Opinion

Surviving a leveraged buyout

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Peter R. Alfele, Cherry, Bekaert & Holland


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A few decades ago, leveraged buyouts (LBOs) were popular structures for a number of well-publicized, publicly held companies that “went private.” Although the term conjures images of corporate raiders, Wall Street espionage and board room battles, an LBO can be an effective exit strategy for the owners of closely held businesses looking to cash in on shareholder value and provide an ownership opportunity for key members of management who have contributed to the organization’s success.In general, there are four methods of accomplishing an LBO:

- Within the targeted company – the company repurchases and retires the founder’s interest with borrowed money or accumulated assets

- Amongst the shareholders – existing minority shareholders individually acquire a majority position directly from the founder

- Through an existing company with substantive operations – a competitor or peer buys out the founder

- Through the creation of a holding company – outside investors capitalize a shell company that acquires the targeted majority interest

Creating a shell or holding company to house the transaction is generally the preferred type of LBO because outside investors often provide a significant source of capital to complete the deal. Further, the outside investor can segregate contingent liabilities while establishing a structure under which additional investments can be made.

The creation of a new company in its simplest terms, an LBO accomplished through the creation of a holding company requires two steps. First, a holding or shell company is organized and capitalized by the continuing shareholders through the issuance of stock (frequently with preferential rights) and debt. Second, the proceeds of the stock issuance and debt funding are used to acquire all or a portion of the founder’s equity interest in the targeted company.

To illustrate, assume that Old Co. was founded by Adam, the original and sole shareholder. Through the years, Brian, Old Co.’s CFO, and Chuck, the company’s Chief Operations Officer have contributed greatly to the company's growth and success and made Adam independently wealthy. Adam desires to pursue other interests and decides to sell his interest.

The book value of Adam’s equity is $2 million. He believes the fair value of Old Co. is $3 million due in part to its trademark, which is independently valued at $250,000. Brian and Chuck wish to continue the enterprise and solicit Delta Capital, an outside investment firm, to provide financing to purchase Adam’s interest. Together, Brian, Chuck and Delta Capital form New Co. with capital contributions of $200,000 each, for a total of $600,000. New Co. also obtains additional financing of $2.4 million from a bank and acquires Adam’s interest at the negotiated purchase price of $3 million.

Accounting for the transaction

For the most part, U.S. generally accepted accounting principles (“GAAP”) require business combinations to be accounted for by the acquisition method described in Statement of Financial Accounting Standards (“SFAS”) 141 – Business Combinations, as amended.

The acquisition method requires the surviving entity of a business combination to record the assets and liabilities of the acquired entity at the full fair value of the assets and liabilities acquired. The purchase price paid in excess of the full fair value of the net assets acquired is reported as goodwill as demonstrated in the following formula:

Purchase price - Fair value of net assets acquired = Goodwill

In the example described, the investment stemming from the arm's length transaction reflects the fair value of the company, which differs from Old Co.’s equity by the $1 million appreciation in net assets. If Old Co. is retained as a subsidiary, that excess should be pushed down to it because of the complete change in ownership. Old Co.’s books account for the push down by adjusting the appropriate assets and liabilities through additional paid-in capital.

The adjustment reflects the individual assets and liabilities at their fair value (including the initial recognition of the marketing-related intangible assets for the trademark). Any excess of the $1 million over the adjustments to individual assets and liabilities is recorded as goodwill. In addition, New Co.’s debt of $2.4 million should also be pushed down by a debit to an inter-company account and a credit to debt.

In applying the accounting guidance to the illustration described above, New Co.’s balance sheet evolves as follows (income tax effects have been ignored for the sake of simplicity):

New Co. (unconsolidated)

Pre-acquisition

Step 1

Step 2

Step 3

Ending Balance

Assets

         

Current assets

$-

$3,000,000

($3,000,000)

$-

$      -

Investment in Old Co - - 3,000,000 - 3,000,000
Total assets $- $3,000,000 $- $- $3,000,000
           

Liabilities and Equity

         
Due to Old Co. $- $- $- $2,400,000 $2,400,000
Debt - 2,400,000 - -2,400,000 -
Equity - 600,000 - - 600,000
Total liabilities and equity $- $3,000,000 $- $- $3,000,000
           
As a result, the subsidiary will reflect stockholder’s equity of $3 million.

Old Co.

Pre-acquisition

Step 1

Step 2

Step 3

Ending Balance

Assets

 

         
Current assets $4,000,000 $       - $       - $       - $4,000,000
 Property and equipment 1,000,000 - - - 1,000,000
 Intangible assets - - - 250,000 250,000
 Goodwill - - - 750,000 750,000
Due from New Co. -   - 2,400,000 2,400,000
Total assets $5,000,000 $- $- $3,400,000 $8,400,000
           

Liabilities and Equity

         
Current liabilities $3,000,000 $       - - - $3,000,000
Debt - -   2,400,000 2,400,000
Equity 2,000,000 - - 1,000,000 3,000,000
Total liabilities and equity $5,000,000 $- $- $3,400,000 $8,400,000
           
           

Step 1 – Shareholders capitalize New Co. with capital contributions and new debt Step 2 – New Co. purchases all of the outstanding shares of Old Co. from Adam Step 3 – New Co.’s debt is pushed down to Old Co., Old Co.’s assets are adjusted to fair value and Old Co. records goodwill for the excess of the purchase price over the fair value of its assets.

Because the $3 million equals New Co.’s equity in the transaction, if consolidated financial statements are presented, a consolidation entry would be made to eliminate the investment of $3 million and the subsidiary’s debt and equity, as demonstrated below:

New Co. and Subsidiary

New Co.

Old Co.

Total

Eliminations

Consolidated Balance

Assets

         
Current assets $       - $4,000,000 $4,000,000 $       - $4,000,000
Property and equipment - 1,000,000 1,000,000 - 1,000,000
Investment in Old Co. 3,000,000 - 3,000,000 -3,000,000 -
Intangible assets - 250,000 250,000 - 250,000
Goodwill - 750,000 750,000 - 750,000
Due from New Co. - 2,400,000 2,400,000 -2,400,000 -
Total assets $3,000,000 $8,400,000 $11,400,000 $5,400,000 $6,000,000
           

Liabilities and Equity

         
Current liabilities $       - $3,000,000 $3,000,000 - $3,000,000
Due to Old Co. 2,400,000 - 2,400,000 -2,400,000 -
Debt - 2,400,000 2,400,000 - 2,400,000
Equity 600,000 3,000,000 3,600,000 -3,000,000 600,000
Total liabilities and equity $3,000,000 $8,400,000 $11,400,000 $3,400,000 $6,000,000
           

The end result of the consolidated entity displays the true economics of the transaction, and reports the assets and equity of the entity at their determined fair values.

Conclusion

The leveraged buyout transaction introduces unusual accounting entries that many surviving executives are not accustom to seeing. Understanding how the balance sheet of a newly formed holding entity develops can help new stakeholders understand how the financial reporting of their enterprise presents the underlying economics of their ventures.

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