Mistakes to avoid on your next acquisition
February 2014 | EXPERT BRIEFING | MERGERS & ACQUISITIONS
Most companies succeed because of their intellectual property (IP), the very thing that distinguishes them from their competition and helps grow their customers, sales and profits. IP is often internally developed and externally acquired, although many stumble or fail on integrating newly acquired IP. This article explains some of the bigger and lesser known mistakes to avoid on your next acquisition.
In general, IP is part of the larger definition for intangible property (intangibles) which includes the rights to use assets such as patents, trademarks, trade names, designs or models, and intellectual property such as know-how and trade secrets. To avoid confusion, this article uses the broader reference of intangibles, but by its definition also applies to the narrower reference of IP.
Many acquisitions involve buying the shares of a company, which the vendor prefers, and the purchaser accepts knowing they are getting the intangibles they desire plus other assets of the target company.
Take for example, Company A and Company B which have negotiated and agreed on a price of $60m. The Purchase Agreement or the Purchase Price Allocation allocates the $60m as follows: $5m for tangible assets (e.g., inventory, receivables, fixed assets); $50m for intangible assets (e.g., patents, trademarks, know-how, trade secrets); and $5m for goodwill. The point here is that Company A paid a lot of money for the intangibles of Company B, the main reason for this acquisition.
Post-acquisition, Company A will market and sell the newly acquired products of Company B through wholly-owned distributors of Company C, D, E, etc. As related parties, all transactions between them must be arm’s length. Otherwise, profits are shifted between companies if the price for a transaction is too high, or too low. This will concern the stakeholders of one or more companies if, for example, tax authorities miss out on taxes, creditors lose collateral that previously generated the profits needed to meet ongoing debt payments, shareholder dividends suffer, board members are questioned, and so on.
Moving the intangibles?
Often Company A and Company B are in different countries, which poses a problem when, post-acquisition, Company A moves the newly acquired intangibles from Country B to Country A so they can take control of the intangibles, often sold for nothing. This mistake will likely be disputed when discovered since the intangibles should have been sold at their fair market value, causing, for example, the tax authorities to reassess Company B for additional taxes, interest and penalties.
Most companies say this is not right – they bought the intangibles as part of the acquisition, it is theirs to use, why would they pay twice? This is a reasonable response, but not entirely true. Company A bought shares of Company B, which is now a subsidiary of Company A and a related party. Post-acquisition, by moving the intangibles, Company A in Country A bought intangibles from Company B in Country B.
The fair market value of the intangibles should be $50m if moved soon after the acquisition. However, if moved later, depending on how much later, its fair market value might have gone up or down depending on its value in use or enhancements by Company A, more or less than $50m.
To recap, the mistake to avoid after buying shares of Company B, when moving the intangibles, is to sell the intangibles from Company B to Company A at their fair market value, not $0.
Developing the intangibles?
Following most acquisitions, Company A begins to make changes after taking control of the intangibles. This part serves as a warning, which might become a costly mistake when licensing intangibles.
For some, Company A might make substantial changes in the technology, research, development and commercialisation of Product B. For others, the only change is to market the product or service as ‘Company B, a subsidiary of Company A’ or ‘Product B, part of the Product A family’. Some do both.
The point here is that Company A succeeds if sales and profits increase for Product B, and fails if sales and profits decrease, which increases or decreases the fair market value of the intangibles for Product B.
Sadly, more acquisitions fail than succeed, providing a litany of examples to learn from. For example, eBay bought Skype for $2.6bn in 2005, and four years later sold it for $1.9bn, unable to successfully integrate their technological systems, according to PC World. Kmart acquired Sears for $11bn in 2005, and despite its best efforts, revenue declined by more than 10 percent in the following years.
Stakeholders will be concerned any time a company makes a significant investment to acquire and develop intangibles, only to write this investment down or off after a few short years.
Licensing the intangibles?
Depending on the movement and development of the newly acquired intangibles, more than one company might now own or share in the ownership of the intangibles. It might no longer be clear whether Company A, Company B or both are the licensor, having good and valid title to all of the intangible property, including all rights to profit from the creation and use of these intangibles.
To better explain this point, if the intangibles of Company B were moved to Company A for $0 consideration, the stakeholders in Country B will likely claim Company B ‘legally owns’ the intangibles, not Company A. However, in the post-acquisition period, if Company A invested heavily in Product B to make it better, creating the next generation of intangibles, the stakeholders in Country A will likely claim Company A ‘economically owns’ the intangibles. This dilemma should be avoided at all cost, by taking steps to ensure Company A has the legal and economic ownership of the intangibles.
There is another concern for the related party distributors of Company C, D, E, etc. Apart from earning a return for distributing Product B, some might argue Company C, D, E, etc. contributed to the value of the intangibles and deserves a share of the intangible profits of Product B. This too must be avoided.
The all in one solution?
When companies move intangibles for $0, they often do not realise it should have been at fair market value. Upon realising their error or omission, after the fact, some companies charge their distributors a higher royalty, price or fee for distributing Product B, claiming the net present value of the higher payments are ‘economically equivalent’ to the fair market value of the intangibles owed to Company B.
In essence, rather than being paid fair market value at the time of the sale, Company B has agreed to a vendor take back or receivable for 100 percent of this amount, which Company A promises to repay using the future sales and profits of Product B. However, it is questionable if arm’s length parties would do this.
In this scenario, Company B is not compensated at the time of selling the intangibles to Company A, and might not be compensated later, giving tax authorities and other stakeholders in Country B cause for a dispute. The distributors of Company C, D, E, etc. are paying too much, more than an arm’s length royalty, price or fee, giving tax authorities and other stakeholders in countries C, D, E, etc. cause for a dispute. Finally, Company A paid nothing for the intangibles purchased from Company B, and might be charging more than an arm’s length royalty, price or fee to the distributors of Company C, D, E, etc.
It appears the ‘all in one’ solution does not work. As the saying goes, ‘two wrongs do not make a right’. If mistakes are made, it is best to correct the original sale of intangibles between Company B and Company A to its fair market value, and post-acquisition, ensure Company A does not charge more than an arm’s length royalty, price or fee to Company C, D, E, etc. for distributing Product B.
While this article explains some of the classic mistakes, it cannot explain the specific solutions for each issue as this will depend on the facts and circumstances of each company and transaction. Ultimately, the right solution for one company might be the wrong solution for another. Each business is different, intangibles are unique, and their value can be easily lost, which unfortunately happens too often. To be helpful, a small team is needed to lead this process consisting of senior employees at the company (finance, R&D, marketing and sales) and selected advisers (legal, tax, valuations and transfer pricing), possibly in different countries.
Matthew Wall is a transfer pricing expert at MDW Consulting Inc. He can be contacted on +1 (416) 737 2276 or by email: firstname.lastname@example.org.
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