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M&A Today – The Numbers & The Law
kpmg
February 12, 2004
Numbers: Mitch Manassa, KPMG LLPLee Singer, FGMK
Law:Neal White, MW&EScott Glickson, Gordon & Glickson
THE NUMBERS
Sarbanes-Oxley 404 Revenue Recognition Purchase Price Allocation Normalization of Financial
Statements Off-Balance Pitfalls
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SARBANES-OXLEY 404
Effective dates Due diligence considerations Acquisition/Merger
considerations Seller pitfalls Private equity
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Revenue33%
Cost28%
Other17%
Loan loss9%
IPR&D6%
Acquisition4%
Revenue & cost
3%
Source: Financial Executive Research Foundation
Main Reasons Sales contingencies not
disclosed to accounting or management
Sales booked before delivery completed
Significant rights of return existed
Software revenue recognized before underlying services were performed
False sales agreements and documentation
“Bill and hold” sales not deferred
RESTATEMENTS IN RECENT YEARS
One third of all restatements were attributed to revenue recognition issues
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REVENUE RECOGNITION
Relevant guidance for technology firms
Complexities in revenue recognition
Due diligence considerations
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ACCOUNTING GUIDANCE Transaction considerations: Maintenance & service
contracts Multiple/bundled elements Distributor/reseller
agreements Customer contracts are key Bill and hold transactions Side agreements Extended payment terms Customizing or installation Price determination
agreements
What are the rules?
Basic principles under SAB 101:
– Persuasive evidence
– Delivery
– Fixed and determinable payment terms
– Collectibility
Other recognition “areas”:
– Percentage of completion
– Completed contract
– Installment sales
– Upfront fees
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REVENUE ANALYSIS Categorize customers as many ways as possible:
– End users, resellers, distributors, or related parties;
– Customers by product or service;– Customers by industry;– Customers by geography; and– One-time verses recurring.
Understand the unique contractual arrangements that exist for each type of customer such as:– Milestone completion;– Rights of approval/return; and– Cancellation clauses.
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PURCHASE PRICE ALLOCATION
Identifiable intangible assets IPR&D Goodwill (remainder) Post-merger amortization Valuations
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NORMALIZATION OF FINANCIAL STATEMENTS
PURPOSE
To remove excess charges or credits in the financial statements; adjusting the financial statements to conform with GAAP and recasting the financial statements to anticipate the major changes that will effect the business after merger or acquisition has been completed
PURPOSE
What prior operations might have looked like under normal conditions and on a consistent basis;
or What prospective buyers might
reasonably be expected to obtain from the company in the future using history as a guide.
COMMON NORMALIZATION ADJUSTMENTS
Balance Sheet Adjustments Income Statement Adjustments Other
BALANCE SHEET ADJUSTMENTS
Non operating assets, excess assets and asset shortages
Loans to/from related parties
INCOME STATEMENT ADJUSTMENTS
Compensation of owner or family members
Fringe benefits Non-recurring income and
expenses Income and expenses related to
excess assets, non-operating assets and asset shortages
Related party revenues and expenses
OTHER
Non cash items Corporate cost allocations Income taxes
OFF-BALANCE SHEET PITFALLS
PURPOSE
Amounts that are not typically booked in a GAAP financial statement, but may have a major effect on forecasted earnings;
and To alert a prospective buyer
about monetary amounts that may have a material effect on financial performance.
TYPICAL OFF-BALANCE SHEET PITFALLS
Warranty obligations (Fin 45, 46) Related party guarantees Lease commitments Maintenance contracts Purchase agreements Deferred taxes Shelf life of product Income, sales and use tax audits Non compete agreements Product liability
The Law – A Mock Negotiation
Law:Neal White, McDermott, Will & Emery Scott Glickson, Gordon & Glickson
THE DEAL
The Company - $200 Million Revenue manufacturer of wireless video wristwatch email web-browser solar powered telephone
Has been S-Corporation for more than 10 years Founder/CEO owns 75% on fully diluted basis,
25% represented in minority investors and employees
Founder has guaranteed company obligations on lease on manufacturing facility
The Buyer – Public Company, NASDAQ Listed The Proposed Price -$50 Million in public
company stock and cash Hart Scott Rodino Notification Required
Asset vs. Stock deal (parties have determined it is neutral from tax perspective)
Representation and warranty regarding no infringement of third party rights by the product technology
Representation and warranty regarding steps taken to protect trade secrets and other confidential information
Representation and warranty of accuracy of all information provided in due diligence and that everything relevant has been disclosed
THE ISSUES THAT THE PARTIES WANT TO RESOLVE IN THE TERMS SHEET BEFORE PROCEEDING
Purchaser’s right to walk for material adverse change
Founder’s condition that his lease guaranty be released at closing
Limitations on liability 1. Statute of Limitations2. Cap on Liability3. Basket For Immaterial Claims4. Joint and several liability of sellers
THE ISSUES THAT THE PARTIES WANT TO RESOLVE IN THE TERMS SHEET BEFORE PROCEEDING
INTELLECTUAL PROPERTY REP
Seller owns and possesses or has the right to use under a valid and enforceable license, sublicense, agreement or permission all Intellectual Property constituting Purchased Assets. Each item of Intellectual Property included in the Purchased Assets will be owned or available for use by Purchaser upon the Closing on terms and conditions identical to those that Seller enjoys immediately before the Closing,
Seller has not interfered with, infringed upon or misappropriated any Intellectual Property rights of third parties as a result of its use of the Purchased Assets,
All persons creating any Intellectual Property as employees or contractors have assigned all rights therein to the Company
Seller has never agreed to indemnify any Person for or against any interference, infringement or misappropriation with respect to the item, except pursuant to ordinary course sales supply contracts with customers;
Seller has taken all necessary action to preserve and protect all Intellectual Property
INTELLECTUAL PROPERTY REP
BUYER’S AND SELLER’S CONDITIONS
Material Adverse Change It shall be a condition to Purchaser’s
obligation to close that there shall have been no material adverse change in the financial condition, business, assets or prospects in the Company, whether Company specific or related to general industry or economic trends,
Release of Guaranty It shall be a condition to Sellers’
obligation to close that Founder shall have been released from his lease guaranty.
ACCURACY OF INFORMATION All information which has been provided to Purchaser
by or on behalf of the Sellers is true and complete and no material fact has been omitted therefrom which would make such information misleading. Sellers has made or caused to be made reasonable inquiry with respect to each covenant, agreement, obligation, representation and warranty of Sellers contained in this Agreement and none of the aforesaid covenants, agreements, obligations, representations or warranties contains any untrue statement of a material fact or omits to state a material fact necessary to make such covenant, agreement, obligation, representation or warranty not misleading. Sellers have disclosed to Purchaser all information that Purchaser could reasonably determine to be material to its acquisition of the Company.
INDEMNIFICATION THRESHOLD & CAP
No amount will be payable by the Sellers in indemnification unless and until the Damages exceed $10,000 in the aggregate. However, this threshold limitation does not apply to any breach of any of Sellers’ representations and warranties of which Sellers had knowledge at any time before the date on which such representation or warranty was made, or (d) any intentional breach by Seller of any covenant or obligation (If the aggregate amount of all Damages exceeds $10,000 then the Sellers shall be jointly and severally for all of the Damages from the first dollar. Seller’s maximum liability under this Agreement is the purchase price.