A presentation for LCPA Business Valuation Workshop October 25, 2012 Presented by: Riley J. Busenlener, CPA/ABV, ASA, JD.

A presentation for LCPA Business Valuation

Workshop

October 25, 2012

Presented by: Riley J. Busenlener,

CPA/ABV, ASA, JD

PATENTS, TRADEMARKS, & INTANGIBLES FAIR VALUE

Outline

• Valuation of Customer Relationships, Technology, and Non-Compete Agreements– A Case Study

• Goodwill Impairment

VALUATION OF CUSTOMER RELATIONSHIPS, TECHNOLOGY, AND NON-COMPETE AGREEMENTS

A Case Study

Case

• Presentation is in case format, outlining keyinformation needs, points for analysis, andassumptions.

• Case Information- Valuation of Intangible Assets of “AlcoBev Inc.”- Was acquired on December 31, 2009 by the private equity firm, Whimsical Investment Group for $150,000 cash– AlcoBev manufactures and distributes commercial alcoholic beverage dispensing equipment

Fair Value in Financial Reporting

• Fair Value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ‐ Topic 820

Fair Value in Financial Reporting

Elements of Fair Value:• Exit price notion, from market participant

perspective• Hypothetical transaction with a market participant• “Market participants are unrelated parties,

knowledgeable of the asset or liability given due diligence, willing and able to transact for the asset/liability, and may be hypothetical”

• For a particular asset and liability• Highest and best use for assets, credit standingfor liabilities

Fair Value in Financial Reporting

• Level 1: Observable inputs that reflect quoted prices for identical assets or liabilities in active markets and assumes the reporting entity can access the markets at the measurement date

• Level 2: Inputs other than quoted market prices included within level 1 that are observable either directly or indirectly

• Level 3: Unobservable inputs reflect the reporting entity's own assumptions about market participant assumptions used in pricing an asset or liability

Step 1: Understanding the Assets

• Understand the Business– History– Products/Services– Industry– Regulations– Competitors

• Understand the Transaction– Motivations– Consideration

• What creates strategic advantage?– Technology/Better Product– Supplier Relationships– Distribution– Contracts– Systems

• What intellectual property(ies) support operations, such as: contracts, tradesecrets, brands, etc.?

Business

• AlcoBev Systems Inc. produces and distributes a line of refrigerated alcoholic beverage dispensing equipment for restaurants, bars, and similar establishments.

• Its products include draft beer dispensers, bar coolers, and frozen beverage machines

• Strong historical growth, over 12% CAGR for the last five years

• 2009 revenue was $90,909

Forecast from Management

Forecast Requirements

• Should not reflect synergies specific to the buyer. Should reflect synergies available to other market participants.

• Eliminate amortization of prior intangible assets from books. Those assets are replaced with new assets from this transaction.

• Forecast should be logical and supported by market data and historical trends. This is a key point of audit review.

• Forecast should be tested using an implied IRR. This should be reasonable when compared to a WACC for the Business.

• Support terminal growth rate. This is another key point in audit review.

Forecast Logic AssessmentReasonably Objective• Can facts be obtained and

informed judgments made about past and future events or circumstances in support of the underlying assumptions?

• Are any of the significant assumptions so subjective that no reasonably objective basis could exist to present a financial forecast?

• Would people knowledgeable in the entity’s business and industry select materially similar assumptions?

• Is the length of the forecast period appropriate?

Appropriate Assumptions• There appears to be a rational

relationship between the assumptions and the underlying facts and circumstances

• The assumptions are complete• It appears that the assumptions

were developed without undue optimism or pessimism

• The assumptions are consistent with the entity's plans and expectations

• The assumptions are consistent with each other

• The assumptions, in the aggregate, make sense in the context of the forecast taken as a whole

IRR Test – Forecast and Discount Rate

Tax Amortization Benefit

TAB = VBA * n/[n-((AF * t * (1+r)^0.5)-1)]where:TAB = Tax amortization benefitVBA = Value before amortizationn = Number of amortization periods in years(15 years in U.S., see IRC 197)AF = Annuity Factor (AF = 1/r - 1/r(1+r)^n)t = Tax rater = discount rate

Revenue Breakdown

Revenue Breakdown

• Allocate revenue by intangible asset groups to be valued

• Consider lifing analysis data for replacement of technology and turnover of customers

• Detailing break down provides test that revenue split is logical

Asset Returns

• Asset investments reflect both a “return on” the investment related to risk and a “return of” the asset for the value decline from wasting of the asset

• Not all assets have a “return of”, since certain intangible assets do not waste away

• All assets will have a “return on”• Asset risks reflect the risk of the asset as part of a

portfolio of assets for a typical market participant company

• Asset returns can be assessed in relationship to Company WACC

Asset Return Spectrum

Asset Returns

Asset Returns

• Enterprise value WACC calculated based on average industry capital structure

• Cost of equity reflects a CAPM methodology using betas of market participants

• Cost of debt reflects the average debt rating of market participants and current market rates of interest

• Individual asset returns were assessed based on risk in comparison to the company as a whole

Technology• AlcoBev patented a new beverage cooling technology that allows for

the rapid cooling of frozen drinks and beer at distribution (CoolzDown), significantly reducing the energy consumption of traditional beer dispensing and frozen beverage machines. The beverage can be stored at a lower temperature prior to service and is brought down to serving temperature with the CoolzDown technology.

• The technology is patented, having a remaining 10 years of patent protection

• The technology is used in 80% of the Company’s Beer Dispensing Equipment

• Technology provides a 15% improvement in energy efficiency over competitor products

• Products with technology contribute an additional 6.5% profit margin over other products

• Technology is unique to Beer Distribution equipment and cannot be applied to other products or services

Methods to Value Technology

Cost Approach• Best used when

technology can be replicated

• Requires analysis of the cost to recreate the technology as it is today

Relief from Royalty

• Best when actual data or closely comparable royalty data is available

Multi-Period Excess Earnings

• Captures the economic value in relationship to the other supporting assets that contribute to cash flow

• Application can be problematic if other MPEE analyses are performed for other assets

Application to the Model

• Methodology selected – relief from royalty• Revenue reflects only revenue from

products using patented technology• Discount rate utilized is based on the cost

of equity of the business• New technology is anticipated to replace

the existing technology over a 10‐year period

• Analysis determined a market participant royalty rate is approximately 2.5%

Royalty Rate Selection Overview

• Royalty rate data should be based on market data whenever possible. Generally, the priority of data is:– Third‐party negotiated royalty rates for the same product– Third‐party negotiated royalty rates for similar products with appropriate

adjustments• Royalty Source – www.royaltysource.com• ktMINE ‐ http://www.bvmarketdata.com/defaulttextonly.asp?

f=ktminedescription• The Financial Valuation Group – www.fvgfl.com

– Internal transfer pricing related royalty rates– Estimated royalty rates based on typical market participant assumptions

• Selecting a royalty rate and supporting its reasonableness begins with assessing the economic benefits provided by the IP– Increased prices– Increased unit sales– Decreased costs– Combination of any or all of the above

Selecting Royalty Rates based on Market Data

• Narrow the identified transactions to those closest to the intellectual property (IP) that is being valued

• Stratify transaction data into groups to identify important factors– Geographic usage– Rights differences– Date of transactions– Usage

• Gather other supporting data that may be useful– Profitability of public licensees (possibly by segment using IP)– Comparable profit margin data– Market share of licensee v. other entities in industry

• Adjust transaction data for key differences if possible– Market data may be used to adjust license for differences

• Identify if Geographic areas have premiums or discounts• Identify if licensing for use in one type of product has premiums or discounts over other

products (clothing versus sunglasses)• Operating profit differences may be used to adjust royalties (if license in a market with

10% operating margin (typically EBIT margin), in a market with a 5% margin the royalty rate might be 50% less.)

Summary of Identified Market Royalties

• Similarities– Cooling technology– Related to beverages

• Issues– Age of transactions– Industry Use (food

packaging versus restaurants)

– Range of Royalties

• Based on differences, determined not to be comparable

Profit Split Methods• Involve assessing the components of profitability and considering

the expected reasonable portion of profit contributed by the intellectual property being valued

• Can be used to check reasonableness of selected royalty rate from market data

• Also can be used to identify a royalty rate when market data is unavailable or inconclusive

• Encompasses a rule known as the 25% rule– Often attributed to research by Robert Goldscheider in the late 1950s.

• Based on 18 exclusive licenses for territories around the world• Licenses were by a Swiss subsidiary of a large American company• Each related product was number 1 or 2 in its market• The intellectual property rights licensed included a patent portfolio, a continual

flow of know‐how, trademarks, and copyrighted marketing and product description materials

• Found royalty rates at approximately 25 percent of pre‐tax operating income

– Generally considered to be a 25% to 33% rule of thumb

25% Rule – The Good and the Bad

Bad• Arbitrary in nature• What does it apply

to? Patents, trademarks, trade secrets

• It is imprecise in measuring incremental profit contribution

Good• Used as a base line among

licensing professionals• Some analytical support from

Smith and Parr Study• Comparison of licensed

royalty rates from Royalty Source database for 15 industries showed the median royalty rate as a percent of average licensee operating profit margins to be 26.7 percent, (ranging from 8.5 percent for semiconductors to 79.7 percent for the automotive industry).

Profit‐Split Considerations

• What is the expected normalized rate p of operating profit?– Look at Normalized Historical (25.8%)– Look at Forecast (25.5%)

• Analyze the factors affecting value to determine a reasonable split– Technology is a key component of product and a

major selling point– Consider Georgia Pacific factors (following slides)

• Consider relative bargaining strength of typical buyer and seller in the negotiation

Georgia Pacific Factors Page 1 of 2

1. The royalties received by the patentee for the licensing of the patent in suit, proving or tending to prove an established royalty.

2. The rates paid by the licensee for the use of other patents comparable to the patent in suit.

3. The nature and scope of the license, as exclusive or non‐exclusive; or as restricted or nonrestricted in terms of territory or with respect to whom the manufactured product may be sold.

4. The licensor's established policy and marketing program to maintain his patent monopoly by not licensing others to use the invention or by granting licenses under special conditions designed to preserve that monopoly.

5. The commercial relationship between the licensor and licensee, such as, whether they are competitors in the same territory in the same line of business; or whether they are inventor and promoter.

6. The effect of selling the patented specialty in promoting sales of other products of the licensee; that existing value of the invention to the licensor as a generator of sales of his nonpatented items; and the extent of such derivative or convoyed sales.

7. The duration of the patent and the term of the license.8. The established profitability of the product made under the patent; its commercial

success; and its current popularity.9. The utility and advantages of the patent property over the old modes or devices, if any,

that had been used for working out similar results.

Georgia Pacific Factors Page 2 of 2

10. The nature of the patented invention; the character of the commercial embodiment of it as owned and produced by the licensor; and the benefits to those who have used the invention.

11. The extent to which the infringer has made use of the invention; and any evidence probative of the value of that use.

12. The portion of the profit or of the selling price that may be customary in the particular business or in comparable businesses to allow for the use of the invention or analogous inventions.

13. The portion of the realizable profit that should be credited to the invention as distinguished from nonpatented elements, the manufacturing process, business risks, or significant features or improvements added by the infringer.

14. The opinion testimony of qualified experts.15. The amount that a licensor (such as the patentee) and a licensee (such as the

infringer) would have agree upon (at the time the infringement began) if both had been reasonably and voluntarily trying to reach an agreement; that is, the amount which a prudent licensee – who desired, as a business proposition, to obtain a license to manufacture and sell a particular article embodying the patented invention – would have been willing to pay as a royalty and yet be able to make a profit and which amount would have been acceptable by a prudent patentee who was willing to grant a license.

Relief from Royalty Model

Relief from Royalty Model

• Deduct from cash flows any costs NOT saved by owning the intellectual property that don’t go away, like maintenance R&D

• Tax amortization benefit reflects potential tax savings form amortizing the asset under IRC 197

Non‐Compete Agreements• As part of the purchase of AlcoBev, certain key management

personnel entered into 3‐year Non‐Compete agreements• Discussions with management indicate that Mr. Bill Jones, Chief

Marketing Officer, is the primary individual that could cause significant losses in future income if he competed with the company– Bill Jones Profile– 17 years in marketing– 5 years with AlcoBev– Prior experience:

• 10 years with TapServe Equipment, Ltd., AlcoBev’s largest competitor, with his last position as head of sales for U.S. division

• 2 years prior experience with Acme Bar Accessories

– Age 42– Married with 2 Children, 1 in College and 1 a High‐School Junior– Strong personal relationship with head of PubStuff Distributors, one of

AlcoBev’s largest customers, and Kegs‐N‐Taps Equipment Supply, another large customer (Together representing 10% of total sales)

Basis of Value

• The value of a Non‐Compete Agreement stems from– potential loss from competition,– the likelihood of competition, and– the likelihood that the agreement will be

enforceable.

• Standard Valuation Method – Differential Discounted Cash Flow Analysis (a.k.a., a With and Without Analysis)

Deriving the Forecast – Identifying Potential Loss

• Assess potential loss– Historical loss or gain from similar competition– Historical growth– Management estimates– Assess likelihood of competition without Non‐Compete Agreement

• Age• Health• Job satisfaction• Market demand• Prior history• Economic factors

• Duration of loss calculation– Terms of the agreement– Time lag before competition could occur– Potential effects after contract agreement (multi‐year contracts with

clients, renewal of lost customer agreements, growth from lost customers, etc.)

Non‐Compete Example Facts and Assumptions

• Chief Marketing Officer– Is well known in the industry– Was hired from a competitor and brought key customers with whom he

had a long‐term business relationship– Has a 3 year Non‐Compete agreement– Is not independently wealthy and would need to work if he left the

business

• Forecast Adjustments for Without Scenario– Revenue reflects loss of 3% of revenue in Years 1‐3 of the forecast

• Total potential loss is approximately 10% of revenue given his personal relationships with customers

• Potential of competing without the Non‐Compete Agreement is only 30%– Is compensated at market rates– Has strong ties to community– Could receive a signing bonus and has been approached by competitors– Is young enough to have at least 2 decades potential with an employer

– Working Capital changed relative to change in revenue

• Discount rate utilized is based on the cost of capital of the business

The With and Without Model

Customer Relationships

• The typical customer base consists of companies that sell and service equipment and supplies to restaurants and bars

• Customers enter into a 3‐year contract with automatic continuation thereafter unless canceled with 30 days notice

• Customers vary by size, but have similar characteristics regarding the expected life and buying decisions

• Customer turnover over the last 5 years has averaged 20%

• Turnover is lower the longer the customer has been with AlcoBev

• Actual turnover data is available for 6 years

Methods to Customer Related Intangibles

Cost Approach• Best used when

valuing customer lists or other assets that are not unique and can be replicated

• Requires analysis of market cost for lists or the cost to recreate the contracts or other assets

Multi-Period Excess Earnings

• Captures the economic value in relationship to the other supporting assets that contribute to cash flow

• Application can be problematic if other MPEE analyses are performed for other assets

Application to the Model• Methodology selected – Multi‐Period Excess Earnings• Revenue reflects only revenue from existing customers

– Based on total revenue estimate for existing customers without turnover• Prior Year revenue grown as price increases and demand increases from customers• Rate used is 2.5% inflation and 0.8% population increase (3.3%)

– Turnover estimated from actual client data and regression of curve• Based on 7 years of data available a revenue weighted turnover was determined• Turnover curve was fit to a trend line to extrapolate the curve beyond the derived

curve

• Expenses applied based on a percentage of revenue• Expenses related to selling to new customers was eliminated• Royalty for patents applied to eliminate contribution of patents to

earnings• Contributory asset charges applied for other supporting assets

including working capital, fixed assets, and Non‐Compete agreements

• Discount rate utilized is based on the cost of equity of the business

Contributory Asset Charges

Contributory Asset Charges

• Required to eliminate other assets that contribute to the revenue stream to derive revenue generated only by the asset being valued.

• Reflects charge for asset value in each year of charge

• Our analysis assumes that the contributory asset relationships remain constant as a percent of revenue over time

• Reflects asset returns previously described• Technology charge is based on royalty rate and

not included in the CAC calculation above

Multi‐Period Excess Earnings Model

Weighted Average Return on Assets (WARA)

Weighted Average Return on Assets (WARA)

• WARA Analysis tests reasonableness of asset returns used in analysis

• Weighted Average Return on Assets should approximate IRR/WACC of Business– Rounding often makes it impossible to perfectly match– Return on Excess Purchase Price (Goodwill) should be

assessed on relative risks of the associated assets

• Return for goodwill should be at cost of equity at a minimum unless in very unusual circumstances

• If WARA does not approximate IRR/WACC, reassess key assumptions especially:– Relative rates of return for assets– Royalty rates or profit split

Purchase Price Allocation Data from 2008

GOODWILL IMPAIRMENT

Goodwill Impairment Studies

• Duff & Phelps and the Financial Executives Research Foundation published the “2010 Goodwill Impairment Study”, which provides an analysis of the companies examined over the 12-month period before and after the goodwill impairment

Goodwill Impairment Studies (cont’d)

• Highlights for Study– Financial service firms had the greatest

proportion of total impairments in 2009. Over 70 percent of total impairments were recognized in the financial services, industrials, and information technology sectors

– FEI members were asked whether they performed an interim goodwill impairment test in either 2009 or 2010. Fifty percent of the respondents indicated they had, with nearly 30 percent citing economic declines as the triggering event.

Goodwill Impairment (Topic 350)

• Goodwill is not amortized, but tested for impairment at the reporting unit level (the operating segment or one level below)

• The fair value of goodwill can be measured only as a residual of all other assets.

• If condition exists that it is “more likely than not”, that fair value of reporting unit is less than its carrying value, then the FASB requires a two-step impairment test to identify potential goodwill impairment and measure the amount of loss to be recognized (if any).

Goodwill Impairment (Topic 350) “Step Zero”

• Previously, Goodwill was tested annually for impairment, or more frequently if certain events occur and circumstances change

• Entities have the option to first access qualitative factors to determine if test is necessary

• “more likely than not” fair value < carrying value then perform step one test. If not, then no need to test

• Unconditional option to skip qualitative assessments and perform step one test

Step One: Goodwill Impairment Test

• Identify the reporting unit• Determine the fair value of the

reporting unit• Compare the fair value of the

reporting unit to the carrying value• If the carrying value exceeds the fair

value, an impairment is indicated• Perform step two of the goodwill

impairment test

Step Two: Recognition and Measurement of an Impairment

Loss• Calculate the implied value of goodwill

– Subtract the fair value of net tangible assets and identifiable intangible assets from the fair value of the reporting unit as of the test date.

– Include intangible assets not previously given recognition in the financial statements

– The difference is the implied value of goodwill

• Determine whether goodwill is impaired– If the implied value of goodwill exceeds the carrying

value of goodwill, there is no impairment– If goodwill’s carrying value exceeds the implied value, a

goodwill impairment exists and the difference must be written off

Carrying Value Concerns

• Enterprise Value Premise– Debt is excluded from the liabilities

assigned to a reporting unit and consequently from the fair value of the reporting unit

• Equity Value Premise– Debt, like any other liability, is available

for assignment to a reporting unit

FASB’s ASU 2011-08 Testing Goodwill for Impairment

• Objective is to simplify thus reducing the cost and complexity of performing Step 1 of the two-step goodwill impairment test

• Adds an optional qualitative approach to determine whether it is more likely than not (having a likelihood of more than 50%) that the fair value of a reporting unit is less than its carrying amount; if so, then Step 1 is required

• Applies to public and nonpublic entities• New qualitative factors replace existing triggering factors for

interim goodwill impairment testing• Does not change the current guidance for testing indefinite-

lived intangible assets for impairment• Published in September 2011 and effective for annual and

goodwill impairment tests performed for fiscal years beginning after December 15, 2011 (early adoption permitted)

FASB’s ASU 2011-08 Testing Goodwill for Impairment: New Qualitative

Factors• General macroeconomic conditions

– Deterioration in general economic conditions– Limitations accessing capital– Fluctuations in foreign exchange rates– Other developments in equity and credit markets

• Industry and market considerations– Deterioration in the operating environment– Increased competition– A decline in market-dependent multiples– A change in the market for the entity’s products or services– A regulatory or political development

• Cost factors that have a negative effect on earnings– Increases in raw materials, labor or other costs

FASB’s ASU 2011-08 Testing Goodwill for Impairment: New Qualitative Factors

• Decline in overall financial performance– Negative or declining cash flows– A decline in actual or planned revenues or earnings

• Entity-specific events– Changes in management or key personnel– Changes in strategy or customers– Bankruptcy or litigation

• Events affecting a reporting unit– A change in the carrying amount of net assets (write offs)– Plans to sell or dispose of a portion or all of a reporting unit– Testing for recoverability of a significant asset group within a reporting

unit– Recognition of goodwill impairment in a component of the reporting

unit

• A sustained decrease in share price, both absolute and relative to peers

Applying ASC 820 Framework to Reporting Units

• Step 1: Determine the unit of account

• Step 2: Determine the valuation premise

• Step 3: Identify the potential markets• Step 4: Determine market access• Step 5: Determine the fair value

Assigning Assets and Liabilities to a Reporting Unit- Additional Considerations

• Debt recognized at the corporate level

• Deferred taxes related to assets and liabilities of a reporting unit

• Cumulative translation adjustment• Contingent consideration

arrangements• Non-controlling interests

Issues and Best Practices of Measuring Fair Value of a Reporting Unit

• Highest and best use:– Issue: current use of a specific reporting unit may be

different from how a market participant may intend to hold the same net assets

– Best practice: consider the interrelationships or synergies among the reporting units to determine the fair value of each

• Discounted cash flow method:– Issue: are market participant assumptions reflected?– Best practice: incorporate market participant

assumptions in the prospective financial information (PFI) (i.e. cash flows and weighted average cost of capital)

Issues and Best Practices of Measuring Fair Value of a Reporting Unit

• Consideration of Market Participant assumptions in management’s PFI– Issue: Planned acquisition activity

• In general assumptions should not include planned acquisition activity

– Issue: Working Capital• Adjustments may be necessary if not at normal levels

– Issue: Deferred Revenue• PFI should be modified to reflect cash flows

– Issue: Non-operating assets and liabilities• PFI should be analyzed to see if adjustments should

be made

Issues and Best Practices of Measuring Fair Value of a Reporting Unit

• Legal form of reporting unit:– Issue: legal forms where the reporting units is not

subject to the payment of income taxes however a market participant would be subject to income taxes

– Best practice: in most cases the discounted cash flows should be calculated on an after-tax basis to ensure consistency with market participant assumptions

• Depreciation and amortization amounts:– Issue: depreciation and capital expenditures are usually

equal in the terminal period– Best practice: consider, in some cases, capital

expenditures may exceed depreciation for companies involved in capital intense industries

Issues and Best Practices of Measuring Fair Value of a Reporting Unit

• Share-based compensation:– Issue: management’s PFI may include

an upward adjustment for share-based compensation

– Best practice: noncash expenses related to share-based payments should not be included as an adjustment as they are already captured in PFI as other accruals

Questions?