Thursday, November 18, 2010

Write-Up of Intangible Assets

In M&A, acquiring a company requires you to pay a control premium above the current market price to capture a majority of the shares outstanding needed to own the company. Usually, a company’s equity trades at values above book value (the idea that the sum is greater than the parts) and that there is value creation.

So in an acquisition scenario, there are a few considerations. Firstly, the market price is above the book value. Secondly, the purchase price is above the market value. The cumulative amount by which the purchase price is above the book value is referred to as “excess”. This excess is usually allocated in two ways: Good will and Write-up of Intangible Assets.

Purchase Price > Market Price > Book Value
Purchase Price = Book Value + Excess
Excess = Goodwill + Write-up of Intangible Assets

Intangible assets would normally be amortized, but in this scenario they do not provide a tax shield. This makes sense because if you could amortize them you would essentially be double counting your DA expense (or depending on what type of asset it is, such as Intellectual Property, your R&D expense). Also, if you could count this as an expense, this would provide a tax shield against your acquisition premium and promote higher premiums.

Another consideration is the effect on asset based leverage ratios depending on where you allocated the write-ups in value. One note was that in companies which depend heavily on leverage (and where asset based ratios can significantly affect ratings and therefore borrowing rates), there is a tendency to try to write up assets rather than allocate the excess to goodwill (also for “optics” reasons).

Aside: Any buyer that is offering an acquisition price below the current market price should seriously reconsider their position. Although we've seen this unique situation with the recent Potash deal, there are some obvious problems with offering a purchase price below the market price.

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