Successful transactions end in purchase prices — a value agreed upon by two or more parties. The transaction may or may not involve a negotiation, but it always involves an agreed price.
Commercial transactions are usually straightforward: one person sells a product, service, or asset, and another person buys it at face value. For example, when you purchase a t-shirt on Amazon, the purchase price is the published ticket of the item.
But not all transactions are this simple, and neither are all purchase prices.
In the case of company acquisitions, for example, the purchase price may be paid in non-monetary terms. Imagine a purchase of $1,000,000 that a buyer pays partly in cash and the rest in company stocks.
In cases like this, it’s more difficult to determine the effective purchase price (aka the actual cash amount after all non-cash compensation is settled). After all, what is the current value of the stocks? This has to be calculated to determine the purchase price, at least to a reasonable degree.
This article defines purchase price, addresses nuances such as the one above, touches on different formulas to compute it, and looks into common misconceptions.
The concept of “purchase price” may seem so simple that it requires no explanation. However, the reality is that it can be complicated with payment types and percent ownership.
In short, a purchase price is the economic value, usually defined in fiat currency at a given point in time, for which a buyer purchases a product, service, or asset. The compensation paid for this value can be fiat currency or other, such as services as payment or benefits in kind.
Using this definition, we can identify 3 key criteria:
- Currency. The value of the purchase price is usually defined in fiat currency (i.e USD, EUR, GBP).
- Payment. Payment may be in fiat currency or in other compensation such as services. The combination of payments is called the “total consideration.”
- Time. The fiat currency value is only valid at one point in time. As time moves forward, market conditions such as inflation and competition can change the value of the purchase price.
We’ll look at detailed examples throughout the article, but here are some high-level ones:
- Price tag on jeans at department store
- Price of a product on Amazon
- Quote for a plumber to fix a sink
- Price of wholesale goods to Walmart
- Quote for consultants to analyze company performance
- Business valuation per share price
- Stock price on a secondary exchange
Purchase Price in Accounting
Purchase prices are extremely important in accounting. When a company purchases a good, the purchase price is usually considered the value placed on the balance sheet.
For example, inventory purchased for $100 becomes $100 as an asset.
Or in the case of fixed assets, the purchase price becomes the starting book value of the asset on the balance sheet, which is then depreciated on the P&L for the life of the asset.
The importance of purchase price in accounting means precise documentation is extremely important.
In exceptional cases, such as an asset purchased with stock, the precise value of the total consideration must be evaluated in the currency of the company. This can be done either by using a technique to value future cash income to present day, or using a fair market value (discussed at the end of the article).
Purchase Price and Goodwill in Accounting
When a company buys another company, purchase price can give way to a special accounting item called goodwill.
If the company is purchased for more than the net fair market value of all its assets, the excess is called goodwill. On the balance sheet, this means there is a debit to both the “shares in affiliates” asset account and the “goodwill” asset account.
Fair market value, simply put, is the amount a reasonable buyer would pay for the assets in the open market, barring he/she has no time constraints or other undue pressures. There are various ways to perform this calculation, but the simplest is to examine recent sales prices of similar assets in the market.
In goodwill purchase scenarios, the buyer needs to record the difference between the fair market value and the purchase price as goodwill — which is a different, intangible asset.
And that goodwill has to be reevaluated each year to ensure it reflects reality — a lengthy process for accountants. Purchase price is important!
Purchase Price as a Legal Term
Unless you’re buying consumer products from a brick and mortar shop, most purchases are bound by both (1) a contract and (2) legislature, the latter of which takes precedence. And in these contracts, a purchase price is always defined.
It’s important to understand how purchase price is used in a purchase contract. On the one hand, it identifies the obligation the buyer has to the seller, and visa versa.
On the other hand, it is used as a catalyst or condition for other obligations in a contract.
For example, contracts often stipulate that only upon receipt of a payment does a seller transfer his/her ownership of the item being sold.
Since the contract is written to be specific, any amount less or more than the purchase price would be a breach of contract.
In some cases, deals have gone south due to a mismatch in the purchase price. I’ve seen it happen professionally myself.
Two ways in which purchase price may act as a catalyst include:
- Triggering termination of contract
- Trigger damages owed to the counterparty for time invested on false pretenses, aka liquidated damages
Purchase Price Formula
There are a few different purchase price formulas, and you should know them all. Why? Because you may not always have access to the purchase price number itself.
On the contrary, in some cases you may only know the total costs and margin of a group of products. The good news is, with the number of units, we can always arrive at purchase price, both per unit and for the group of units.
The purchase price formula is Purchase Price = Cost Price + Margin. We can also write the formula (Purchase Price*Units) = (Cost Price*Units) + (Margin*Units) which represents the total purchase price for all units sold in a period.
It can also be written as Total Purchase Price = Units * (Product Cost + Product Margin)
How to Calculate Purchase Price
Let’s look at two examples to illustrate how to use these formulas.
Imagine you read about a deal in which the product cost is $100 and the desired margin is 20%. The margin value is thus $20 ($100 * 20%). Using our formula, the purchase price is $120.
Imagine now a scenario in which you have partial financial statements of a company. You know the total cost of units sold is $250,000, and you know the unit margin is 15%. You also know the number of units purchased was 350, but you only sold 250.
First you would identify the unit values. The unit cost is ~$714 ($250,000 / 350). You know the margin is $107 ($714*15%). Now you simply need to add the values and multiply by the number of units sold (250). Purchase price per unit is $821, and the total purchase price is $205,250.
Factors to Consider in Purchase Price
Now we have an idea of what purchase price represents in practice and in accounting, let’s look at common factors to consider. Knowing these will help you deepen your understanding. There’s a section below on each of these topics:
- Purchase Price vs Valuation Price
- Purchase Price vs Selling Price
- Purchase Price vs Loan Amount
- Tax considerations
- Payments in Foreign Currency
- Future Payments and Discounted Cash Flows (rev share, stock compensation)
Purchase Price vs Valuation Price
In non-commercial transactions, such as business acquisitions, it’s not uncommon for buyers to purchase only a portion of a company. When a company has more than one shareholder, then each shareholder is a partial owner.
In a shareholder transaction, therefore, it’s very important to differentiate between valuation price and purchase price. The valuation price is the total value of the company, whereas the purchase price is the percent portion, determined by number of total shares, that is being sold.
For example, imagine a company is valued at $1,000,000 and is composed of 20,000 shares, or $50/share. Currently there is one shareholder, and he sells a 20% stake in the company of 4,000 shares. The buyer pays $200,000 (4,000 * $50). The purchase price is $50 per unit, or $200,000 in total, and the valuation is $1,000,000.
Remember this because it’s easy to forget in practice: valuation ≠ purchase price!
Purchase Price vs Selling Price
The difference between selling price and purchase price is a question of timing. The selling price is the initial tag a seller puts on a product, while the purchase price is the value at which the product is finally sold.
For example, when I sold my first car, the selling price was $2,000 because that’s what I put it up for (it was a really, really old car). But the buyer negotiated to purchase it for $1,500, which became the purchase price.
In capital markets, there is a related concept called buy vs sell price. The buy price and sell price of a security are different, since the sell price is the listed amount and the buy price is the listed amount plus brokerage fees.
Purchase Price vs Loan Amount
Purchase price and loan amount most often show up together in the context of home buying. In reality, they’re present any time debt is used to make a purchase.
A loan amount is the designated portion of a purchase price that is funded with a loan. The purchase price is the same whether or not the buyer uses a loan to make the purchase, but a loan will improve the buyers short term liquidity.
For example, imagine a home valued at $300,000. You want to buy 100% of it but only have $50,000 in cash. You will take out a $250,000 loan to meet the cash purchase price of $300,000. In this case, the purchase price is $300k, and the loan amount is $50k.
It is possible that purchase price and loan amount are the same value. When you buy a car, for example, you would probably take out a loan for the full value of the purchase price. As you pay down the loan, however, the loan amount will become less than the purchase price.
Purchase Price is Pre-Tax
When a seller closes a deal and turns a profit, s/he must declare that profit as taxable income (not always, but capital gain exceptions are outside the scope of this article).
In fact, in a corporate context, all assets have a tax base, which indicates how they should be taxed over time.
As a seller, it’s important to remember that the value earned on a sale is not the purchase price alone, but the after-tax income of the good.
In some places, taxes can cut out 20% of the income. In other places such as Luxembourg, where I started my career, an asset sold after 6 months incurs 0% capital gains taxes.
Future Payments and Discounted Cash Flows
Another important point is time of payment. B2B companies have long implemented installment-based payments. And with the introduction of companies like Splitit and Klarna, even consumer product providers can allow buyers to pay in installments over time.
But due to the time value of money, cash received in the future is inherently worth less than cash received today. Why? Because money can be invested if received today, which means higher returns than if received in the future.
This is a critical point surrounding purchase price. If a purchase price is established today and the buyer pays it over time, then the current value of those payments is less than the purchase price!
While most people will ignore the time value of money in a sale, accountants are not allowed to. They must show the fair value of a purchase, and the fair value will always consider the time value of money. Let’s look at an example.
Discounted Cash Flow Example
Imagine a manufacturing company sells steel rods to a buyer. The manufacturer agree to accept payment in 3 installments over three years, since the amount is very large and the seller is liquid. The purchase price is set at $650,000,000.
An initial payment of $450,000,000 is due up-front, and the rest is split into two payments — the first at closing day + 1 year, and the second at closing day + 2 years. Closing is December 31, 2021.
Now let’s imagine that with the delayed $2M at the closing date, the seller could have invested in US Treasury Notes with 1 and 2 year maturities. The 1-year notes has a yield of 0.07%, and the 2-year note has a yield of 0.22%, both of which are paid annually.
This means the investor could make $70K on the first installment by investing today, and $440k on the second installment, for a total of $508k if invested today.
However, since he won’t have the money today, he’s “losing” that value. This is why we discount future cash flows. Here’s what it looks like laid out:
While a seller may choose to ignore this “loss,” accountants will actually need to book the sale at the $649M amount, since this is the fair market value. In other words, the purchase price is time sensitive and delayed payments can change it. Some don’t care, but accountants do.
Purchase Price Accrued
A brief note on accruals. In general, accrued simply means that a service was rendered but no money was exchanged.
An accrued purchase price occurs when a seller delivers the good to the buyer at an agreed upon price and receives the money later. This usually occurs when the buyer wants to inspect the good before transferring cash.
Deferred Purchase Price
A deferred purchase price is the opposite of an accrual. The buyer sends the money before the good is delivered. This usually happens when the good is high-risk, such as precious jewelry, and even transporting it requires some incentive for the seller.
Purchase Price in Foreign Currency
The value of a product purchased in a foreign currency can be tricky for companies and individuals alike. Buyers and sellers have to record the value of a sale in their home country, with the local currency. But how should they handle the exchange rate?
A buyer who purchases a product valued in a foreign currency should initially record the value at the exchange rate at the date of closing.
If the purchase is accrued, then she/he must record the value at the day of delivery, then adjust his/her books for any change once the payment is made.
If the purchase is deferred, then the buyer must record the value at the day of payment, then adjust his/her books once the payment is made.
A vendor who sells a product valued in a foreign currency (very rare) should record the value in his home country currency at the exchange rate of the day of closing.
If the purchase is accrued, s/he should record the value at the day of delivery and adjust when payment is received.
If the purchase is deferred, then the seller should record the sale at the exchange rate at the day of payment and adjust when the product is delivered.
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