A successful M&A transaction is a journey that begins well before closing and continues well beyond. Here are three things buyers and sellers should consider before the transaction.
1. Survey the landscape
Conduct a survey of the operating landscape for the industry as a whole and determine the target’s position within this landscape. Typically, buyers will have thorough industry knowledge, and most target companies will have a Confidential Investment Memorandum (CIM) or similar document that outlines industry trends and the target’s strengths relative to other industry participants. However, there are two potential blind spots:
First is the passage of time: The operating landscape may change significantly between the time the CIM is drafted and an investment decision is made. This is especially true in highly regulated industries like the healthcare industry. It is important to understand both Federal and State regulations in the healthcare industry. For example, the final rule for the 2021 Physician Fee Schedule, appearing in the December 10, 2020 Federal Register, outlines significant changes in pay with a magnitude last seen in 2006/07. Meanwhile, state laws can change significantly: One prime example is the State of Florida enacted legislation in 2019 that changes Certificate of Need (CON) requirements for certain healthcare entities. The new legislation sunsets CON requirements for specialty hospitals and could result in increased competition for existing providers.
Second is the information gap between broad industry data and company specifics. Buyers should attempt to narrow the gap by validating company specific information in the CIM and supplementing the CIM with additional information on the specific business niche, potential geographic concentration, or other unique factors pertaining to the target.
2. Intangible asset identification
Purchase accounting rules require a formal identification and valuation of intangible assets (and liabilities) at the time of acquisition. Hence most valuations of acquired intangibles are performed after the transaction closes. However, buyers in many industries can benefit from identifying the target’s intangible assets and liabilities before making a purchase offer. Identifying intangible assets can provide insights on the key drivers of revenue and profitability of the target company, thereby informing the buyer’s investment thesis. For example, ABC Technologies may provide a reliable but somewhat dated technology platform to a long-standing group of customers. Conversely, XYZ Technologies may have high customer turnover but the industry’s leading and patented technology platform. Although ABC and XYZ may have had similar financial performance in the past, future growth and earnings trends could diverge given the different intangible assets underlying each business.
3. Transaction structure
Warren Buffet observed that “Price is what you pay, and value is what you get.” At any given purchase price, the transaction structure can materially change the ultimate proceeds: both the consideration ultimately paid to the sellers and the value of assets received by the buyer. Hence both parties benefit from a thorough financial statement impact analysis given different transaction structures. Some of the most impactful items to consider are the following:
i. Will the transaction be structured as an asset or stock purchase? From a tax perspective, a stock purchase is generally more favorable to the seller.
ii. If the transaction contemplates earnouts (contingent consideration), these are accounted for at their fair value at the time of the acquisition. Depending on the structure of the earnout, its fair value may be close to the face value of the payment, or it may be far below.
iii. Roll-over equity. When the economic characteristics of roll-over equity, especially return and liquidity considerations, align closely with the characteristics of the controlling shareholders’ interests, the value of roll-over shares is typically similar to that of controlling shares. However, roll-over shares may also be subject to significant discounts.
iv. Equity compensation. Many organizations will provide financial incentives to management, employees, and members of the Board of Directors in the form of incentive units. This can lead to a dilution of value of existing investors and lowered earnings due to compensation expense being recorded.
Regardless of the transaction structure, purchase accounting rules will result in a re-statement of certain assets, including inventory, deferred revenues, and in-process research & development (IPR&D). Buyers should consider the financial statement impact of these items.
The unique characteristics of the target’s business drivers and intangible assets, coupled with the deal structure of the contemplated transaction, can result in divergent outcomes for buyers and sellers. To prevent unforeseen surprises, be sure to surround yourself with experienced transaction advisers.