1. Alternative Approaches to Valuing Customer-Related Intangible Assets
PJ Patel, CFA, ASA Ed Hamilton, CFA
Managing Director Vice President
ppatel@valuationresearch.com ehamilton@valuationresearch.com
Direct: 609.243.7030 Direct: 609.243.7018
Mobile: 609.240.1337 Mobile: 609.221.8174
Valuation Research Corporation
2. Agenda
• Qualitative Considerations
• Customers in Certain Situations
• Alternative Valuation Techniques
• With-and-Without Approach
• Distributor Method
• Cost Approach
1
3. Continuum of Customer Assets
Recurring
Customers
Transactional Transactional customer
with long
Customer purchase customer relationships Take or pay
term
lists order based relationships with contracts
contracts
customers with MSAs switching
costs
2
4. Customer Value – Two Scenarios
Company Customer Margin Comments
Relationship
Defense • Contractual 9% • Customers are a
Contractor – IT • Multi-year key acquisition
Related • Renewals and/or rationale
extensions often • Customers often
occur the primary
intangible
Consumer • Purchase order 25% • Customers of
Branded – Food based limited importance
• Non-contractual • Customers help
• Based on company reach
strength of consumer but
brands, consumer brand is key
demand
3
5. MPEEM – Two Scenarios
IT Defense Branded
Contractor Product
Revenue $100,000 $100,000
EBITA 9,000 25,000
9.0% 25.0%
Pre-Tax Returns on Supporting Assets
Charge for Use of the Trademark 0 (5,000)
Adjusted Income Before Taxes 9,000 20,000
Less: Income Taxes 3,600 8,000
Debt Free Net Income 5,400 12,000
5.4% 12.0%
Returns on Supporting Assets
Working Capital (1,200) (900)
Property, Plant & Equipment (180) (2,700)
Workforce (2,500) (500)
Return on Supporting Assets (3,880) (4,100)
-3.9% -4.1%
Net After Tax Cash Flow to Cust. Relationships 1,520 7,900
Implied Royalty Rate 1.5% 7.9%
4
6. MPEEM – Alternative Calculation
Branded Branded
Product Product
Revenue $100,000 $100,000
EBITA 25,000 25,000
25.0% 25.0%
Pre-Tax Returns on Supporting Assets
Charge for Use of the Trademark (5,000) (15,000)
Adjusted Income Before Taxes 20,000 10,000
Less: Income Taxes 8,000 4,000
Debt Free Net Income 12,000 6,000
12.0% 6.0%
Returns on Supporting Assets
Working Capital (900) (900)
Property, Plant & Equipment (2,700) (2,700)
Workforce (500) (500)
Return on Supporting Assets (4,100) (4,100)
-4.1% -4.1%
Net After Tax Cash Flow to Cust. Relationships 7,900 1,900
Implied Royalty Rate 7.9% 1.9%
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7. MPEEM – Key Limitation
• When the customer relationship asset is the unique asset, use of a
traditional MPEEM may be appropriate.
• When another asset is the unique asset, use of the MPEEM may overstate
customer value.
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8. Qualitative Issues
• Valuation of Customer assets is heavily dependant on qualitative issues
• Prior to choosing a valuation method, it is important to understand the
qualitative characteristics of the customer asset and its relationship to the
business
• Are the customers a primary asset of the business?
• What is the relative importance of the customer relationships vs. other
assets of the business?
• Where does balance of power lay between a company and its
customers?
• Are there significant barriers to entry?
• Are there significant switching costs?
• What is the relative class spend (i.e. customers vs. technology)?
• Where are the company’s products in their life cycle?
• Are there any contractual rights (e.g., trademark registration, patents,
customer contracts, etc.)?
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9. Match Qualitative Info to Market Data
Customer Type Market Proxy Margins earned by Market Proxy
Transactional purchase Appears similar to the type of Typically 3-6% - may be greater or
order based customers relationships maintained by lower depending on
distributers customer/manufacturer leverage
Transactional customer Appears similar to the type of Expect margins to be at the high end
relationships with MSAs relationships maintained by of distributors but below those of
distributers, although slightly customers with long term contracts
stronger
Recurring customer Appears similar to the types of Expect margins to be higher than
relationships with relationships maintained by distributors but lower than customers
switching costs companies with long term with long term contracts. Although in
contracts although not as strong some unique cases margins may be
much higher.
Customers with long term Appears similar to the types of Varies, however margins for certain
contracts relationships maintained by long term service providers range
contract manufacturers, defense from 5-10%
contractors etc
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10. Income Approach
• Value is based on the present value of expected future cash flows
attributable to the asset being valued
• Three primary factors
• What are the earnings or cash-flows relating to the asset being valued?
• What is the expected life?
• What is the appropriate discount rate?
• Approach takes several forms:
• With-and-Without Model
• Multi-Period Excess Earnings Model
• Distributor Method
9
11. With-and-Without Model - Overview
• Value is estimated by quantifying cash flows under a scenario in which the
customer-related assets must be replaced but assuming all other assets
are present.
• Base case cash flows are projected in a manner consistent with
company/asset group projections
• Without scenario incorporates the costs and lost profits over the time period
expected to rebuild customer asset
• The value is based on present value of the differential cash flows
• Useful in valuing non-primary assets
• Theoretically intuitive
• Costs incurred, profits lost and time period to recreate asset are highly
subjective and difficult to quantify
10
12. With-and-Without Method – Key Assumptions
• Impact on revenue
• Impact on cost of goods sold
• Direct costs to establish and recreate the customer-related assets
• Other costs such as direct and indirect SG&A
• Other required assets or expenditure, e.g. working capital and capital
expenditures
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13. With-and-Without Method – Recreating the Customer Rel.
• Expected time to recreate
• Historical time to build to current levels
• Typical sales cycle
• Time to establish a new relationship
• Lag between sales proposal and an order
• Level of competition in industry
• Minimum sales guarantees once an initial product is sold.
• Switching costs and whether this will increase the difficulty of attracting new
customers.
12
14. With-and-Without Model - Example
• Company A acquires Company B, a manufacturer of branded consumer
electronics. Company A acquired Company B primarily for its brand and all
other assets were thought to be easily replaceable. The purchase price was
$168 million.
• After consideration of additional SG&A costs to replace the customers and
other cash flow impacts, new cash flows are projected to be reduced by
$12 million, $6 million and $3 million for years one, two, and three,
respectively.
Year 1 Year 2 Year 3
Cash Flows - With 100.0 110.0 120.0
Cash Flows - Without 88.0 104.0 117.0
Incremental Cash Flows 12.0 6.0 3.0
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15. With-and-Without Method - Calculation
Year 1 Year 2 Year 3
Debt-Free Net Cash Flows (with Cust. Rels.) 100.0 110.0 120.0
Debt-Free Net Cash Flows (w/o Cust. Rels.) 88.0 104.0 117.0
Incremental Cash Flows 12.0 6.0 3.0
Midpoint 0.5 1.5 2.5
Present Value Factor 0.9428 0.8381 0.7449
Present Value of Incremental Cash Flows 11.3 5.0 2.2
Sum of PV of Incremental Cash Flows 18.6
TAB 4.3
Fair Value 22.9
Tax Benefit=L/(L-(Fa*T))
Tax Life 15 Years
Tax Rate 40.0%
Discount Rate 12.5%
Amortization Factor 7.0352
Tax Benefit 23.1%
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16. With-and-Without Method – VRC Comments
The group also discussed calculating the With-and-Without Method by
estimating the value of each scenario independently. In the end, this approach
was not recommended/included due to difficulties and drawbacks in
implementing.
Comments/Considerations
• The group had significant discussion around which cash flows to discount
and at what discount rate.
• Is the discount rate consistent with the total loss of customers?
• If different discount rates are used for the two scenarios, and the without
scenario is more risky, a higher discount rate leads to lower value for the
without scenario and thus a higher value for the customer-related asset.
This is counterintuitive.
15
17. Distributor Method – Theory & Usage
• A business is composed of various functional components (e.g. trademarks,
technology, manufacturing, marketing, sales & distribution.)
• For certain functions, market-based data may assist in isolating the margin
associated with a functional component.
• Distributor data may be appropriate when the customer relationships have
characteristics that are similar to those of a distributor
• Useful because it allows for use of the MPEEM to value another asset, e.g.
technology or brands.
16
18. Distributor Method
• Value is based on the present value of expected future cash flows attributed to the
asset being valued
• Cash flows are projected based on market participant inputs for certain key inputs
with adjustments for growth and customer attrition similar to the MPEEM
• DM is useful in valuing non-primary assets and reduces reliance on CACs
• DM requires selection of appropriate comparable companies who can provide a
reasonable market based proxy (i.e. they serve a similar function) and profit margin
for the customer asset being valued
• DM requires many inputs:
• Projected revenue
• Expected margin
• Long term growth rates
• Attrition rates
• CACs for certain limited contributory assets
• CACs are not required for manufacturing related working capital, PP&E, workforce,
product trademarks and technology as these items are captured in the distributor’s
COGS
17
19. Distributor Method - Example
• Company A acquires Company B – a manufacturer of branded consumer products.
Company B generates $100 million in revenue per year. Company B sells its
products to retailers. The brands are the primary asset of the business and
contributory assets include working capital, PP&E and workforce related to the
sales/distribution function.
• To properly allocate cash flow and value between the brands and customer
relationships, the distributor method is used to value the customer relationships and
the MPEEM using PFI is used to value the brands.
• Key inputs are as follows:
• Expected revenue growth – 3%
• Expected customer attrition – 10%
• Appropriate distributor margin – 4.1%
• CACs are needed for working capital, PP&E, trademark and workforce based
on distributor levels rather than manufacturer levels
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20. Distributor Method - Example
Year 1 Year 2 Year 3
Revenue Adjusted for Growth $100,000 $103,000 $106,090
Remaining After Attrition 95.0% 85.5% 77.0%
Revenue After Attrition 95,000 88,065 81,636
EBITA (4.1%) 3,895 3,611 3,347
Less: Income Taxes 1,558 1,444 1,339
Debt Free Net Income 2,337 2,166 2,008
Contributory Asset Charges
Normal Working Capital (684) (634) (588)
Property, Plant & Equipment (238) (220) (204)
Workforce (95) (88) (82)
Return on Supporting Assets (1,017) (942) (874)
Net After Tax Cash Flows 1,321 1,224 1,135
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21. Distributor Method vs. MPEEM
Distributor Method MPEEM
Revenue Adjusted for Growth $100,000 $100,000
Remaining After Attrition 95.0% 95.0%
Revenue After Attrition 95,000 95,000
EBITA 3,895 19,000
4.1% 20.0%
Adjustments
Less: Royalty Charge for use of TM 0 (9,500) 10.0%
Adjusted EBITA 3,895 9,500
Less: Income Taxes 1,558 3,800
Debt Free Net Income 2,337 5,700
Debt Free Net Income Margin 2.5% 6.0%
Contributory Asset Charges
Normal Working Capital (684) (1,425)
Property, Plant & Equipment (238) (1,900)
Workforce (95) (1,045)
Return on Supporting Assets (1,017) (4,370)
-1.1% -4.6%
Net After Tax Cash Flows 1,321 1,330
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22. Distributor Method vs. MPEEM
Distributor Method MPEEM
Revenue Adjusted for Growth $100,000 $100,000
Remaining After Attrition 95.0% 95.0%
Revenue After Attrition 95,000 95,000
EBITA 3,895 28,500
4.1% 30.0%
Adjustments
Less: Royalty Charge for use of TM 0 (9,500) 10.0%
Adjusted EBITA 3,895 19,000
Less: Income Taxes 1,558 7,600
Debt Free Net Income 2,337 11,400
Debt Free Net Income Margin 2.5% 12.0%
Contributory Asset Charges
Normal Working Capital (684) (1,425)
Property, Plant & Equipment (238) (1,900)
Workforce (95) (1,045)
Return on Supporting Assets (1,017) (4,370)
-1.1% -4.6%
Net After Tax Cash Flows 1,321 7,030
Implied Royalty Rate 1.4% 7.4%
21
23. Distributor Method vs. MPEEM
Distributor Method MPEEM
Revenue Adjusted for Growth $100,000 $100,000
Remaining After Attrition 95.0% 95.0%
Revenue After Attrition 95,000 95,000
EBITA 3,895 28,500
4.1% 30.0%
Adjustments
Less: Royalty Charge for use of TM 0 (19,000) 20.0%
Adjusted EBITA 3,895 9,500
Less: Income Taxes 1,558 3,800
Debt Free Net Income 2,337 5,700
Debt Free Net Income Margin 2.5% 6.0%
Contributory Asset Charges
Normal Working Capital (684) (1,425)
Property, Plant & Equipment (238) (1,900)
Workforce (95) (1,045)
Return on Supporting Assets (1,017) (4,370)
-1.1% -4.6%
Net After Tax Cash Flows 1,321 1,330
22
24. Distributor Method – Final Comments
• Key attributes
• When using the distributor method, inputs used in the MPEEM should reflect
distributor inputs, such as:
• Working capital to revenue ratios
• PP&E to revenue ratios
• Other assets that may be present such as trademarks, workforce, etc.
• Development of an appropriate discount rate
• There are drawbacks to this approach:
• It should not be used when customer relationships are the primary asset
• For many relationships a market proxy may not be available
• Cash flows relating to customer relationships may be overstated. However,
MPEEM using PFI appears to further overstate cash flows to customer
relationships, especially if applied mechanically without thought to qualitative
attributes
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25. Cost Approach - Overview
• Premise is that a prudent investor would pay no more for an asset
than the amount for which the utility of the asset could be replaced.
• May be appropriate when the customer related asset isn’t the
primary asset and can be recreated in a short period of time.
• Time to recreate is critical – if time is significant may point to a value
greater than an accumulation of costs.
• May be used for early-stage companies that are unable to forecast
revenue with reasonable certainty or when other approaches are
difficult or not possible.
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26. Cost Approach – Costs
• Direct – Costs incurred to develop customer related asset - direct
advertising, marketing, selling, etc. Should reflect current costs but
historical may be a reasonable proxy.
• Indirect – G&A and other related costs.
• Developer’s Profit – Reflects the expected return on the investment.
Should be a reasonable profit margin based on market inputs.
• Opportunity Costs – Profits lost while the asset is being created.
Based on a reasonable rate of return on the expenditures while
asset is being created. Applicable if asset cannot be used while
being created.
• Taxes – Not tax affected. It is believed market participants view
expenses on a pre-tax basis.
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27. Cost Approach - Example
• Company A acquires Company B a manufacturer of
branded consumer electronics. Purchase price was $500
million.
• Customer related assets were created ratably over the
past three years at a cost of $21 million ($15 million
direct, $6 million indirect)
• Developer’s profit based on market observations.
• Opportunity costs based on a 12% return and an
average 3 month lead time between initial contact and
first purchase.
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28. Cost Approach - Example
Direct & Indirect Costs % of Total Value
Direct Costs 15.0 55.8%
Indirect Cost 6.0 22.3%
Total Costs 21.0
Developer's Profit
Developer's Profit Margin (1) 20%
Developer's Profit 5.25 19.5%
Opportunity Cost
# of Customers 1,000
Average Lead Time (Months) 3
Required Return 12%
Investment per Customer (2) 0.021
Opportunity Cost per Customer (3) 0.00063
Total Opportunity Costs (4) 0.630 2.3%
Total Cost 26.880 100.0%
Calculations
1 - (Cost / (1 - Margin) * Margin) such that the margin earned is 20%.
Profit / (Revenue) = 5.25 / (21.0 + 5.25) = 20% margin.
2 - Total Costs / # of Customers
3 - Lead Time in Years * Required Return * Investment per Customer
4 - Opportunity Cost per Customer * # of Customers
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29. Summary of Valuation Techniques
Valuation Pros Cons Best Used when
Techniques
Multi-Period - Consistent with PFI - Sig. number of assumptions - Customers are the primary
Excess Earnings - Assumptions / inputs needed, i.e. LTGR, attrition asset of the business
Model available rate, etc
Distributor Model - Inputs are available - Market inputs can be - Customers are a non-primary
- Reduces reliance on CACs subjective and require valuer asset
- Some portion of goodwill not judgment
included in value - Requires availability of
- Allows use of MPEEM to appropriate market inputs.
value primary asset
With-and-Without - Underlying theory is intuitive - Key assumptions are - Customers are a non-primary
Model subjective and difficult to asset
support
Cost Approach - Objective, if good data is - Data difficult to find - Customers are a non-primary
available - May understate the value asset and cost data is readily
- Goodwill not included in available
value estimate
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30. Valuation Research Corporation
• Formed in 1975, VRC has eight U.S. offices and eight international affiliates.
• VRC provides M & A advisory services, fairness and solvency opinions in
support of corporate transactions, and valuations of intellectual property and
tangible assets for financial reporting and tax purposes.
• VRC maintains relationships with corporations, lenders, accountants,
investment banks, private equity firms, and law firms.
• VRC was instrumental in forming the Appraisal Issues Task Force (AITF), a
valuation industry group that meets quarterly with representatives from the
FASB, the SEC, and the PCAOB to discuss valuation issues surrounding
financial reporting.
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31. P.J. Patel, CFA, ASA
• Mr. Patel is a Managing Director with VRC and specializes in the valuation of
businesses, assets and liabilities for financial reporting purposes.
• Mr. Patel is an active member of the Appraisal Industry Task Force (AITF).
• He is a member of the Appraisal Foundations Working Group preparing an
industry Practice Aid for valuing customer related assets.
• Mr. Patel is a frequent presenter on valuation issues for financial reporting
purposes and has recently presented on valuation issues relating to ASC 805
(SFAS141R), ASC 350/360 (SFAS142/144), ASC 820 (SFAS157) and other
emerging issues. In addition, Mr. Patel was on the Fair Value Panel at the 2008
AICPA SEC Conference. He has been quoted numerous times in the press
regarding valuation issues.
Contact Information:
ppatel@valuationresearch.com
Direct: 609.243.7030
Mobile: 609.240.1337
30
32. Ed Hamilton, CFA
• Mr. Hamilton is a Vice President with VRC and specializes in the valuation of
businesses, assets and liabilities for financial reporting purposes.
• Mr. Hamilton is an active member of the AITF and is currently involved with the
Appraisal Foundation Working Group preparing a Practice Aid for the valuation of
customer relationships.
• Mr. Hamilton is a frequent presenter on valuation issues for financial reporting
purposes and has recently presented on valuation issues relating to ASC 805
(SFAS141R), ASC 350/360 (SFAS142/144), ASC 820 (SFAS157) and other emerging
issues.
Contact Information:
ehamilton@valuationresearch.com
Direct: 609.243.7018
Mobile: 609.221.8174
31