There’s no better teacher on the use of option pricing models in valuation than Mark Zyla, and his session this afternoon in Miami was no exception (Mark also does most of the fair value training for the AICPA FVS).
He reminds all appraisers that Topic 805 requires the measurement of contingencies in business combinations. There are two categories of these contingencies that are generally identified:
- Contractual Contingencies: Recognize all assets and liabilities that arise from contractual contingencies; Measure at fair value as of the acquisition date
- Non-contractual Contingencies: Test for recognition is whether it is “more likely than not”that a contingency gives rise to an asset or liability; If so, measure at fair value as of the acquisition date; If not, do not recognize and apply Topic 405, Contingencies
What types of acquired contingencies will most appraisers face? Mark lists the following examples:
- Environmental liabilities
- In process research and development
- Unfunded pensions
- Certain financial liabilities
- Income tax issues
- Indemnification issues
Here’s an example Mark provided to the attendees at today’s meeting for applying the first of these methods, PWERM, in a situation where there are a reasonably small number of outcomes but relative complexity in anticipating the most reasonable outcome (like most analysts, Mark prefers the Monte Carlo method when there are large numbers of possible outcomes).
- Assume Acquirer Corp purchases Target Corp on 1/1/x1 for $500 million.
- Target has just introduced a new product line that is expected to generate significant sales.
- Contingeny 1: If Target achieves target EBIT of $125 million in year 1, Acquirer will pay an additional $15 million to the previous owners.
- Target also intends to spin off a division in year 1, and expects to receive $10 million.
- Contingency 2: If proceeds exceed $15 million, Acquirer will pay an additional $3 million to the previous owners
- The discount rate is 10%.
- Division is not sold: 35%
- Division is sold for <$15 million: 50%
- Division is sold for >$15 million: 15%