March 22, 2004
EDA Vendor Strategy for Acquisitions
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Due Diligence - Trust, but Verify
Due diligence is a rigorous investigation and evaluation of the business to be acquired. It may be carried out by personnel of the acquiring firm, although it is not uncommon to contract diligence experts particularly for the financial, tax and legal analyses. The goal of due diligence can be expressed in a phrase “No surprises”. Due diligence covers market reviews, risk assessments, and the evaluation of management competencies, as well as to identify areas to concentrate on for synergies or operational impact. If the deal is going to be a stock swap then due diligence will be mutual.
Ray Bingham says the technical evaluation begins with the underlying science. Cadence often uses university professors and industry luminaries in this effort. Then Cadence uses its own expert to determine if the technology is suitable for integration into the company's larger solution.
Randy Tinsley says everything flows from the talent pool. What is their track history? How are they seen by their customers?
Dennis Weldon want to know that the technical advantage will hold up, that the product is extensible not spaghetti code. If the technology is in a new area, they may hire a consultant for due diligence.
Non-technical items cover all aspects of the business. A partial checklist of items to be reviewed include corporate documents and organization, financial data, SEC filings, internal management controls, materials related to indebtedness, contracts (liabilities, rights to assign or terminate), human resources policies and benefit plans, intellectual property (form, scope..), plant-property-equipment, and IT environment.
Valuations - How much is a company worth?
In the case of a public company, the starting point is its market capitalization, i.e. the current share price times the number of outstanding shares. There are several well recognized techniques for setting a valuation as outlined below.
Asset focused valuation methods
Book Value - assets net of depreciation and amortization less liabilities
Adjusted book value - use only tangible assets or change book value to market value
Replacement value or Liquidation value
Discounted Cash Flow (DCF) - the value is the sum of the net present values projected for future years (normally 3 to 5 years) plus the value of “continuing operations” after the projected period. The residual value might be the potential sale price for the business at the end of the forecast period or an assumed steady cash flow in perpetuity. An appropriate discount rate is the “risk-free” rate of return (as with government securities) plus some premium for investing in the risk of a business venture.
Market focused valuation methods
Multiple from comparable businesses based upon P/E, revenues, profit,
The First Chicago method evaluates risk reward scenarios by developing 3 distinct financial plans, assigning a probability to each, calculating a composite outcome and then generating a valuation based upon a required rate of return.
Each of these approaches has problems. Valuations based on tangible assets establish at best a floor value. Valuations based upon multiples require comparable businesses. There may not be a comparable business or there may be many with significantly different values. Any method based upon multiyear revenue or profit projections is subjective. Valuations are generally used to convince oneself or the other firm of the reasonableness or unreasonableness of any offer. If one pays too high a price, there is nothing left to invest. All acquirers want the acquisition to be accretive in a relatively short period of time.
Under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (HSR Act), parties to a merger or are required to report their intentions in advance and provide relevant information to both the FTC and DoJ. The parties must then await approval from the agencies or expiration of a 30-day waiting period before closing the transaction. This period may be extended by a request for additional material. As of December 2000, only those transactions valued at $50 million or more (the size-of-transaction test) must be notified. There is also a size-of-the parties test unless the deal exceeds $200M. These rules facilitate government review generally for concerns related to antitrust
and public interest (e.g. proposed foreign ownership of critical technologies). There were 173 challenges in years 1999-2003
Generally, any purchase or sale of securities must be registered with the SEC at the federal level, or the applicable state securities agency unless an exemption from registration applies. A federal exemption is allowed when the terms of the exchange have been approved in a "fairness hearing" conducted by any state governmental agency. Only six states including California have adopted the enabling legislation to permit fairness hearings. This may result in reduced costs by the avoidance of registration fees and the time and expense required in order to comply with the Federal securities law requirements.
The bulk sales law found in the Uniform Commercial Code adopted by most states provides a mechanism under which Sellers of assets out of inventory must give advance notice to trade creditors. If the notice is not properly given, then the sale is ineffective against the Seller's creditors, and the assets may be levied against by the creditors.
If the transaction is a cash purchase, then neither company has a taxable event. However, the shareholders of the acquired company have a taxable gain on the sale of their securities.
If the transaction qualifies as a "reorganization" under Section 368 of the Internal Revenue Code ("IRC"), in which the Buyer's stock is exchanged for the stock or assets of the Seller, then generally no tax will be assessed on any of the parties. Gain will be recognized, of course, at the time that the stock that is received is resold following the transaction. Further, gain is generally recognized on cash and other non-stock consideration received - called "boot". A tax-free reorganization is deemed to have occurred only where there is continuity of equity interest and continuity of business interest.
Under certain restrictions previous net operating loses (NOL) of the acquired company can be carried forward to apply against future profits of the acquiring company for tax purposes.
Accounting for the Acquisition
In almost all cases the purchase price exceeds the value of tangible assets less liabilities. Tangible assets include cash, marketable securities, receivables, inventories, plant and equipment. Liabilities include accounts and notes payable, long term debt, accruals, projected benefit obligation in excess of plan assets. The excess is referred to as “goodwill”.
The Financial Accounting Standards Board (FASB) sets the rules of the road for how to record and report financial transactions. The relevant standards promulgated in June 2001 are No. 141, Business Combinations and No. 142, Goodwill and Other Intangible Assets. These standards mandated the purchase accounting treatment for M&As. Accordingly, goodwill is now subject to periodic impairment reviews. Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value.
Intangible assets, whose benefits results from contractual or legal rights and that can be separately sold, transferred or licensed, are recorded separately from goodwill. Examples included patents, licensing agreements, and customer contracts. Intangibles with finite lifetimes are amortized over the expected useful life with possible adjustments if impairment is detected.
R&D projects underway within the acquired firm that have no alternative use and are not currently technologically feasible require immediate expensing. Technological feasibility is established upon completion of a detail program design or, in its absence, completion of a working model. The In-Process R&D (IPRD) charge is determined by estimating costs to develop the acquired in-process technology into commercially viable products, estimating the resulting net cash flows from such projects and discounting the net cash flows back to their present value. The discount rate reflects the uncertainty surrounding successful development of the acquired in-process technology.
After the Deal is Closed
M&As give the shareholders of the acquired firm a premium for their equity. The acquiring firm has the challenge of delivering value based upon superior management and synergy. Unfortunately, most mergers and acquisitions do not produce value for the shareholders of the acquiring firms. Key reasons why deals fail include incompatible cultures, inappropriate leadership, hidden liabilities, loss of key personnel, strategic misalignment and poor employee communication.
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-- Jack Horgan, EDACafe.com Contributing Editor.
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