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

3. Patents, Trademarks, & Intangibles Fair value

4. Outline
Valuation of Customer Relationships, Technology, and Non-Compete Agreements
A Case Study
Goodwill Impairment

5. Valuation of Customer Relationships, Technology, and Non-Compete Agreements
A Case Study

6. Case
• Presentation is in case format, outlining key information needs, points for analysis, and assumptions. • 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

7. 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

8. 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 standing for liabilities

9. 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

10. 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, trade secrets, brands, etc.?

11. 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

12. Forecast from Management

13. 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.

14. Forecast Logic Assessment
Reasonably 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

15. IRR Test – Forecast and Discount Rate

16. Tax Amortization Benefit
TAB = VBA * n/[n-((AF * t * (1+r)^0.5)-1)] where: TAB = Tax amortization benefit VBA = Value before amortization n = 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 rate r = discount rate

17. Revenue Breakdown

18. 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

19. 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

20. Asset Return Spectrum

21. Asset Returns

22. 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

23. 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

24. 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

25. 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%

26. 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 –
ktMINE ‐
The Financial Valuation Group –
– 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

27. 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.)

28. 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

29. 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

30. 25% Rule – The Good and the 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).

31. 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

32. Georgia Pacific Factors Page 1 of 2
The royalties received by the patentee for the licensing of the patent in suit, proving or tending to prove an established royalty.
The rates paid by the licensee for the use of other patents comparable to the patent in suit.
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.
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.
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.
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.
The duration of the patent and the term of the license.
The established profitability of the product made under the patent; its commercial success; and its current popularity.
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.

33. Georgia Pacific Factors Page 2 of 2
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.
The extent to which the infringer has made use of the invention; and any evidence probative of the value of that use.
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.
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.
The opinion testimony of qualified experts.
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.

34. Relief from Royalty Model

35. 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

36. 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)

37. 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)

38. 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.)

39. 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

40. The With and Without Model

41. 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

42. Methods to Customer Related Intangibles
Cost Approach
Multi-Period Excess Earnings
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
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

43. 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

44. Contributory Asset Charges

45. 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

46. Multi‐Period Excess Earnings Model

47. Weighted Average Return on Assets (WARA)

48. 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

49. Purchase Price Allocation Data from 2008

50. Goodwill impairment

51. 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

52. Goodwill Impairment Studies (cont’d)
Highlights for Study
Financial service firms had the greatest proportion of total impairments in 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 Fifty percent of the respondents indicated they had, with nearly 30 percent citing economic declines as the triggering event.

53. 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).

54. 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

55. 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

56. 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

57. 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

58. 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)

59. 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

60. 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

61. 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

62. 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

63. 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)

64. 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

65. 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

66. 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

67. Questions?