Jahani and Associates’ Strategy to Maximize M&A Value Using Intangible Assets
Private equity (PE) mergers and acquisitions (M&A) activity has been steadily increasing since 2008.1
Jahani and Associates (J&A)—a top New York investment bank led by Managing Director Joshua Jahani—has found that these private company buyers create returns for their investors and management through two ways:
- They increase the free cash flow of purchased companies to more than the investment made to buy the company.
- They improve the company’s operations and finances, then sell it for a premium to another buyer several years later.
This strategy has proven to be very effective. Since 2010, private equity returns have outperformed standard market returns.2 However, PE buyers are faced with two problems when it comes to generating returns for their management and investors. These problems are grounded in the fact that intangible assets matter most when it comes to generating returns and make up over 80% of M&A value. The problems are:
- It is difficult to determine the fair value of purchased intangibles accurately, and thus, it is challenging to optimize financial reporting.
- When selling a company several years after investment, it is difficult for PE buyers to prove to strategic acquirers, public investors, and other PE buyers that they own intangibles that matter to them.
The following research, evidence, and strategies provide a solution for both these problems. The solution to problem one is to perform a more insightful purchase price allocation (PPA) than is typically done in the market. The solution to problem two is to execute a better sell-side process driven by acknowledging that intangible assets matter most.
Using Purchase Price Allocation to Optimize Financial Reporting for PE Portfolios
Purchase price allocation is done near or after the closing of an M&A transaction. The goal of PPA is to relate the total money paid for a target company to the assets of that target. PPA work is based on five asset categories: cash, tangible assets, intangible assets, goodwill, and liabilities.
What are Intangible Assets?
Intangible assets lack physical properties. They have the potential to either generate income or save costs for the owner. Most of the time, intangibles are not contained in a firm’s balance sheet. These may include customer contracts for health insurance companies and in-house developed technology for consumer product companies. Intangibles are usually amortized between three to 15 years based on their characteristics and useful life. The useful life of intangibles is subject to legal, regulatory, or contractual provisions that are considered during valuation.3
Intangible assets are typically valued by one of three methodologies:
- Cost Valuation
Income valuation considers the incremental value an intangible brings to a firm’s cash flow. Market valuation involves identifying the price an asset trades at in an efficient market, then applying that value to an identified intangible asset. Cost valuation requires estimating the amount of money that would be spent to replace the intangible asset. In general, income and market valuation methods value assets at their highest, whereas cost valuation creates a lower asset value.
Landing on a unified valuation method between buyers and sellers can be challenging. Determining a fair value for both buyers and sellers requires a deep level of expertise in operational, financial, and regulatory due diligence. At Jahani and Associates (J&A), our experienced team of tech investors and wellness investors led by Managing Director Joshua Jahani have designed a valuation solution based on the analysis of thousands of purchase price allocations and our collective industry experience for startups and Fortune 500 companies.
M&A studies have shown that intangible assets and goodwill make up most of M&A deal value.4,5 Intangible assets and goodwill are amortized differently. Amortization is the process of writing off the cost of an intangible asset, just as depreciation is the process of writing off the cost of a tangible one. High amortization or depreciation lowers net income in a company’s financial statements. Private companies amortize goodwill over 15 years as an asset, and public companies do not amortize goodwill. Instead, public companies must undergo costly impairment tests for goodwill each year. Goodwill impairment tests include studying intangible assets to determine if their fair market value and useful life has significantly changed since the asset was acquired.6
Intangible assets, apart from goodwill, can be amortized between three to 15 years. Therefore, when a buyer allocates more of its purchase price to intangible assets than to goodwill, it can increase the company’s amortization expense, lower its net income, and optimize its financial reporting.
However, this does not change the overall purchase price; it only changes the amounts allocated to goodwill and intangible assets. Figure 1 is an illustrative example of how allocating more purchase price to intangibles can optimize a buyer’s financial reporting.
The Financial Accounting Standards Board (FASB) and the Accounting Standards Codification (ASC) 805 outline the rules for acquisition accounting that can be used to determine which assets and what asset amounts can be placed into the intangible asset category, separate from goodwill. The key to performing an intelligent PPA is rooted in understanding FASB ASC 805.
Jahani and Associates have analyzed over 6,000 PPAs from publicly traded companies to determine the intangible assets that matter most. The intangibles that matter most are determined by industry verticals. For example, customer contracts are overwhelmingly valued in health insurance companies, but technology developed for in-house use makes up most of the M&A value for consumer product companies.
Steps Buyers Can Take to Optimize Financial Reporting Through Purchase Price Allocation
There is good news for private equity buyers: the performance of a better purchase price allocation process can optimize financial reporting.
Jahani and Associates’ experienced team of tech investors and wellness investors led by Managing Director Joshua Jahani have created this process based on our experience and through researching thousands of purchase price allocations. We offer a step-by-step guide that identifies the intangibles that matter, values them, and subsequently optimizes financial reporting. Each step of the traditional process is disrupted by Jahani and Associates’ methodology.
At its core, the process uses publicly available data and best practices valuation methods to create a strong case for the value of each identifiable intangible asset. The prevalence of intangible assets differs by industry. Therefore, industry dynamics are carefully analyzed during purchase price allocation work to identify the assets that matter most today and will likely matter most in the future. Figure 3 shows this disruption along each step of the process.
Step 1: Understand the Intangible Assets that Matter in the Respective Industries
Jahani and Associates have reviewed thousands of purchase price allocations to determine the most common intangible assets by industry. Before starting a purchase price allocation project, this analysis is required to make sure industry standards are followed, and identified intangibles align with reality.
Step 2: Allocate the Purchase Price Based on FASB ASC 805 Criteria
Based on FASB’s rules, buyers and their advisors must understand what constitutes an intangible asset. The criteria are separability, measurability, and predictability. An asset must meet all three of these criteria to be considered an intangible asset. Income, cost, or market valuation methods can be used to determine the fair value of an intangible asset.
Step 3: Calculate Goodwill and Execute the Chosen Strategy
After calculating each assets’ fair value, goodwill can be determined and minimized for the buyer. Increasing the allocation of intangibles with less than 15 years of useful life will always increase the amortization of the new entity and, therefore, optimize financial reporting. In some cases, amortization may need to be minimized. This may be the case if buyers want to maximize net income for reporting or competitive purposes.
Using Intangibles to Perform a Better Sell-Side M&A Process
Beyond purchase price allocation, understanding how intangible assets perform creates powerful insights for the M&A sell-side process. Sell-side M&A is Jahani and Associates’ most active service offering and has gained popularity because of the focus on intangibles. Intangible assets allow sellers to naturally create the buyer’s business case when running a process. Figure 4 shows the steps that can be used to accomplish this.
Step 1: Identify What Makes Your Company Valuable
This M&A strategy is based on increasing a firm’s valuation according to FASB rules. The valuation process draws from asset and market valuation methodologies with a focus on intangible assets. Because intangible assets are often more elusive and difficult to quantify, the first step is to identify precisely what will be valued, why it will be valued, and how it will be valued. The quantitative drivers for this are often key performance indicators (KPIs) specific to the business. For example, ad-tech KPIs may include daily active users, time spent inside an application, or the number of interfaces integrated into the technology. KPIs must be very specific and consistently measurable. If they are not, then the valuation will be indefensible.
The process to identify a company’s valuation requires a deep understanding of the firm’s industry, potential buyers, M&A activity, and internal strengths. Business owners should conduct an internal assessment of their perceived strengths and then compare those strengths to measurable intangibles identified through market analysis as shown in this paper. The owners must determine how to value these intangibles and collect relevant information as required through income, market, or asset valuation methodologies.
Step 2: Develop, Prove, and Maximize the Identified Value Over Time
The process of developing an intangible asset becomes the process of doing business. In fact, business as usual and intangible asset development are often two ways to describe the same thing. The only difference between business as usual and developing intangible assets is the data collected along the way.
The relevant data collected during market analysis, the process of identifying what makes a company valuable, is also the data that should be used to develop intangible assets carefully. For example, suppose time spent on the application is identified as an intangible asset in the market. In that case, a company should record both the costs and effort to develop those assets through user experience design, added functionality, better graphics, and any other relevant business processes.
Step 3: Monetize Your Assets by Communicating Your Value Better Than Your Competition
For the business owner, monetization happens once the transaction is consummate and the investment banking process is complete. M&A provides an excellent way to measure the impact of intangible assets on a company’s valuation and confirm their role in the purchase price. As of December 2018, all public and private companies are required to allocate M&A purchase prices according to FASB ASC 805.3
Ignoring Intangible Assets Can Cost Buyers Millions of Dollars.
Intangibles make up over 90% of M&A value, according to Jahani and Associates’ research. The best time to maximize identifiable intangibles is during purchase price allocation. This effort creates significant ROI when the business is later sold. Private equity buyers can then reap the benefits of their careful thinking by having proof of the intangibles that exist in their businesses several years later. Without performing more informed purchase price allocations, this case is very difficult to make. Innovating purchase price allocation, which Jahani and Associates does, creates significant financial benefits when private equity firms look to exit. Intangible assets make up most of the value in both private and public capital markets today. Because these assets are not subject to the same standardized reporting as tangible assets, buyers are disadvantaged when it comes to understanding and investing in them.
The principles laid out in this whitepaper give buyers actionable tools to optimize their financial reporting and boost their balance sheet value for future sell-side performance. There is a plethora of evidence that intangible assets make up most of the financial value in both private and public equity markets.
Ignoring intangible assets during purchase price allocation or sell-side M&A is a mistake that can cost private equity firms millions or tens of millions of dollars. The buyers must make purposeful investments to understand, identify, develop, and monetize intangible assets to maintain a competitive edge in increasingly competitive industries.
ABOUT THE RESEARCH
In 2019, Jahani and Associates reviewed M&A activity among the largest companies in the financial services, healthcare, energy, IT services, and branded consumer products industries to determine the intangible assets that matter most in each industry. Intangible-asset pro formas were taken from the Securities and Exchange Commission (SEC) reports only. J&A also surveyed over 15 private equity business leaders in the United States to understand how executives used intangible-asset reporting to make business decisions.
ABOUT JAHANI & ASSOCIATES
Jahani and Associates (J&A) is an independent investment bank located in New York, New York. The firm specializes in healthcare and technology and provides specialized M&A and capital markets advisory services. The combination of J&A’s unmatched skills in technology, engineering, and business operations allows the firm to create sustainable value for its clients. J&A works at the intersection of cutting-edge financial theory and business practicality. Creativity is highly valued within the firm, which allows J&A to continually improve the way businesses thrive.
1. McKinsey & Company, “The Rise and Rise of Private Markets: McKinsey Global Private Market Review 2018,” (McKinsey&Company, 2018).
2. Emily Schillinger, “Private Equity Returns Are Still Best, Even After Fees,” Financial Times, July 22, 2018.
3. Financial Accounting Standards Board, “Business Combinations (Topic 805): Accounting for Identifiable Intangible Assets in a Business Combination,” Financial Accounting Series: Accounting Standards Update, no. 2014–18 (December 2014): 1–24.
4. Jahani & Associates, “Using Intangibles to Advance Your Sell-Side M&A Strategy,” (Jahani & Associates, October 2018).
5. Jahani & Associates, “Health Insurance: Using Intangibles to Make Better Buy-Side M&A Decisions,” (Jahani & Associates, March 2019).
6. “FASB Issues Two Updates for Private Companies on Accounting for Goodwill, Interest Rate Swaps,” News Release 01/16/14, Financial Accounting Standards Board, last modified January 16, 2014.