customer-related and other intangible assets to the satisfaction of clients and their auditors within the FinTech industry across a multitude of niches (payments, wealth management, insurance, lending, and software).Most recently, we completed a purchase price allocation for a private equity firm that acquired a FinTech company in the Payments niche.Please contact us to explore how we can help you. Originally published in the Value Focus: FinTech Industry Newsletter, Mid Year 2019.

Due to the historical popularity of this post, we revisit it this week. The purpose of this post is to help you, the reader, understand how the characteristics of the asset management industry, in general, and those attributable to a specific firm, influence the values of the assets acquired in transactions between banks and asset managers. As banks of all sizes seek new ways to differentiate themselves in a competitive market, we see many banks contemplating the acquisition of an existing asset management firm as a way to expand and diversify the range of services they can offer to clients.  Following a transaction, the bank is required under accounting standards to allocate the purchase price to the various tangible and intangible assets acquired.  As noted in the following figure, the acquired assets are measured at fair value. Transaction structures between banks and asset managers can be complicated, often including deal term nuances and clauses that have significant impact on fair value.  Purchase agreements may include balance sheet adjustments, client consent thresholds, earnouts, and specific requirements regarding the treatment of other existing documents like buy-sell agreements.  Asset management firms are unique entities with value attributed to a number of different metrics (assets under management, management fee revenue, realized fee margin, etc.). It is important to understand how the characteristics of the asset management industry, in general, and those attributable to a specific firm, influence the values of the assets acquired in these transactions. Common intangible assets acquired in the purchase of a private asset manager include the trade name, existing customer relationships, non-competition agreements with executives, and the assembled workforce. Trade NameThe deal terms we see employ a wide range of possible treatments for the trade name acquired in the transaction.  The bank will need to make a decision about whether to continue using the asset manager’s name into perpetuity or only use it during a transition period as the asset manager’s services are brought under the bank’s name.  This decision can depend on a number of factors, including the asset manager’s reputation within a specific market, the bank’s desire to bring its services under a single name, and the ease of transitioning the asset manager’s existing client base.  However, if the bank plans immediately to take asset management services under its own name and discontinue use of the firm’s name, then the only value allocable to the tradename would be defensive.In general, the value of a trade name can be derived with reference to the royalty costs avoided through ownership of the name.  A royalty rate is often estimated through comparison with comparable transactions and an analysis of the characteristics of the individual firm name.  The present value of cost savings achieved by owning rather than licensing the name over the future period of use is a measure of the value of the trade name.Customer RelationshipsThe nature of relationships between clients and portfolio managers often gives rise an allocation to the existing customer relationships transferred in a transaction.  Generally, the value of existing customer relationships is based on the revenue and profitability expected to be generated by the accounts, factoring in an expectation of annual account attrition.  Attrition can be estimated using analysis of historical client data or prospective characteristics of the client base.  Many of the agreements we see include a clause that requires a certain percentage of clients to consent to transfer their accounts in order for the deal to close at the stated price.  If the asset manager secures less than the required amount of client consents, the purchase price may be adjusted downward or the deal may be terminated entirely.  Due to their long-term nature and importance as a driver of revenue in the asset management industry, customer relationships may command a relatively high portion of the allocated value.Non-Competition AgreementsIn many asset management firms, a few top executives or portfolio managers account for a large portion of new client generation and are often being groomed for succession planning.  Deals involving such firms will typically include non-competition and non-solicitation agreements that limit the potential damage to the company’s client and employee bases if such individuals were to leave.These agreements often prohibit the individuals from soliciting business from existing clients or recruiting current employees of the company.  In certain situations, the agreement may also restrict the individuals from starting or working for a competing firm within the same market.  The value attributable to a non-competition agreement is derived from the expected impact competition from the covered individuals would have on the firm’s cash flow and the likelihood of those individuals competing absent the agreement.  In the agreements we’ve observed, a restricted period of two to five years is common.Assembled WorkforceIn general, the value of the assembled workforce is a function of the saved hiring and assembly costs associated with finding and training new talent.  However, in a relationship-based industry like asset management, getting a new portfolio or investment manager up to speed can include months of networking and building a client base, in addition to learning the operations of the firm.  Employees’ ability to establish and maintain these client networks can be a key factor in a firm’s ability to find, retain, and grow its business.  An existing employee base with market knowledge, strong client relationships, and an existing network often may command a higher value allocation to the assembled workforce.  Unlike the intangible assets previously discussed, the assembled workforce is valued as a component of valuing the other assets.   It is not recognized or reported separately, but rather as an element of goodwill.GoodwillGoodwill arises in transactions as the difference between the price paid for a company and the value of its identifiable assets (tangible and intangible).  Expectations of synergies, strategic market location, and access to a certain client group are common examples of goodwill value derived from the acquisition of an asset manager.  The presence of these non-separable assets and characteristics in a transaction can contribute to the allocation of value to goodwill.EarnoutsIn the purchase price allocations we do for banks and asset managers, we frequently see an earnout structured into the deal as a mechanism for bridging the gap between the price the bank wants to pay and the price the asset manager wants to receive.  Earnout payments can be based on asset retention, fee revenue growth, or generation of new revenue from additional product offerings.  Structuring a portion of the total purchase consideration as an earnout provides some downside protection for the bank, while rewarding the asset management firm for continuity of performance or growth.  Earnout arrangements represent a contingent liability that must be recorded at fair value on the acquisition date.ConclusionThe proper allocation of value to intangible assets and the calculation of asset fair values require both valuation expertise and knowledge of the subject industry.  Mercer Capital brings these together in our extensive experience providing fair value and other valuation work for the asset management industry.  If your company is involved in or is contemplating a transaction, call one of our professionals to discuss your valuation needs in confidence.

Clients frequently want to know, “How long is an equity compensation valuation good for?” We get it. You want to provide employees, contractors, and other service providers who are compensated through company stock with current information about their interests, but the time and cost required to get a valuation must also be considered.Due to the natural business changes every company goes through, accounting and legal professionals often recommend updates at least annually if no significant change or financing has occurred.However, unique company or market characteristics often necessitate more frequent updates. Here are some of the factors to consider when determining the need for a valuation update:Significant changes in the company’s financial situationShift in overall strategyAchievement of business milestonesChanges in market or industry conditionsGain or loss of major customer accountsAdditional fundingIssuance of new equity compensationPotential for an upcoming IPOChanges in expectation as to the timing of an exit eventEven for companies that have fairly steady operations, the effects of small business changes accumulate over time. Companies that deal with major changes relatively infrequently may be suited to regular summary updates to supplement full comprehensive reports as a way to maximize the cost-benefit analysis of equity compensation valuation. Originally published in the Financial Reporting Update: Equity Compensation, June 2019.

Equity-based compensation has been a key part of compensation plans for years.  When the equity compensation involves a publicly traded company, the current value of the stock is known and so the valuation of share-based payments is relatively straightforward.  However, for private companies, the valuation of the enterprise and associated share-based compensation can be quite complex.The AICPA Accounting & Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, describes four criteria that should be considered when selecting a method for valuing equity securities:Going Concern.  The method should align with the going-concern status of the company, including expectations about future events and the timing of cash flows.  For example, if acquisition of the company is imminent, then expectations regarding the future of the enterprise as a going concern are not particularly relevant.Common Share Value.  The method should assign some value to the common shares, unless the company is in liquidation with no expected distributions to common shareholders.Independent Replication.  It is important that the results of the method used by a valuation specialist can be independently replicated or approximated using the same underlying data and assumptions.  When completing the valuation, proprietary practices and models should not be the primary method of determining value.Complexity and Stage of Development.  The complexity of the method selected should be appropriate to the company’s stage of development. In other words, a simpler valuation method (like an OPM) with fewer underlying assumptions may be more appropriate for an early-stage entity with few employees than a highly complex method (like a PWERM). With these considerations in mind, let’s take a closer look at the four most common methods used to value private company equity securities.Current Value Method (CVM)The Current Value Method estimates the total equity value of the company on a controlling basis (assuming an immediate sale) and subtracts the value of the preferred classes based on their liquidation preferences or conversion values.  The residual is then allocated to common shareholders. Because the CVM is concerned only with the value of the company on the valuation date, assumptions about future exit events and their timing are not needed. The advantage of this method is that it is easy to implement and does not require a significant number of assumptions or complex modeling.However, because the CVM is not forward looking and does not consider the option-like payoffs of the share classes, its use is generally limited to two circumstances. First, the CVM could be employed when a liquidity event is imminent (such as a dissolution or an acquisition). The second situation might be when an early-stage company has made no material progress on its business plan, has had no significant common equity value created above the liquidation preference of the preferred shares, and for which no reasonable basis exists to estimate the amount or timing of when such value might be created in the future.Generally speaking, once a company has raised an arm’s-length financing round (such as venture capital financing), the CVM is no longer an appropriate method.Probability-Weighted Expected Return Method (PWERM)The Probability-Weighted Expected Return Method is a multi-step process in which value is estimated based on the probability-weighted present value of various future outcomes.  First, the valuation specialist works with management to determine the range of potential future outcomes for the company, such as IPO, sale, dissolution, or continued operation until a later exit date.  Next, future equity value under each scenario is estimated and allocated to each share class.  Each outcome and its related share values are then weighted based on the probability of the outcome occurring.  The value for each share class is discounted back to the valuation date using an appropriate discount rate and divided by the number of shares outstanding in the respective class.The primary benefit of the PWERM is its ability to directly consider the various terms of shareholder agreements, rights of each class, and the timing when those rights will be exercised. The method allows the valuation specialist to make specific assumptions about the range, timing, and outcomes from specific future events, such as higher or lower values for a strategic sale versus an IPO.  The PWERM is most appropriate to use when the period of time between the valuation date and a potential liquidity event is expected to be short.Of course, the PWERM also has limitations.  PWERM models can be difficult to implement because they require detailed assumptions about future exit events and cash flows.  Such assumptions may be difficult to support objectively. Further, because it considers only a specific set of outcomes (rather than a full distribution of possible outcomes), the PWERM may not be appropriate for valuing option-like payoffs like profit interests or warrants. In certain cases, analysts may also need to consider interim cash flows or the impact of future rounds of financing.Option Pricing Model (OPM)The Option Pricing Model treats each class of shares as call options on the total equity value of the company, with exercise prices based on the liquidation preferences of the preferred stock. Under this method, common shares would have material value only to the extent that residual equity value remains after satisfaction of the preferred stock’s liquidation preference at the time of a liquidity event. The OPM typically uses the Black-Scholes Option Pricing Model to price the various call options.In contrast to the PWERM, the OPM begins with the current total equity value of the company and estimates the future distribution of outcomes using a lognormal distribution around that current value. This means that two of the critical inputs to the OPM are the current value of the firm and a volatility assumption. Current value of the firm might be estimated with a discounted cash flow method or market methods (for later-stage firms) or inferred from a recent financing transaction using the backsolve method (for early-stage firms). The volatility assumption is usually based upon the observed volatilities of comparable public companies, with potential adjustment for the subject entity’s financial leverage.The OPM is most appropriate for situations in which specific future liquidity events are difficult to forecast.  It can accommodate various terms of stockholder agreements that affect the distributions to each class of equity upon a liquidity event, such as conversion ratios, cash allocations, and dividend policy. Further, the OPM considers these factors as of the future liquidity date, rather than as of the valuation date.The primary limitations of the OPM are its assumption that future outcomes can be modeled using a lognormal distribution and its reliance on (and sensitivity to) key assumptions like assumed volatility. The OPM also does not explicitly allow for dilution caused by additional financings or the issuance of options or warrants.  The OPM can only consider a single liquidity event. As such, the method does not readily accommodate the right or ability of preferred shareholders to early-exercise (which would limit the upside for common shareholders). The potential for early-exercise might be better captured with a lattice or simulation model.  For an in-depth discussion on the OPM, see our whitepaper A Layperson’s Guide to the Option Pricing Model at mer.cr/2azLnB.Hybrid MethodThe Hybrid Method is a combination of the PWERM and the OPM.  It uses probability-weighted scenarios, but with an OPM to allocate value in one or more of the scenarios.The Hybrid Method might be employed when a company has visibility regarding a particular exit path (such as a strategic sale) but uncertainties remain if that scenario falls through. In this case, a PWERM might be used to estimate the value of the shares under the strategic sale scenario, along with a probability assumption that the sale goes through. For the scenario in which the transaction does not happen, an OPM would be used to estimate the value of the shares assuming a more uncertain liquidity event at some point in the future.The primary advantage of the Hybrid Method is that it allows for consideration of discrete future liquidity scenarios while also capturing the option-like payoffs of the various share classes. However, this method typically requires a large number of assumptions and can be difficult to implement in practice.ConclusionThe methods for valuing private company equity-based compensation range from simplistic (like the CVM) to complex (like the Hybrid Method). In addition to the factors discussed above, the facts and circumstances of a particular company’s stage of development and capital structure can influence the complexity of the valuation method selected. In certain instances, a recent financing round or secondary sale of stock becomes a datapoint that needs to be reconciled to the current valuation analysis and may even prove to be indicative of the value for a particular security in the capital stack (see “Calibrating or Reconciling Valuation Models to Transactions in a Company’s Equity” on page 6). At Mercer Capital, we recommend a conversation early in the process between company management, the company’s auditors, and the valuation specialist to discuss these issues and select an appropriate methodology. Originally published in the Financial Reporting Update: Equity Compensation, June 2019.

The extensive use of core versus reported earnings by public companies has been a widespread phenomenon for at least 25 years. During the past decade, the practice also has become widespread among companies (and their bankers who market deals) that are issuing debt in the leverage loan and high yield markets.The practice is controversial. The SEC periodically will crack down on companies it thinks are pushing the envelope. Bank regulators have raised the issue of questionable adjustments to borrowers’ EBITDA for widely syndicated leverage loans.Investors are aware of the issue, too, but have not demanded the practice to stop. In mid-2017, I attended a conference on private credit. One session dealt exclusively with adjusted EBITDA. One panelist offered that adjustments in the range of 5-10% of reported EBITDA were okay, but the consensus was the adjustments were out of control. Covenant Review reported that as of mid-2017 the average leverage for middle market LBOs over the prior two years was 5.5x based upon the target’s adjusted EBITDA compared to reported EBITDA of ~7x. The issue is no better, and perhaps worse, in 2018 judging from market sentiment.If investors are solely relying upon company defined adjusted EBITDA, then they may be vacating their fiduciary duties when investing capital. That said, an analysis of core versus reported earnings is a critical element of any valuation or credit assessment of a non-early stage company with an established financial history.Table 1 below provides a sample overview of the template we use at Mercer Capital. The process is not intended to create an alternate reality; rather, it is designed to shed light on core trends about where the company has been and where it may be headed.AdjustmentsAdjustments typically consist of items that are non-recurring, unusual, and infrequent. They also may entail elements for a change in business operations, such as the addition of a new product or the discontinuation of a division. This is where judgment is particularly important because we have noticed a trend among some investors to credit businesses with future earnings for initiatives such as stepped-up hiring of revenue producers in which a favorable outcome is highly uncertain.Minority vs. ControlAdjustments considered should take into account whether the valuation is on a minority interest or controlling interest basis. An adjustment for an unusual litigation expense will not be impacted by the level-of-value; however, other potential adjustments—particularly synergies a buyer could reasonably be expected to realize would only apply in a control valuation.Core Trends vs. PeersThe development of the adjusted earnings analysis should allow one to identify the source of revenue growth and the trend in margins through a business cycle. The process also will facilitate comparisons with peers both historically and currently to thereby make further qualitative judgments about how the business is performing.Out Year Budget vs. Adjusted HistoryThe adjusted earnings history should create a bridge to next year’s budget, and the budget a bridge to multi-year projections. The basic question should be addressed: Does the historical trend in adjusted earnings lead one to conclude that the budget and multi-year projections are reasonable with the underlying premise that the adjustments applied are reasonable?Core Earnings vs. Ongoing Earning PowerCore earnings differ from earning power. Core earnings represent earnings after adjustments are made for non-recurring items and the like in a particular year. Earning power represents a base earning measure that is representative through the firm’s (or industry’s) business cycle and, therefore, requires examination of adjusted earnings ideally over an entire business cycle. If the company has grown such that adjusted earnings several years ago are less relevant, then earning power can be derived from the product of a representative revenue measure such as the latest 12 months or even the budget and an average EBITDA margin over the business cycle.Platform Companies/Roll-UpsCompanies that are executing a roll-up strategy can be particularly nettlesome from a valuation perspective because there typically is a string of acquisitions that require multiple adjustments for transaction related expenses and the expected earnings contribution of the targets. The math of adding and subtracting is straightforward, but what is usually lacking is seasoning in which a several year period without acquisitions can be observed in order to discern if past acquisitions have been accretive to earnings. Public market investors struggle with this phenomenon, too, but often the high growth profile of roll-ups will trump questions about earning power and what is an appropriate multiple until growth slows.Income and Market-Based Valuation ApproachesIn addition to providing insight into how a business is performing, the adjusted earnings statement will “feed” multiple valuation methods. These include the Discounted Cash Flow and Single Period Earning Power Capitalization Methods that fall under the Income Approach, and the Guideline (Public) Company and Guideline (M&A) Transaction Methods that constitute Market Approaches.It may be obvious, but we believe an analysis of adjusted (and reported) earnings statements for a subject company over a multi-year period is a critical, if not the critical element, in valuing securities that are held in private equity and credit portfolios. Mercer Capital has nearly 40 years of experience in which tens of thousands of adjusted earnings statements have been created. Please call if we can help you value investments held in your portfolio.Originally published in Mercer Capital’s Portfolio Valuation Newsletter: Fourth Quarter 2018

ASU 2016-01 shook up financial reporting at the beginning of the year, as companies scrambled to determine compliance with the new requirements for reporting equity investments.The rise of corporate venture capital over recent years largely flew under the accounting radar until this update took effect, creating significant volatility for many corporate investors in their reported earnings as they were required to recognize the gains and losses from investments previously held at cost.Now that the initial shock has worn off, CFOs may be able to rest a little easier, but they shouldn’t forget about the requirements under ASU 2016-01 entirely.Even if the company elected the measurement alternative that allows for the investment to be reported at cost, don’t forget about the requirement for impairment testing that goes along with it. Some companies may choose to perform the initial Step Zero analysis internally before engaging a valuation firm to navigate the rest of the process, while others turn over the entire process to a valuation professional.“An entity may elect to measure an equity security without a readily determinable fair value [and that does not qualify for the practical expedient]…at its cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer.” ASU 2016-01 Paragraph 321-10-35-2 Originally appeared in Mercer Capital's Financial Reporting Update: Goodwill Impairment

What is Step Zero?A qualitative approach to test goodwill for impairment was introduced by the Financial Accounting Standards Board (“FASB”) when it released Accounting Standards Update 2011-08 (“ASU 2011-08”) in September 2011 as an update to goodwill impairment testing standards under Topic 350, Intangibles—Goodwill and Other.ASU 2011-08 set forth guidance for an optional qualitative assessment to be performed before the traditional quantitative two step goodwill impairment testing process.This preliminary qualitative assessment is known as “Step Zero.”The goal of Step Zero is to simplify and reduce costs of performing the traditional quantitative goodwill impairment test process.According to ASU 2011-08, Step Zero allows entities “the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount.”Step One is required only if the qualitative assessment supports the conclusion that it is more likely than not (i.e., likelihood greater than 50%) that the fair value is less than the carrying value.Otherwise, Step One of the goodwill impairment testing process is not required.Alternatively, Step Zero can be skipped altogether, and the traditional quantitative goodwill impairment test can be performed beginning with Step One.Industry ConsiderationsThe standards update release by FASB outlines the individual qualitative categories of the assessment.Specific qualitative events and circumstances to be evaluated include the economy, industry, cost factors, financial performance, firm-specific events, reporting unit events, and changes in share price.ASU 2011-08 defines industry events and circumstances as follows:“Industry and market conditions such as a deterioration in the environment in which an entity operates, an increased competitive environment, a decline in market-dependent multiples or metrics (consider in both absolute terms and relative to peers), a change in the market for an entity’s products or services, or a regulatory or political development.”The process of evaluating an industry involves assessing each of these stated events and circumstances since the previous reporting period and determining how they affect the comparison of fair value to carrying value.By comparing current conditions to the prior period, an analysis of relative improvement or deterioration can be made concerning each industry factor and the industry as a whole.Increasing multiples, share prices, financial metrics, and M&A activity indicate that an industry is improving and suggests that it is more likely than not that the reporting unit’s fair value is greater than its carrying value. Decreasing multiples, share prices, financial metrics, and M&A activity indicate the industry is weakening and suggests that fair value may be less than the reporting unit’s carrying value.Industry AnalysisAn analysis of the S&P 1500, an index that includes approximately 90% of the market capitalization of U.S. stocks, reveals the prevalence of impairment in different industries. For example, of the companies reporting goodwill on their balance sheets, 25% of telecommunication, 17% of consumer staples, and 14% of consumer discretionary companies recorded goodwill impairment charges in 2017.On the other hand, the more robust performance of financial, information technology, and real estate companies is manifest in that only 4% of companies reporting goodwill in each industry recorded a goodwill impairment charge in 2017.Further analysis indicates that companies in the energy and telecommunication industries are currently more likely to be potential impairment candidates as 20% and 38%, respectively, of companies reporting goodwill have cushions (the amount by which market value of equity exceeds book value of equity) of less than 25%. Deterioration in the operating environment of these industries may result in an increase in goodwill impairment charges.Industries with fewer impairment candidates at the moment include real estate, utilities, and industrials.Industry considerations are particularly important to the qualitative assessment and provide valuable insight on the potential for impairment. The qualitative assessment is especially valuable in industries that are performing well as it is less likely that goodwill is impaired.Step Zero provides the opportunity to perform a preliminary qualitative analysis to determine the necessity of performing the traditional two step goodwill impairment test and can lead to a simpler, more efficient impairment testing process.The analysts at Mercer Capital have experience in, and follow, a diverse set of industries.We help clients assemble, evaluate, and document relevant evidence for the Step Zero impairment test. Call us today so we can help you. Originally appeared in Mercer Capital's Financial Reporting Update: Goodwill Impairment

Earlier this year, we considered the impact of the Tax Cuts and Jobs Act of 2017 (“TCJA”) on purchase price allocations.In this article, we turn our focus to the impact of the TCJA on goodwill impairment testing.Changes to the tax code will affect both the qualitative assessment (often referred to as Step Zero) and quantitative impairment test.Qualitative AssessmentCompanies preparing a qualitative assessment are required to assess “relevant events and circumstances” to evaluate whether it is more likely than not that goodwill is impaired.ASC 350 includes a list of eight such potential events and circumstances.Quantitative AssessmentThe same features which, on balance, have made it more likely that reporting units will garner a favorable qualitative assessment also contribute to the fair value of reporting units under the quantitative assessment.Reduction in income tax rate.All else equal, a reduction in the applicable federal income tax rate from 35% to 21% increases after-tax cash flows and contributes to higher fair values for reporting units.Bonus depreciation provisions.The tax bill allows certain capital expenditures to be deducted immediately for purposes of calculating taxable income.While the aggregate amount of depreciation deductions is unaffected, the acceleration of the timing of tax benefits can have a marginally positive effect on the fair value of some reporting units.Interest deduction limitations.One potentially negative effect of the tax bill on reporting unit fair values is the limitation on the amount of interest expense that is deductible for tax purposes.For some highly-leveraged businesses, the interest deduction limitation can increase the weighted average cost of capital.We expect the interest deduction limitations to adversely affect only a small minority of companies.Increase in after-tax cost of debt.When calculating the cost of debt as a component of the cost of capital, analysts multiply the pre-tax cost of debt by one minus the corporate tax rate.The new lower tax rate will, therefore, cause the after-tax cost of debt to increase by a small increment.All else equal, an increase to the weighted average cost of capital has a negative impact on the fair value of a reporting unit.On balance, we expect the negative effect from higher costs of capital to be smaller than the positive cash flow effect from lower tax rates.ConclusionThe Tax Cuts and Jobs Act of 2017 is a material factor to be considered in both qualitative and quantitative assessments of goodwill impairment in 2018.While the provisions are not uniformly favorable to higher valuations, the balance of factors suggests that goodwill impairments will be less likely in the coming impairment cycle.To discuss how the new tax regime affects your company’s goodwill impairment more specifically, please give one of our professionals a call. Originally appeared in Mercer Capital's Financial Reporting Update: Goodwill Impairment

When testing the goodwill of a reporting unit for impairment, the order of operations matters. Because the units themselves may contain assets subject to impairment testing, it is important to first reflect accurate carrying values for those assets before testing the goodwill of the unit overall.If the goodwill of the unit is tested before a write down of certain of its assets occurs, there may be increased risk of inaccurately allocating impairment between the assets and goodwill of the unit. Similarly, failing to address the order of testing could lead to the false conclusion that the goodwill of a reporting unit is impaired, when there is really only impairment of its underlying identifiable assets. These errors occur when the unit’s fair value of goodwill is compared to an inaccurately high carrying value that results from failing to adjust asset values first.According to the AICPA Accounting & Valuation Guide: Testing Goodwill for Impairment [paragraph 2.57], the order of impairment testing should be as follows:Financial statement preparers should not neglect the proper order of impairment testing to ensure current allocation of impairment. Originally appeared in Mercer Capital's Financial Reporting Update: Goodwill Impairment

A logical fallacy occurs when one makes an error in reasoning.Causal fallacies occur when a conclusion about a cause is reached without enough evidence to do so.The cum hoc (“with this”) fallacy is committed when a causal relationship is assumed because two events occur together.When it comes to financial reporting, an example of this fallacy would be assuming that goodwill cannot be impaired unless the company’s shares are trading below book value.This is a tempting fallacy–especially as the U.S. economy is continuing a long expansion, companies are posting solid earnings, and valuations are reaching new highs.The S&P 500 increased 19% in 2017 and the Nasdaq was up 28%.In these market conditions, goodwill impairment probably does not seem like a pressing concern.After all, goodwill is considered impaired only when fair value drops below carrying value, right?While this is true, accounting standards require that goodwill be tested for impairment at the reporting unit level.Impairment relates to a reporting unit’s ability to generate cash flows.This means that a company’s goodwill can be impaired at the reporting unit level, even as its stock trades above book value.This was the case for multinational conglomerate General Electric last year.GE had a tumultuous 2017 as the company’s CEO and CFO departed, the dividend was cut, and a corporate restructuring was announced.The salient event for the purposes of this article is a $947 million impairment loss recorded in its Power Conversion Unit during the third quarter of 2017.This unit is what became of GE’s 2011 $3.2 billion acquisition of Converteam, an electrical engineering company.According to the company’s 2017 annual report, the causes for this impairment included downturns in marine and oil and gas markets, pricing and cost pressures, and increased competition.GE’s stock felt the turmoil, falling 42% in 2017.Shares traded at $17.25 at their lowest point, implying a market capitalization of $150.5 billion.But even at this point, GE’s stock was not trading below book value ($64.3 billion at the end of 2017).GE’s market value exceeded book value of equity by $86.2 billion.So while impairment and market value/share price are related, it is not safe to assume that there is no impairment if the stock trades above book value.Another notable example is CVS Health.The company made headlines with one of the largest mergers of the year when it announced the acquisition of insurer Aetna, Inc. for $69 billion in December 2017.A smaller, less widely reported transaction transpired in November when the company announced the sale of its RxCrossroads reporting unit to McKesson Corp. for $735 million.This unit was part of CVS’s 2015 acquisition of nursing home pharmacy Omnicare, Inc. and provided reimbursement assistance and sales operation support, among other services.In the second quarter of 2017, CVS recognized a $135 million impairmentcharge related to this reporting unit.As with GE, CVS never traded below book value.CVS stock declined approximately 8% in 2017 and hit a low of $66.45 on November 6.The market capitalization at this point was approximately $67.7 billion.The book value of CVS equity was $34.9 billion at September 30, 2017 and $37.7 billion at year-end.The above examples expose the fallacious idea that a company can avoid impairment charges simply because its stock trades above book value.That is not to say that there is no relationship between the two; an impairment charge can certainly signal the market and affect share price, or a decline in share price may foreshadow an impending impairment charge.Because goodwill must be tested for impairment at the reporting unit level, impairment may occur even when the company’s market cap exceeds book value. Originally appeared in Mercer Capital's Financial Reporting Update: Goodwill Impairment

Many family offices are built from the success of once fledgling businesses that many would now know as household names. Successor generations seek to maintain and build that wealth through prudent investments in equities, fixed income, and private equity investments in mature companies. In recent years, however, family offices have started taking notes from their entrepreneurial beginnings and are investing more in early-stage ventures. Though more often seen as LPs in traditional venture capital funds, family offices are also increasingly taking on the role of direct—and sometimes lead—venture investors.An analysis from Crunchbase News shows the progression of family office venture investment over the last few years. While this is a small sample, it helps demonstrate the growing trend. Crunchbase also notes several prominent family venture-backed exits including Twilio, Okta, Bitly, and Workday.We have previously analyzed the rise of corporate venture capital and its effect on the funding landscape. So what does the increase in family office investors mean for venture capital? Here are a few of the characteristics that make venture investments from family offices unique.InvolvementDespite an industry focus on the new wealth being built in the technology hubs of the U.S., abundant sources of potential investment lay in family offices all over the country. Family office investors are likely to source deals through their personal networks and professional ties with local business activity. Family offices typically take an active interest in each portfolio company and, therefore, may be likely to invest their capital in local ventures in order to better stay up-to-date with company developments. In order to maintain this involvement, a board seat may also be one of the requirements when a family office joins the cap table.MotivationWhether they hold a share of the original family company or a subsequent business investment, family offices often have a stake in mature industry players. Because of previous work within the space or an inside vantage point from an ownership position, family offices can often lend industry insight. They may also possess a unique perspective for identifying startups that could disrupt, or partner with, the incumbents in the industry. Family office investors typically enter with strategic motivations for investing, not just the lure of large returns.Time HorizonThe primary focus of family offices is to preserve and grow capital for multiple generations. Family offices are, therefore, usually able to adopt a very long-term view of their overall portfolio. However, it should not be mistaken that family offices are willing to have their capital tied up forever. Like any other investment firm, family offices develop objectives and exit expectations for their various investments.As family offices join the landscape of non-traditional investors in venture capital, startups may find that they have more options when it comes to funding. We expect to continue to see an increase in the diversity of funding sources, with cap tables boasting a combination of traditional, corporate, and family investors.Originally published in Portfolio Valuation: Private Equity & Venture Capital Marks & Trends, Third Quarter 2018.

Mercer Capital’s latest financial reporting update focuses on the topic of goodwill impairment. In this whitepaper, we feature five articles:Financial Reporting Fallacy: The Whole May Appear Healthier Than the PartsIndustry Considerations for Step Zero: Qualitative AssessmentsAccounting Standards Update 2016-01: Impairment Considerations for Equity InvestmentsWhat is the Order of Testing for Impairment?Tax Reform and Impairment Testing Mercer Capital provides a full range of fair value measurement services and opinions that satisfy the scrutiny of auditors, the SEC, and other regulatory bodies. We have broad experience with fair value issues related to public and private companies, financial institutions, private equity firms, start-ups, and other closely held businesses. We also handle a number of different kinds of special projects that corporate finance departments may be outsourcing – completely or partially. In addition, we help clients think through certain financial or strategic questions and perform financial due diligence and quality of earning analyses for some transactions. National audit firms regularly refer financial reporting valuation assignments to Mercer Capital.

On December 22, 2017, President Trump signed The Tax Cuts and Jobs Act, which resulted in sweeping changes to the U.S. tax code.The Act decreased the corporate tax rate to 21% from 35%, in addition to modifying specific provisions around interest, depreciation, carrybacks, and repatriation taxes.The change in tax rate will have the biggest impact on purchase accounting. In the energy industry, this will manifest itself in several ways.  This blog post explores some of the impacts to valuations performed under fair value accounting in ASC 805 and ASC 820.Cash Flows and ReturnsWhen we evaluate prospective financial information, a lower tax rate will result in higher after-tax earnings.The value of the tax shield created by depreciation and deductions will be influenced by both the lower corporate tax rate (which reduces the tax shield’s value) and accelerated depreciation of qualifying capital equipment purchases (which increases the tax shield’s value).  This could mean incentives for energy-oriented companies to (i) create a more modernized drilling rig fleet sooner that are best suited for today’s multi-frac lateral wells and (ii) accelerated plans to create more infrastructure and pipelines in active basins such as the Permian, Bakken and Eagle Ford.  In addition, it also could drive more refinery and LNG liquefaction plant development.  In most cases, a lower tax rate will increase cash flows, increasing the internal rate of return on acquisitions for a given purchase price.On the other hand, if lower tax rates drive higher purchase prices, internal rates of return may be unchanged.In terms of the weighted average cost of capital (WACC), the lower tax rate actually increases the after-tax cost of debt.Keeping other inputs constant, this modestly increases WACCs.Relief from RoyaltyUnder the relief from royalty method, after-tax royalties avoided increase as the tax rate falls.However, the tax amortization benefit (TAB) component of the intangible value also declines as a result of the lower tax rate, which serves to partially offset the increase in after-tax cash flows.Scenario AnalysisIn a scenario analysis used to value a noncompete agreement, a lower tax rate will again decrease the tax amortization benefit.Since both scenarios under the with and without approach will reflect the same tax rate, the impact of the new lower rate will be muted.As a result, the fair value of noncompete agreements may well be somewhat lower under the new tax rate.Cost ApproachThe cost approach, which is often used to value assets such as the assembled workforce or some technologies, the impact depends on whether a pre-tax or after-tax measurement basis is used.If fair value is measured on a pre-tax basis, the fair value of such assets is unaffected.If measured on an after-tax basis, costs avoided net of tax will be higher under lower tax rates, although this gain will be offset somewhat by the decrease in the TAB. Multi-Period Excess Earnings Method The impact of the tax rate on assets valued under the Multi-Period Excess Earnings Method (MPEEM) is more ambiguous since two key elements will be affected – the contributory asset charges and the tax rate used to derive after-tax cash flows.On the cash flow side of things, the lower tax rate will result in higher cash flow but a lower TAB.As far as contributory assets are concerned:Relief from royalty asset charges will increase under a lower tax rateWith and without scenario analysis with level payments charges will potentially decrease due to the lower base valueCost approach asset charges may increase or decrease depending on the net effect of taxes and TAB calculationsReserves & Goodwill The net impact of a lower tax rate on goodwill will vary by transaction.  Since reserves are typically viewed through a pre-tax lens, the value of reserves could be muted (all else held constant).  However, we note that if tax incentives increase CapEx and drilling plans, then more reserves could move up the category chain (P2 to P1 for example) and thus increase the fair value of reserves.  If the lower tax rate results in a higher transaction price, the aggregate increase in fair value will likely result in a larger allocation to goodwill.  This would apply more to intangible based energy companies.  Upstream companies typically do not book goodwill.  If, instead, the lower tax rate increases the projected IRR on a transaction, the impact on residual goodwill is harder to predict and will depend on the composition of the assets acquired.The changes to corporate taxes under the new bill are wide-ranging.In addition to the effect of lower rates discussed in this post, fair value specialists need to be alert to how other specific provisions of the bill may influence individual energy companies.Impact of Tax Rate Decrease on Valuation MethodCash Flows/Returns Higher after-tax cash flows/impact on returns depends on transaction priceTax Amortization Benefits DecreaseRelief from Royalty Method Increase (potential offset by decrease in TAB)Cost Approach (pre-tax) No ChangeCost Approach (post-tax) Increase (potential offset by decrease in TAB)With and Without Scenario Potentially lower (potential offset by decrease in TAB)MPEEM May Increase or Decrease (depends on magnitude of other changes)

The stakes for a business combination are high. Each party must negotiate a price and deal terms that promote its own interests but accommodate the counterparty’s expectations. Reaching an agreement can be a lengthy process and may require incorporating special provisions to help close the deal. Contingent consideration is a common example of such a provision.Measuring the fair value of contingent consideration (commonly referred to as an “earnout”) for financial reporting is a complex process – based on a number of variable inputs, unique risk profiles, and potentially complicated payoff structures.Valuation professionals must be well versed in the concepts of fair value, probability, and risk.Here’s what you need to know about what goes into that fair value measurement before it lands on your desk.How Does an Earnout Differ from Other Purchase Price Adjustments?While both purchase price adjustments and earnouts can affect the total consideration paid in a transaction, they differ substantially in terms of criteria and realization.Common purchase price adjustments include adjustments for working capital, client consents, and indebtedness.Purchase price adjustments, which are based on financial statement information, are observable and knowable at the closing date of the transaction, while earnouts are not.Earnouts, on the other hand, are payments based on performance that occurs subsequent to the measurement date. Although the eventual earnout payment cannot be known at the closing date, valuation specialists have developed techniques to enhance the reliability of fair value measurements.What Criteria Must Be Established in a Fair Value Measurement?The Purchase Agreement establishes the basic criteria, structure, and time frame for the earnout.Based on these characteristics, the valuation professional must determine several inputs for his or her modeling.Earnout Metric The Purchase Agreement will define one or more performance metrics for the earnout.A common example is EBITDA for the twelve-month period following the acquisition.The future outcome(s) of the relevant metrics are used to determine the future payout.For purposes of fair value measurement, valuation specialists may reference management projections, analyst expectations, and industry forecasts to model the expected payoff.VolatilitySince the actual value of the earnout metric cannot be known with certainty at the measurement date, the expected value is paired with an estimate of expected volatility. While there are several ways to estimate expected volatility, the estimate should be reasonable in the context of the volatility observed for similar companies, the subject company’s fundamentals, and the characteristics of the specific metric.Discount RateThe appropriate discount rate may be estimated through a bottom-up approach, where beta is built up using earnout-related factors, or through a top-down approach, which starts with the beta implied by the equity discount rate for the company overall.In the top-down approach, the valuation professional adjusts the company level beta up or downward for differences in risk between the metric and the company’s equity. The type of risk associated with the metric will affect the model that should be used to value the earnout.The two broad categories of risk are:Diversifiable. Diversifiable or “unsystematic” risk is specific to the subject company and can be reduced through diversification. For example, the risk associated with occurrence of a nonfinancial milestone such as patent approval is considered diversifiable.Non-Diversifiable. Non-diversifiable or “systematic” risk is related to the risk inherent in the market. For example, the risk associated with achieving a financial target such as revenue growth is considered non-diversifiable.Payoff StructureThe structure of the earnout reflects the provisions established in the Purchase Agreement.Questions that a valuation specialist may ask include:Is the underlying metric risk diversifiable (unsystematic) or not (systematic)?Is the payoff structure linear or non-linear?If multiple periods are involved, are the periods dependent on, or independent of, the other periods?The answers to these questions can help the valuation professional determine the structure of the payoff and whether a scenario based model or option pricing model is best suited to the fair value measurement of the earnout liability.TermThe term over which the metric is measured is established in the Purchase Agreement.The earnout may be determined after one period or over a multi-period time frame. Payments may be made throughout the earnout period, at the end of the earnout period, or at a later date. Additional time to payment may increase counterparty risk, or the risk that the Buyer will default on the earnout payment due.Credit Risk of the BuyerEarnouts typically represent a subordinate, unsecured liability for the Buyer.Thus, risk should be considered for the Buyer’s ability to meet the earnout obligation, commonly called counterparty credit risk or default risk. A valuation professional will look for any mitigating factors that could reduce or eliminate this risk, including:Guarantee by a bank or third partyEscrow account for full or partial funding of the earnoutEarnout structured as a note to increase its security rankingWhat Methods Are Used to Measure Fair Value?The two primary methods used to measure fair value are the scenario based method and the option pricing method. Selection of the method and model most appropriate for a given situation will depend on to the structure and risk profile of the subject earnout.Scenario Based MethodUnder the scenario based method, valuation specialists apply probability weights to the relevant metrics, and then discount the corresponding payouts at an appropriate rate. This method is most appropriate when the underlying metric for the earnout has a linear payoff structure or the underlying risk is diversifiable. Models within this method can effectively conform to any distribution assumption. This method is intuitive and is likely to mimic how the parties to the transaction thought about the earnout. However, these models can be perceived as unreliable since the inputs are qualitative in nature.Option Pricing MethodWhen applying the option pricing method, valuation specialists use models such as Black-Scholes to measure the fair value of a portfolio of financial instruments that replicate the potential payouts of the earnout structure. This method is best suited for earnouts with nonlinear payoff structures and metrics with non-diversifiable risk. A significant benefit to the method is that the use of historical data to estimate volatility, correlation, and the discount rate creates consistency among input assumptions. However, the complexity of the mathematics associated with the models is not well understood by those without financial expertise, rendering them much less intuitive.Understanding the DifferencesA simple example of an earnout that could be modeled with the scenario based method is as follows: a payment of 30% of the next fiscal year EBITDA. The payoff in this model is linear since it has a constant relationship with the relevant metric, meaning that a payout is due whether EBITDA is $1 million or $100 million (Example 1 below).In contrast, an earnout with a threshold or cap is better suited to an option pricing method. For example, a payment of 30% of the next fiscal year EBITDA only if EBITDA meets or exceeds $50 million. The payoff is the same as the linear scenario after EBITDA reaches the threshold; however, the payoff is $0 for any value of EBITDA below that.The second example can be modeled as a portfolio of options, where the threshold value of the metric ($50 million) acts as an effective strike price.What Guidance Exists Regarding Fair Value Measurement of Contingent Consideration?The measurement of contingent consideration has historically been a matter of considerable diversity in practice.While some common practices have generally been followed, new guidance clarifies best practices.A working group formed by The Appraisal Foundation issued a first exposure draft of new guidance regarding the measurement of contingent considerations in February 2017.This guidance details the methods described above and best practices for their application. The exposure draft endorses the risk-neutral valuation framework as the preferred basis for fair value measurements.A risk-neutral framework makes risk adjustments to the earnout metric to account for the unsystematic risk inherent in the metric. The guidance is expected to promote the consistency and reliability of fair value measurements.What Are the Implications of Fair Value on Financial Statements?Earnouts can act as a way to “bridge the gap” between what the Buyer wants to pay and what the Seller wants to receive. They can provide downside protection for the Buyer and upside potential for the Seller. These benefits contribute to the common use of earnout provisions in business combinations. However, the financial reporting consequences of an earnout may be counterintuitive once the transaction has closed and the Buyer becomes the owner of the acquired company.Subsequent to this point, if the relevant metric exceeds initial expectations, the Buyer will report a loss on its income statement associated with remeasuring the contingent liability at its new, higher value. In effect, if business goes well, the Buyer will report a loss. In contrast, if business goes poorly, the Buyer will report a gain upon remeasurement of the contingent liability at its new, lower fair value. Sophisticated deal makers understand the short-term implications for the Buyer’s financial statements but remain focused on the long-term goal.ConclusionThe uncertainty associated with contingent consideration means that the fair value of the earnout will rarely equal the amount that is actually paid out at the future payment date. While valuation professionals do not know what the future holds, they do have tools and techniques to reliably measure the fair value of the earnout liability as of the date of the transaction. While the nuances encountered in fair value measurement of earnouts can extend well beyond the scope of this article, we hope it provided some insight into what goes into the numbers before they reach your company’s accounting department.The inclusion of an earnout in a transaction negotiation can serve various purposes.Bridge the differences in Buyer and Seller expectationsServe as a form of alternative financing and defer a portion of the purchase priceProvide incentive for management to help the company meet post-transaction targetsShift and allocate risk between the various parties involvedThe motivation behind an earnout can influence management’s choice of earnout structure in order to achieve the intended purposes.Definition of Fair Value (ASC 820)“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.”Objective of Fair Value Measurement (ASC 820)“To estimate the price at which an orderly transaction would take place between market participants under the market conditions that exist at the measurement date.”

As banks of all sizes seek new ways to differentiate themselves in a competitive market, we see many banks contemplating the acquisition of an existing asset management firm as a way to expand and diversify the range of services they can offer to clients.  Following a transaction, the bank is required under accounting standards to allocate the purchase price to the various tangible and intangible assets acquired.  As noted in the following figure, the acquired assets are measured at fair value. Transaction structures between banks and asset managers can be complicated, often including deal term nuances and clauses that have significant impact on fair value.  Purchase agreements may include balance sheet adjustments, client consent thresholds, earnouts, and specific requirements regarding the treatment of other existing documents like buy-sell agreements.  Asset management firms are unique entities with value attributed to a number of different metrics (assets under management, management fee revenue, realized fee margin, etc.). It is important to understand how the characteristics of the asset management industry, in general, and those attributable to a specific firm, influence the values of the assets acquired in these transactions. Common intangible assets acquired in the purchase of a private asset manager include the trade name, existing customer relationships, non-competition agreements with executives, and the assembled workforce. Trade NameThe deal terms we see employ a wide range of possible treatments for the trade name acquired in the transaction.  The bank will need to make a decision about whether to continue using the asset manager’s name into perpetuity or only use it during a transition period as the asset manager’s services are brought under the bank’s name.  This decision can depend on a number of factors, including the asset manager’s reputation within a specific market, the bank’s desire to bring its services under a single name, and the ease of transitioning the asset manager’s existing client base.  However, if the bank plans immediately to take asset management services under its own name and discontinue use of the firm’s name, then the only value allocable to the tradename would be defensive.In general, the value of a trade name can be derived with reference to the royalty costs avoided through ownership of the name.  A royalty rate is often estimated through comparison with comparable transactions and an analysis of the characteristics of the individual firm name.  The present value of cost savings achieved by owning rather than licensing the name over the future period of use is a measure of the value of the trade name.Customer RelationshipsThe nature of relationships between clients and portfolio managers often gives rise an allocation to the existing customer relationships transferred in a transaction.  Generally, the value of existing customer relationships is based on the revenue and profitability expected to be generated by the accounts, factoring in an expectation of annual account attrition.  Attrition can be estimated using analysis of historical client data or prospective characteristics of the client base.  Many of the agreements we see include a clause that requires a certain percentage of clients to consent to transfer their accounts in order for the deal to close at the stated price.  If the asset manager secures less than the required amount of client consents, the purchase price may be adjusted downward or the deal may be terminated entirely.  Due to their long-term nature and importance as a driver of revenue in the asset management industry, customer relationships may command a relatively high portion of the allocated value.Non-Competition AgreementsIn many asset management firms, a few top executives or portfolio managers account for a large portion of new client generation and are often being groomed for succession planning.  Deals involving such firms will typically include non-competition and non-solicitation agreements that limit the potential damage to the company’s client and employee bases if such individuals were to leave.These agreements often prohibit the individuals from soliciting business from existing clients or recruiting current employees of the company.  In certain situations, the agreement may also restrict the individuals from starting or working for a competing firm within the same market.  The value attributable to a non-competition agreement is derived from the expected impact competition from the covered individuals would have on the firm’s cash flow and the likelihood of those individuals competing absent the agreement.  In the agreements we’ve observed, a restricted period of two to five years is common.Assembled WorkforceIn general, the value of the assembled workforce is a function of the saved hiring and assembly costs associated with finding and training new talent.  However, in a relationship-based industry like asset management, getting a new portfolio or investment manager up to speed can include months of networking and building a client base, in addition to learning the operations of the firm.  Employees’ ability to establish and maintain these client networks can be a key factor in a firm’s ability to find, retain, and grow its business.  An existing employee base with market knowledge, strong client relationships, and an existing network often may command a higher value allocation to the assembled workforce.  Unlike the intangible assets previously discussed, the assembled workforce is valued as a component of valuing the other assets.   It is not recognized or reported separately, but rather as an element of goodwill.GoodwillGoodwill arises in transactions as the difference between the price paid for a company and the value of its identifiable assets (tangible and intangible).  Expectations of synergies, strategic market location, and access to a certain client group are common examples of goodwill value derived from the acquisition of an asset manager.  The presence of these non-separable assets and characteristics in a transaction can contribute to the allocation of value to goodwill.EarnoutsIn the purchase price allocations we do for banks and asset managers, we frequently see an earnout structured into the deal as a mechanism for bridging the gap between the price the bank wants to pay and the price the asset manager wants to receive.  Earnout payments can be based on asset retention, fee revenue growth, or generation of new revenue from additional product offerings.  Structuring a portion of the total purchase consideration as an earnout provides some downside protection for the bank, while rewarding the asset management firm for continuity of performance or growth.  Earnout arrangements represent a contingent liability that must be recorded at fair value on the acquisition date.ConclusionThe proper allocation of value to intangible assets and the calculation of asset fair values require both valuation expertise and knowledge of the subject industry.  Mercer Capital brings these together in our extensive experience providing fair value and other valuation work for the asset management industry.  If your company is involved in or is contemplating a transaction, call one of our professionals to discuss your valuation needs in confidence.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

Corporate venture capital has increased as an investment activity for large corporations in recent years. By one count, the top ten corporate venture capital groups made 1,640 investments between 2010 and 2016.Intel Capital, the most active corporate venture capital investor over the past six years, made investments in 34 new companies totaling $455 million in 2016 alone.With corporate venture capital activity on the rise, a keen eye is being turned to public company reporting of equity holdings, as well. Valuations of VC-backed startups have grown rapidly in recent years, making many early venture investments worth well in excess of original cost. For example, Google Ventures (GV) invested in AirBnB in late 2010 at a valuation of $71.8 million. In March 2017, less than seven years later, AirBnB completed a $448 million financing round at a reported valuation of $29.3 billion, an increase in post-money value of more than 400x since the 2010 investment. [Source: VC Experts]Yet, many corporate balance sheets carry minority investments at cost – the value originally paid for the interest. Current U.S. GAAP does not require disclosure of the gains (and occasional losses) attributable to minority investments held at cost. While the incumbent accounting methodologies provide some information about deterioration in investment value, large valuation increases remain largely hidden from view. Unlike an asset for which replacement cost similar to the original outlay may be a reasonable estimate of worth, the value of investments in fledgling investee startups can change dramatically as these companies develop into successful businesses. With startups remaining private longer in the absence of exit events like IPOs, rising valuations of the underlying companies can diverge significantly from the cost basis of early investments. ASU 2016-01 seeks to provide more transparency and relevance to financial statement users, as well as decrease the complexity of equity investment impairment testing for financial statement preparers. The guidance applies to all equity investments that are not consolidated with the investor or accounted for under the equity method.1 That is, investments that represent less than 20% ownership or for which the owner lacks influence over investee operations. While the update has applications to both financial assets and financial liabilities, in this whitepaper we focus on the former, specifically minority equity interests. The update divides these investments into securities with readily determinable fair values and those without readily determinable fair values.Under current GAAP, unconsolidated equity investments are accounted for using either the cost or equity method. Investments with a readily determinable fair value (such as a share of public company stock) will be carried at fair value. For equity investments without a readily determinable fair value, entities can choose to apply a new Measurement Alternative. “An entity may elect to measure an equity security without a readily determinable fair value [and that does not qualify for the ASC 820 practical expedient2] at its cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer.”3 Elections to measure a security using this guidance may be made on an investment-by-investment basis. However, once an entity elects to measure an equity security using the Measurement Alternatively, it should be applied consistently unless the alternative is no longer permitted.Observable price changes mean those resulting from orderly transactions, including those that are known or can reasonably be known at the date of measurement. However, it is important to note that the transactions must involve identical or similar investments from the same issuer. Determining the similarity of a new security issuance to one held by the reporting company should take into consideration the specific rights and obligations of the issuance, such as voting rights, distribution rights and preferences, and conversion features. While simplifying the process of determining changes (both upward and downward) to the reported value of equity investments, the Measurement Alternative does not eliminate the need to test for impairment. However, it does allow for the use of a single-step qualitative assessment at each reporting period. Qualitative indications of impairment include, but are not limited to, the following.4 A significant deterioration in the earnings performance, credit rating, asset quality, or business prospects of the investee.A significant adverse change in the regulatory, economic, or technological environment of the investee.A significant adverse change in the general market condition of either the geographical area or the industry in which the investee operates.A bona fide offer to purchase, an offer by the investee to sell, or a completed auction process for the same or similar investment for an amount less than the carrying amount of that investment.Factors that raise significant concerns about the investee’s ability to continue as a going concern, such as negative cash flows from operations, working capital deficiencies, or noncompliance with statutory capital requirements or debt covenants.If a qualitative impairment is identified, the reporting entity should estimate the fair value of the investment and recognize an impairment loss equal to the difference between the carrying amount of the investment and its fair value. Although the intended result of ASU 2016-01 is to increase the scope of decision-useful information reported on corporate balance sheets, it also has the potential to complicate reporting for entities with investments in venture-backed startups. Re-measuring fair value of ownership interests in companies that have become significantly more valuable since the reporting entity’s initial investment could result in higher volatility of reported income (from non-core business sources). Beginning in their quarterly 2017 filings, a few major corporate investors – including Google, Salesforce, and Cisco – acknowledged an increase in income and expense volatility is expected as a result of this transition. The portion of the investment landscape inhabited by corporate venture players continues to increase. Industry participants have begun adapting to the resulting changes of corporate participation. Both founders and investors will likely keep close watch as industry changes continue to unfurl and as corporate VCs begin to adopt these new requirements.

Over the past decade, we have been retained by several investment funds to assist them in responding to formal and informal SEC investigations regarding fair value measurement of portfolio investments. Reflecting back on those engagements yields a couple observations and reminders for funds and fund managers as they go through the quarterly valuation process.First, fund managers should recognize that valuation matters, and it will really matter when something has gone awry. To that end, we recommend that funds:Document valuation procedures to follow (and follow them). Since valuation requires judgment, disagreements are inevitable. However, are you following the established valuation process? In hindsight, judgments are especially susceptible to second-guessing if established policies and procedures are not followed.Designate a member of senior management to be responsible for oversight of the valuation process. Placing valuation under the purview of a senior member of management demonstrates that valuation is an important function, not a compliance afterthought.Create contemporaneous and consistent documentation of valuation conclusions and rationale. No valuation judgment is “too obvious” to merit being documented. On the other side of the next crisis, what seems reasonable today may appear anything but. The middle of an investigation is not the best time to re-construct rationales for prior valuation judgments.Second, it is important for fund managers to stay abreast of evolving best practices (or know people who do). Fair value measurement for illiquid portfolio investments is an evolving discipline. We recommend that funds:Solicit relevant input from the professionals responsible for the investment, auditors, and third-party valuation experts. Relying on appropriate professionals demonstrates that the fund managers take compliance seriously and are committed to preparing reliable fair value measurements.Check your math. In the glare of the regulatory spotlight, few things will prove more embarrassing than elementary computational errors. The proverbial ounce of prevention is certainly worth the pound of cure.Disclose the valuation process and conclusions. Just like potential investors do, regulators take comfort in transparency.The best time to prepare for a regulatory investigation is before it starts. Call us today to discuss your portfolio valuation process in confidence.Originally published on Mercer Capital's Portfolio Valuation Newsletter: Second Quarter 2017

This guest post first appeared on Mercer Capital’s Financial Reporting Blog on January 18, 2016. When performing a purchase price allocation for an Exploration and Production (E&P) company, careful attention must be paid to both the accounting rules and the specialty nuances of the oil and gas industry. E&P companies are unique entities compared to traditional businesses such as manufacturing, wholesale, services or retail. As unique entities, the accounting rules have both universal rules to adhere as well as industry specific. Our senior professionals bring significant experience in performing purchase price allocations in the E&P area where these two principles collide. For the most part, current assets, current liabilities are straight forward. The unique factors of an E&P are found in the fixed assets and intangibles: producing, probable and possible reserves, raw acreage rights, gathering systems, drill rigs, pipe, working interests, royalty interests, contracts, hedges, etc. Different accounting methods like the full cost method or the successful efforts method can create comparability issues between two E&P’s that utilize opposite methods. We will explore the unique factors in future entries. In this blog post, we discuss the guidelines for purchase price allocations that all companies must adhere. Reviewing a purchase price allocation report can be a daunting task if you don’t do it for a living – especially if you aren’t familiar with the rules and standards governing the allocation process and the valuation methods used to determine the fair value of intangible assets. While it can be tempting as a financial manager to leave this job to your auditor and valuation specialist, it is important to stay on top of the allocation process. Too often, managers find themselves struggling to answer eleventh hour questions from auditors or being surprised by the effect on earnings from intangible asset amortization. This guide is intended to make the report review process easier while helping to avoid these unnecessary hassles. Please note that a review of the valuation methods and fair value accounting standards is beyond the scope of this guide. Grappling with these issues is the responsibility of the valuation specialist, and a purchase price allocation report should explain the valuation issues relevant to your particular acquisition. Instead, this guide focuses on providing an overview of the structure and content of a properly prepared purchase price allocation report.General RulesWhile every acquisition will present different circumstances that will impact the purchase price allocation process, there are a few general rules common to all properly prepared reports. From a qualitative standpoint, a purchase price allocation report should satisfy three conditions:The report should be well-documented. As a general rule, the reviewer of the purchase price allocation should be able to follow the allocation process step-by-step. Supporting documentation used by the valuation specialist in the determination of value should be clearly listed and the report narrative should be sufficiently detailed so that the methods used in the allocation can be understood.The report should demonstrate that the valuation specialist is knowledgeable of all relevant facts and circumstances pertaining to the acquisition. If a valuation specialist is not aware of pertinent facts related to the company or transaction, he or she will be unable to provide a reasonable purchase price allocation. If the report does not demonstrate this knowledge, the reviewer of the report will be unable to rely on the allocation.The report should make sense. A purchase price allocation report will not make sense if it describes an unsound valuation process or if it describes a reasonable valuation process in an abbreviated, ambiguous, or dense manner. Rather, the report should be written in clear language and reflect the economic reality of the acquisition (within the bounds of fair value accounting rules).Assignment DefinitionA purchase price allocation report should include a clear definition of the valuation assignment. For a purchase price allocation, the assignment definition should include:Objective. The definition of the valuation objective should specify the client, the acquired business, and the intangible assets to be valued.Purpose. The purpose explains why the valuation specialist was retained. Typically, a purchase price allocation is completed to comply with GAAP financial reporting rules.Effective Date. The effective date of the purchase price allocation is typically the closing date of the acquisition.Standard of Value. The standard of value specifies the definition of value used in the purchase price allocation. If the valuation is being conducted for financial reporting purposes, the standard of value will generally be fair value as defined in ASC 820.Statement of Scope and Limitations. Most valuation standards of practice require such statements that clearly delineate the information relied upon and specify what the valuation does and does not purport to do.Background InformationThe purchase price allocation report should demonstrate that the valuation specialist has a thorough understanding of the acquired business, the intangible assets to be valued, the company’s historical financial performance, and the transaction giving rise to the purchase price allocation.Company OverviewDiscussion related to the acquired company should demonstrate that the valuation specialist is knowledgeable of the company and has conducted sufficient due diligence for the valuation. The overview should also discuss any characteristics of the company that play a material role in the valuation process. The description should almost always include discussion related to the history and structure of the company, the competitive environment, and key operational considerations.Intangible AssetsThe intangible assets discussion should both provide an overview of all relevant technical guidance related to the particular asset and detail the characteristics of the asset that are significant to the valuation. The overview of guidance demonstrates the specialist is aware of all the relevant standards and acceptable valuation methods for a given asset.After reading this section, the reviewer of the purchase price allocation report should have a clear understanding of how the existence of the various intangible assets contribute to the value of the enterprise (how they impact cash flow, risk, and growth).Historical Financial PerformanceThe historical financial performance of the acquired company provides important context to the story of what the purchasing company plans to do with its new acquisition. While prospective cash flows are most relevant to the actual valuation of intangible assets, the acquired company’s historical performance is a useful tool to substantiate the reasonableness of stated expectations for future financial performance.This does not mean that a company that has never historically made money cannot reasonably be expected to operate profitably in the future. It does mean that management must have a compelling growth or turn-around story (which the specialist would thoroughly explain in the company overview discussion in the report).Transaction OverviewTransaction structures can be complicated and specific deal terms often have a significant impact on value. Purchase agreements may specify various terms for initial purchase consideration, include or exclude specific assets and liabilities, specify various structures of earn-out consideration, contain embedded contractual obligations, or contain other unique terms. The valuation specialist must demonstrate a thorough understanding of the deal terms and discuss the specific terms that carry significant value implications.Fair Value DeterminationThe report should provide adequate description of the valuation approaches and methods relevant to the purchase price allocation. In general, the report should outline the three approaches to valuation (the cost approach, the market approach, and the income approach), regardless of the approaches selected for use in the valuation. This demonstrates that the valuation specialist is aware of and considered each of the approaches in the ultimate selection of valuation methods appropriate for the given circumstances.Depending on the situation, any of a number of valuation methods could be appropriate for a given intangible asset. While selection of the appropriate method is the responsibility of the valuation specialist, the reasoning should be documented in the report in such a way that a report reviewer can assess the valuation specialist’s judgment.At the closing of the discussion related to the valuation process, the report should provide some explanation of the overall reasonableness of the allocation. This discussion should include both a qualitative assessment and quantitative analysis for support. While this support will differ depending on circumstances, the report should adequately present how the valuation “hangs together.”Something to RememberA purchase price allocation is not intended to be a black box that is fed numbers and spits out an allocation. The fair value accounting rules and valuation guidance require that it be a reliable and auditable process so that users of financial statements can have a clear understanding of the actual economics of a particular acquisition. As a result, the allocation process should be sufficiently transparent that you are able to understand it without excessive effort, and the narrative of the report is a necessary component of this transparency.

The following outlines our process when providing periodic fair value marks for venture capital fund investments in pre-public companies.Examine the most recent financing round economicsThe transaction underlying the initiation of an investment position can provide three critical pieces of information from a valuation perspective:Size of the aggregate investment and per share price.Rights and protections accorded to the newest round of securities.Usually, but not always, an indication of the underlying enterprise value from the investor’s perspective. Deal terms commonly reported in the press (example) focus on the size of the aggregate investment and per share price. The term "valuation" is usually a headline-shorthand for implied post-money value that assumes all equity securities in the company’s capital structure have identical rights and protections. While elegant, this approach glosses over the fact that for pre-public companies, securities with differing rights and protections should and do command different prices. The option pricing method (OPM) is an alternative that explicitly models the rights of each equity class and makes generalized assumptions about the future trajectory of the company to deduce values for the various securities. Valuation specialists can also use the probability-weighted expected return method (PWERM) to evaluate potential proceeds from, and the likelihood of, several exit scenarios for a company. Total proceeds from each scenario would then be allocated to the various classes of equity based on their relative rights. The use of PWERM is particularly viable if there is sufficient visibility into the future exit prospects for the company. The economics of the most recent financing round helps calibrate inputs used in both the OPM and PWERM.Under the OPM, a backsolve procedure provides indications of total equity and enterprise value based on the pricing and terms the most recent financing round. The indicated enterprise value and a set of future cash flow projections, taken together, imply a rate of return (discount rate) that may be reasonable for the company. Multiples implied by the indicated enterprise value, juxtaposed with information from publicly traded companies or related transactions, can yield valuation-useful inferences.Under the PWERM, in addition to informing discount rates and providing comparisons with market multiples, the most recent financing round can inform the relative likelihood of the various exit scenarios. When available, indications of enterprise value from the investor’s perspectives can further inform the inputs used in the various valuation methods. In addition to the quantitative inputs enumerated above, discussions and documentation around the recent financing round can provide critical qualitative information, as well.Adjust valuation inputs to measurement dateBetween a funding round and subsequent measurement dates, the performance of the company and changes in market conditions can provide context for any adjustments that may be warranted for the valuation inputs. Deterioration in actual financial projections may warrant revisiting the set of projected cash flows, while improvements in market multiples for similar companies may suggest better pricing may be available for the company at exit. Interest from potential acquirers (or withdrawal of prior interest) and general IPO trends can inform inputs related to the relative likelihood of the various exit scenarios.Measure fair valueMeasuring fair value of the subject security entails using the OPM and PWERM, as appropriate and viable, in conjunction with valuation inputs that are relevant at the measurement date. ASC 820 defines fair value as, "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."Reconciliation and tests of reasonablenessA sanity check to scrutinize fair value outputs is an important element of the measurement process. Specifically as it relates to venture capital investments in pre-public companies, such a check would reconcile a fair value indication at the current measurement date with a mark from the prior period in light of both changes in the subject company, and changes in market conditions.Mercer Capital assists a range of alternative investment funds, including venture capital firms, in periodically measuring the fair value of portfolio assets for financial reporting purposes to the satisfaction of the general partners and fund auditors. Call us – we would like to work with you to define appropriate fund valuation policies and procedures, and provide independent opinions of value.

Golden parachute payments have long been a controversial topic. These payments, typically occurring when a public company undergoes a change-in-control, can result in huge windfalls for senior executives and in some cases draw the ire of political activists and shareholder advisory groups. Golden parachute payments can also lead to significant tax consequences for both the company and the individual. Strategies to mitigate these tax risks include careful design of compensation agreements and consideration of noncompete agreements to reduce the likelihood of additional excise taxes.When planning for and structuring an acquisition, companies and their advisors should be aware of potential tax consequences associated with the golden parachute rules of Sections 280G and 4999 of the Internal Revenue Code. A change-in-control (CIC) can trigger the application of IRC Section 280G, which applies specifically to executive compensation agreements. Proper tax planning can help companies comply with Section 280G and avoid significant tax penalties.Golden parachute payments usually consist of items like cash severance payments, accelerated equity-based compensation, pension benefits, special bonuses, or other types of payments made in the nature of compensation. In a CIC, these payments are often made to the CEO and other named executive officers (NEOs) based on agreements negotiated and structured well before the transaction event. In a single-trigger structure, only a CIC is required to activate the award and trigger accelerated vesting on equity-based compensation. In this case, the executive’s employment need not be terminated for a payment to be made. In a double-trigger structure, both a CIC and termination of the executive’s employment are necessary to trigger a payout.Adverse tax consequences may apply if the total amount of parachute payments to an individual exceeds three times (3x) that individual’s “Base Amount.” The Base Amount is generally calculated as the individual’s average annual W2 compensation over the preceding five years.As shown in Figure 1 below, if the (3x) threshold is met or crossed, the excess of the CIC Payments over the Base Amount is referred to as the Excess Parachute Payment. The individual is then liable for a 20% excise tax on the Excess Parachute Payment, and the employer loses the ability to deduct the Excess Parachute Payment for federal income tax purposes. Several options exist to help mitigate the impact of the Section 280G penalties. One option is to design (or revise) executive compensation agreements to include “best after-tax” provisions, in which the CIC payments are reduced to just below the threshold only if the executive is better off on an after-tax basis. Another strategy that can lessen or mitigate the impact of golden parachute taxes is to consider the value of noncompete provisions that relate to services rendered after a CIC. If the amount paid to an executive for abiding by certain noncompete covenants is determined to be reasonable, then the amount paid in exchange for these services can reduce the total parachute payment. According to Section 1.280G-1 of the Code, the parachute payment “does not include any payment (or portion thereof) which the taxpayer establishes by clear and convincing evidence is reasonable compensation for personal services to be rendered by the disqualified individual on or after the date of the change in ownership or control.” Further, the Code goes on to state that “the performance of services includes holding oneself out as available to perform services and refraining from performing services (such as under a covenant not to compete or similar arrangement).” Figure 2 below illustrates the impact of a noncompete agreement exemption on the calculation of Section 280G excise taxes. How can the value of a noncompete agreement be reasonably and defensibly calculated? Revenue Ruling 77-403 states the following: “In determining whether the covenant [not to compete] has any demonstrable value, the facts and circumstances in the particular case must be considered. The relevant factors include: (1) whether in the absence of the covenant the covenantor would desire to compete with the covenantee; (2) the ability of the covenantor to compete effectively with the covenantee in the activity in question; and (3) the feasibility, in view of the activity and market in question, of effective competition by the covenantor within the time and area specified in the covenant.”A common method to value noncompete agreements is the “with or without” method. Fundamentally, a noncompete agreement is only as valuable as the stream of cash flows the firm protects “with” an agreement compared to “without” one. Cash flow models can be used to assess the impact of competition on the firm based on the desire, ability, and feasibility of the executive to compete. Valuation professionals should consider factors such as revenue reductions, increases in expenses and competition, and the impact of employee solicitation and recruitment.Mercer Capital provides independent valuation opinions to assist public companies with IRC Section 280G compliance. Our opinions are well-reasoned and well-documented, and have been accepted by the largest U.S. accounting firms and various regulatory bodies, including the SEC and the IRS.