Alternative Methods For Valuing Customer Relationships(11.15.12)

Alternative Methods for Valuing

Customer Relationships Webcast

November 13, 2012

Ed Hamilton, CFA

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• 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: [email protected] Direct: 609.243.7018 Mobile: 609.221.8174

P.J. Patel, CFA

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• 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: [email protected] Direct: 609.243.7030 Mobile: 609.240.1337

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Valuation Research Corporation

• Formed in 1975, VRC has nine U.S. offices and eight international affiliates.

• VRC provides fairness and solvency opinions in support of corporate transactions, 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.

• Accounting Background and Overview • Identification of Customer-related Assets and Value Considerations • Valuation Methodologies • Valuation Methodology Selection • Other Considerations • Appendix on Attrition Rate Calculations • Appendix of Case Studies

Topics Covered in the Valuation Advisory

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Customer lists

Transactional purchase

order based customers

Transactional customer

relationships with MSAs

Recurring customer

relationships with

switching costs

Customers with long

term contracts

Take or pay contracts

Continuum of Customer Assets

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• Qualitative understanding of the relative importance of the customer-related asset being valued:

• Industry Characteristics • Company Characteristics • Product/Service Characteristics • Customer-related Asset Characteristics

• Other key factors to consider: • Barriers to change

• Stickiness of customer relationships • Switching costs

• Qualitative attributes are just as important as quantitative attributes in determining the value of customer relationships

Identification of Customer-related Assets and Value Considerations

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• Income Approach: • Multi-Period Excess Earnings Method • Distributor Method • With-and-Without Model

• Cost Approach • Market Approach

Valuation Approaches

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MPEEM based customer cash flow Company revenue/earnings Less: Taxes Less: Charges for contributory assets Equals: Cash flows related to customer relationships • Residual cash flow model • Best used when:

• Customers are the primary assets or • Margins are within a reasonable range of normal industry levels

Summary of Methods: MPEEM

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Revenue Adjusted for Growth $100,000 Remaining After Attrition 95.0%

Revenue After Attrition 95,000 EBITA 19,000

20.0% Less: Royalty Charge for use of TM (9,500) 10.0%

Adjusted EBITA 9,500

Less: Income Taxes 3,800 Debt Free Net Income 5,700

Debt Free Net Income Margin 6.0%

Contributory Asset Charges Normal Working Capital (1,425)

Property, Plant & Equipment (1,900) Workforce (1,045)

Return on Supporting Assets (4,370) -4.6%

Net After Tax Cash Flows 1,330

Sample MPEEM Cash Flow Calculation

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DM based customer cash flow Company Revenue Earnings of market proxy Less: Taxes Less: Charges for contributory assets (based on market proxy) Equals: Cash flows related to Customer Relationships • Residual cash flow model but isolates cash flows relating to customer

relationships

• Best used when: • Customers are NOT the primary assets or • A reasonable market proxy exists for the customer relationships

Summary of Methods: Distributor Method

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Revenue Adjusted for Growth $100,000 Remaining After Attrition 95.0%

Revenue After Attrition 95,000 EBITA 3,895

4.1% Less: Royalty Charge for use of TM 0

Adjusted EBITA 3,895

Less: Income Taxes 1,558 Debt Free Net Income 2,337

Debt Free Net Income Margin 2.5%

Contributory Asset Charges Normal Working Capital (684)

Property, Plant & Equipment (238) Workforce (95)

Return on Supporting Assets (1,017) -1.1%

Net After Tax Cash Flows 1,321

Sample Distributor Method Cash Flow Calculation

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Value of business/entity with customer relationships Less: Value of business/entity without customer relationships, where customer relationships are recreated Equals: Value of the Customer Relationships • Best used when:

• Customers are NOT the primary assets or • Customer relationships can be recreated • Time to recreate the customer relationships is short and does not change the

structure of the business

Summary of Methods: With-and-Without

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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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Cost Approach – Costs

Direct Costs Plus: Indirect costs Plus: Developer’s profit – Reflects the expected return on the investment. Should be a reasonable profit margin based on market inputs. Plus: 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. Equals: Value of customer relationships Taxes – Not tax affected. It is believed market participants view expenses on a pre-tax basis.

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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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Valuation Techniques

Pros Cons Best Used When

MPEEM • Consistent with PFI • Assumptions/inputs available

Sig. number of assumptions needed, i.e. LTGR, attrition rate, etc

Customers are the primary asset of the business

Distributor Method

• Inputs are available • Reduces reliance on CACs • Some portion of goodwill not included in value • Allows use of MPEEM to value primary asset

• Market inputs can be subjective and require valuer judgment • Requires availability of appropriate market inputs.

Customers are a non-primary asset

With-and-Without Method

Underlying theory is intuitive Key assumptions are subjective and difficult to support

Customers are a non-primary asset

Cost Approach • Objective, if good data is available • Goodwill not included in value estimate

• Data difficult to find • May understate the value

Customers are a non-primary asset and cost data is readily available

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Valuation Methodology Selection

GlobalCo is a multinational consumer products good (CPG) and acquires RegionalCo for a purchase price of $160 million. RegionalCo sells products under several key brand names. RegionalCo has developed customer relationships over its 20 year history. Acquisition rationale: acquisition of brands Intangible assets present: brands, customer relationships • Revenues: $100 million • Profit margins: 20%

Case Study #1

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Value estimates: • MPEEM - $10 million • Distributor Method - $10 million • With and Without - difficult to quantify lost revenue, earnings – Range of

value $5 million to $25 million • Cost Approach – $1 million to $5 million based on S&M costs. But the

inputs are difficult to support.

Selected valuation methodology – MPEEM or distributor method

Case Study #1

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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% 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

Distributor Method vs. MPEEM

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GlobalCo is a multinational consumer products good (CPG) and acquires RegionalCo for a purchase price of $160 million. RegionalCo sells products under several key brand names. RegionalCo has developed customer relationships over its 20 year history. Acquisition rationale: acquisition of brands Intangible assets present: brands, customer relationships • Revenues: $100 million • Profit margins: 30%

Case Study #1b

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Value estimates: • MPEEM - $50 million • Distributor Method - $10 million • With and Without - difficult to quantify lost revenue, earnings – Range of

value $5 million to $25 million • Cost Approach – $1 million to $5 million based on S&M costs. But the

inputs are difficult to support.

Selected valuation methodology – Distributor method

Case Study #1b

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$100,000 $100,000 Remaining After Attrition 95.0% 95.0%



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%




Net After Tax Cash Flows 1,321 7,030 Implied Royalty Rate 1.4% 7.4%

Calculations: Case Study #1b

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$100,000











Alternative Calculations: Case Study #1b

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$100,000











Alternative Calculations: Case Study #1c

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ContractCo is an IT service provider to varying parts of the US government and acquires SmallCo for a purchase price of $100 million. SmallCo is also an IT service provider to varying parts of the US government has several multi-year government contracts. Acquisition rationale: customer relationships and workforce (with security clearances) Intangible assets present: customer relationships (including backlog) and workforce • Revenues: $200 million • Profit margins: 8%

Case Study #2

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Value estimates: • MPEEM - $20 million • Distributor Method – n/a since a reasonable market proxy is not available • With and Without – difficult to quantify lost revenue, earnings – Range of

value $5 million to $25 million • Cost Approach – $5 million based on S&M costs. But the inputs are difficult

to quantify since contracts are unique and difficult to replace. Cost data is likely not a good proxy for the future benefit stream.

Selected valuation methodology – MPEEM

Case Study #2

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BigCo is a national manufacturer of widgets and acquires SmallCo for a purchase price of $500 million. SmallCo also manufactures widgets and sells to similar customers. The widgets are a commodity product that are sold on a transactional basis through distributors. SmallCo is able generate above normal margins due to its state of the art facility as a result of historical cap ex. Acquisition rationale: state of the art facility, customer relationships and workforce Intangible assets present: customer relationships, trademarks and workforce • Revenues: $500 million • Profit margins: 10%

Case Study #3

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Value estimates: • MPEEM - $150 million • Distributor Method – $50 million • With and Without - Range of value $20 million to $75 million. The with and

without method is still to quantify but is less subjective than in other situations as customers (distributors) are not unique and time and cost to re-create can be estimated.

• Cost Approach – $50 million. The cost approach is still somewhat difficult to quantify but is less subjective than in other situations as customers (distributors) are not unique and time and cost to re-create can be estimated.

Selected valuation methodology – Distributor method, with and without method or cost approach. MPEEM determined not to be appropriate given difficulties in estimating cash flows related to customer relationships vs. PP&E.

Case Study #3

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Customer Assets Evolve Out of Other Activities

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Customer Relationships S&M

A&P

Brands Technology (including

R&D)

Customer Service

Quality Control

• Method selection can be difficult • The cost approach may not capture all future benefits • The with and without method requires a significant number of inputs and is

typically subjective • The income approach methods tend to be the most commonly used

methods in valuing customer relationships • Value is based on the present value of expected future cash flows

attributable to the asset being valued • Three primary factors

• Cash-Flow • Life • Discount Rate

Valuation Methodology Selection

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What is the appropriate level of Cash Flow: Review Business Functions

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Sales & Distribution

Manufacturing

Intellectual Property

Determining the cash flow related to customer relationships is difficult and has the biggest impact on value

Customer lists

Transactional purchase

order based customers

Transactional customer

relationships with MSAs

Recurring customer

relationships with

switching costs

Customers with long

term contracts

Take or pay contracts

Continuum of Customer Assets

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Distributor Model, With-and-Without, MPEEM MPEEM Cost

U.S. Office Locations

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Boston 260 Franklin Street Suite 530 Boston, MA 02110 617.330.1610 Chicago 200 West Madison Street Suite 2110 Chicago, IL 60606 312.957.7500 Cincinnati 105 East Fourth Street Suite 1005 Cincinnati, OH 45202 513.579.9100

Milwaukee 330 East Kilbourn Avenue Suite 1020 Milwaukee, WI 53202 414.271.8662 New York 500 Fifth Avenue 39th Floor New York, NY 10110 212.983.3370 Pittsburgh Three Gateway Center 401 Liberty Avenue, Suite 1740 Pittsburgh, PA 15222 412.246.9333

Princeton 200 Princeton South Corporate Center Suite 200 Ewing, NJ 08628 609.243.7000 San Francisco 50 California Street Suite 1300 San Francisco, CA 94111 415.277.1800 Tampa 777 South Harbour Island Boulevard Suite 980 Tampa, FL 33602 813.463.8510

International Affiliate Office Locations

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Buenos Aires Vuelta de Obligado 2728 Piso 2 Buenos Aires C1428 ADT Argentina Frankfurt Rennbahnstraße 72-74 60528 Frankfurt am Main Germany Hong Kong 6/F Pacific Place Three 1 Queen’s Road East Hong Kong

London 10 Greycoat Place Victoria London SW1P ISB United Kingdom Luxembourg 31 Boulevard Marcel Cahen L-1311 Luxembourg Madrid Alcalá, 265, Edificio 2 28027 Madrid Spain Melbourne Level 16, 379 Collins Street Melbourne, Victoria 3000 Australia

Monterrey Ricardo Cantu Leal #115 Colonia LTH Col. Florida Monterrey, N.L. C.P. 64830 Mexico São Paulo Rua Paes Leme, 524 - 12° Andar - Pinheiros CEP 05424-904 São Paulo SP Brazil Toronto 16 Dewitt Court Markham, ON L3P 3Y3 Canada

Alternative Methods For Valuing Customer Relationships(11.15.12)

Documents

valuation of businesses

primary assets

contributory assets

emerging issues

tax cash flows

valuation research corporation

financial reporting

debt free net income