Page 59 - M & A Disputes

Identifying Indications of How the Deal Was Done

In order to appropriately calculate economic damages sought as a result of indemnity claims against a
buyer or seller, it is important for the practitioner to attempt to understand how the buyer and seller de-
rived and agreed to the purchase price of the target.

The purchase price of the target reflects its investment value, which is the value to each particular inves-
tor based on individual investment requirements and expectations.

In a deal, the buyer is buying a balance sheet and an anticipated stream of earnings or cash flow. As
such, a buyer’s purchase price considers the evaluation and analysis of the amount of working capital
that it needs to support the operations of the business. If that level of working capital is not met, a buyer
may deduct the difference from the anticipated stream of earnings in arriving at the purchase price.

The anticipated stream of earnings ultimately sets the purchase price. However, deals are consummated
in the marketplace for a variety of reasons, and those reasons are often very difficult to determine from
an outside perspective. It is possible that the buyer and seller may have determined the purchase price
through employing one or more of the following valuation approaches. Of course, as stated, there may
have been other strategic factors considered by the buyer and seller when arriving at a purchase price:

 Income approach. A general way of determining a value indication of a business, a business
ownership interest, a security, or an intangible asset using one or more methods that convert an-
ticipated economic benefits into a present single amount.

 Market approach. A general way of determining a value indication of a business, a business
ownership interest, a security, or an intangible asset by using one or more methods that compare
the target with similar businesses, business ownership interests, securities, or intangible assets
that have been sold.

 Cost approach. A general way of determining a value indication of an individual asset by quanti-
fying the amount of money required to replace the future service capability of that asset. fn 1

In the income approach, most often, a purchase price is initially determined based on the present value
of the projected future cash flows over a five-year period plus the present value of a terminal value. In
some instances, a longer projected period may be considered. The discount rate used in this type of dis-
counted cash flow model is the rate of return that an investor would require for the risk associated with
an investment in the target company or similarly situated investment. A valuation principle states that
the value of an entity or asset represents the net present value of the future economic benefits that are
expected to be produced by the entity being valued.

In the market approach, most often, a purchase price is initially determined based on the trailing 12
months (TTM) or annualized EBITDA of the target multiplied by a price-to-EBITDA multiple derived
from an analysis of guideline companies’ market pricing (or acquisition transactions involving guideline
companies). The preliminary purchase price could then be adjusted for any working capital excess or de-
ficiency above or below a contractually agreed-upon level. EBITDA is typically the metric of an earn-

fn 1 International Glossary of Business Valuation Terms.

© 2020 Association of International Certified Professional Accountants 57