4 OutlineValuation of Customer Relationships, Technology, and Non-Compete AgreementsA Case StudyGoodwill 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 dateLevel 2: Inputs other than quoted market prices included within level 1 that are observable either directly or indirectlyLevel 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 BusinessAlcoBev 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 machinesStrong historical growth, over 12% CAGR for the last five years2009 revenue was $90,909
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 ObjectiveCan 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 AssumptionsThere appears to be a rational relationship between the assumptions and the underlying facts and circumstancesThe assumptions are completeIt appears that the assumptions were developed without undue optimism or pessimismThe assumptions are consistent with the entity's plans and expectationsThe assumptions are consistent with each otherThe assumptions, in the aggregate, make sense in the context of the forecast taken as a whole
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
18 Revenue BreakdownAllocate revenue by intangible asset groups to be valuedConsider lifing analysis data for replacement of technology and turnover of customersDetailing break down provides test that revenue split is logical
19 Asset ReturnsAsset 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 assetNot all assets have a “return of”, since certain intangible assets do not waste awayAll 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 companyAsset returns can be assessed in relationship to Company WACC
22 Asset ReturnsEnterprise value WACC calculated based on average industry capital structureCost of equity reflects a CAPM methodology using betas of market participantsCost of debt reflects the average debt rating of market participants and current market rates of interestIndividual asset returns were assessed based on risk in comparison to the company as a whole
23 TechnologyAlcoBev 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 protectionThe technology is used in 80% of the Company’s Beer Dispensing EquipmentTechnology provides a 15% improvement in energy efficiency over competitor productsProducts with technology contribute an additional 6.5% profit margin over other productsTechnology is unique to Beer Distribution equipment and cannot be applied to other products or services
24 Methods to Value Technology Cost ApproachBest used when technology can be replicatedRequires analysis of the cost to recreate the technology as it is todayRelief from RoyaltyBest when actual data or closely comparable royalty data is availableMulti-Period Excess EarningsCaptures the economic value in relationship to the other supporting assets that contribute to cash flowApplication can be problematic if other MPEE analyses are performed for other assets
25 Application to the Model Methodology selected – relief from royaltyRevenue reflects only revenue from products using patented technologyDiscount rate utilized is based on the cost of equity of the businessNew technology is anticipated to replace the existing technology over a 10‐year periodAnalysis 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 adjustmentsRoyalty Source –ktMINE ‐The Financial Valuation Group –– Internal transfer pricing related royalty rates– Estimated royalty rates based on typical market participant assumptionsSelecting 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 valuedStratify transaction data into groups to identify important factors– Geographic usage– Rights differences– Date of transactions– UsageGather 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 industryAdjust transaction data for key differences if possible– Market data may be used to adjust license for differencesIdentify if Geographic areas have premiums or discountsIdentify 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 SimilaritiesCooling technologyRelated to beveragesIssuesAge of transactionsIndustry Use (food packaging versus restaurants)Range of RoyaltiesBased on differences, determined not to be comparable
29 Profit Split MethodsInvolve assessing the components of profitability and considering the expected reasonable portion of profit contributed by the intellectual property being valuedCan be used to check reasonableness of selected royalty rate from market dataAlso can be used to identify a royalty rate when market data is unavailable or inconclusiveEncompasses 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 worldLicenses were by a Swiss subsidiary of a large American companyEach related product was number 1 or 2 in its marketThe intellectual property rights licensed included a patent portfolio, a continual flow of know‐how, trademarks, and copyrighted marketing and product description materialsFound 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 natureWhat does it apply to? Patents, trademarks, trade secretsIt is imprecise in measuring incremental profit contributionGoodUsed as a base line among licensing professionalsSome analytical support from Smith and Parr StudyComparison 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 splitTechnology is a key component of product and a major selling pointConsider 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.
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&DTax 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 agreementsDiscussions 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 companyBill Jones Profile17 years in marketing5 years with AlcoBevPrior experience:10 years with TapServe Equipment, Ltd., AlcoBev’s largest competitor, with his last position as head of sales for U.S. division2 years prior experience with Acme Bar AccessoriesAge 42Married with 2 Children, 1 in College and 1 a High‐School JuniorStrong 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, andthe 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 lossHistorical loss or gain from similar competitionHistorical growthManagement estimatesAssess likelihood of competition without Non‐Compete AgreementAgeHealthJob satisfactionMarket demandPrior historyEconomic factorsDuration of loss calculationTerms of the agreementTime lag before competition could occurPotential 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 OfficerIs well known in the industryWas hired from a competitor and brought key customers with whom he had a long‐term business relationshipHas a 3 year Non‐Compete agreementIs not independently wealthy and would need to work if he left the businessForecast Adjustments for Without ScenarioRevenue reflects loss of 3% of revenue in Years 1‐3 of the forecastTotal potential loss is approximately 10% of revenue given his personal relationships with customersPotential of competing without the Non‐Compete Agreement is only 30%Is compensated at market ratesHas strong ties to communityCould receive a signing bonus and has been approached by competitorsIs young enough to have at least 2 decades potential with an employerWorking Capital changed relative to change in revenueDiscount rate utilized is based on the cost of capital of the business
41 Customer Relationships The typical customer base consists of companies that sell and service equipment and supplies to restaurants and barsCustomers enter into a 3‐year contract with automatic continuation thereafter unless canceled with 30 days noticeCustomers vary by size, but have similar characteristics regarding the expected life and buying decisionsCustomer turnover over the last 5 years has averaged 20%Turnover is lower the longer the customer has been with AlcoBevActual turnover data is available for 6 years
42 Methods to Customer Related Intangibles Cost ApproachMulti-Period Excess EarningsBest used when valuing customer lists or other assets that are not unique and can be replicatedRequires analysis of market cost for lists or the cost to recreate the contracts or other assetsCaptures the economic value in relationship to the other supporting assets that contribute to cash flowApplication can be problematic if other MPEE analyses are performed for other assets
43 Application to the Model Methodology selected – Multi‐Period Excess EarningsRevenue reflects only revenue from existing customersBased on total revenue estimate for existing customers without turnoverPrior Year revenue grown as price increases and demand increases from customersRate used is 2.5% inflation and 0.8% population increase (3.3%)Turnover estimated from actual client data and regression of curveBased on 7 years of data available a revenue weighted turnover was determinedTurnover curve was fit to a trend line to extrapolate the curve beyond the derived curveExpenses applied based on a percentage of revenueExpenses related to selling to new customers was eliminatedRoyalty for patents applied to eliminate contribution of patents to earningsContributory asset charges applied for other supporting assets including working capital, fixed assets, and Non‐Compete agreementsDiscount rate utilized is based on the cost of equity of the business
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 chargeOur analysis assumes that the contributory asset relationships remain constant as a percent of revenue over timeReflects asset returns previously describedTechnology charge is based on royalty rate and not included in the CAC calculation above
48 Weighted Average Return on Assets (WARA) WARA Analysis tests reasonableness of asset returns used in analysisWeighted Average Return on Assets should approximate IRR/WACC of BusinessRounding often makes it impossible to perfectly matchReturn on Excess Purchase Price (Goodwill) should be assessed on relative risks of the associated assetsReturn for goodwill should be at cost of equity at a minimum unless in very unusual circumstancesIf WARA does not approximate IRR/WACC, reassess key assumptions especially:Relative rates of return for assetsRoyalty rates or profit split
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 StudyFinancial 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 sectorsFEI 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 changeEntities 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 testUnconditional option to skip qualitative assessments and perform step one test
55 Step One: Goodwill Impairment Test Identify the reporting unitDetermine the fair value of the reporting unitCompare the fair value of the reporting unit to the carrying valueIf the carrying value exceeds the fair value, an impairment is indicatedPerform step two of the goodwill impairment test
56 Step Two: Recognition and Measurement of an Impairment Loss Calculate the implied value of goodwillSubtract 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 statementsThe difference is the implied value of goodwillDetermine whether goodwill is impairedIf the implied value of goodwill exceeds the carrying value of goodwill, there is no impairmentIf 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 PremiseDebt is excluded from the liabilities assigned to a reporting unit and consequently from the fair value of the reporting unitEquity Value PremiseDebt, 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 testAdds 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 requiredApplies to public and nonpublic entitiesNew qualitative factors replace existing triggering factors for interim goodwill impairment testingDoes not change the current guidance for testing indefinite-lived intangible assets for impairmentPublished 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 conditionsDeterioration in general economic conditionsLimitations accessing capitalFluctuations in foreign exchange ratesOther developments in equity and credit marketsIndustry and market considerationsDeterioration in the operating environmentIncreased competitionA decline in market-dependent multiplesA change in the market for the entity’s products or servicesA regulatory or political developmentCost factors that have a negative effect on earningsIncreases in raw materials, labor or other costs
60 FASB’s ASU 2011-08 Testing Goodwill for Impairment: New Qualitative Factors Decline in overall financial performanceNegative or declining cash flowsA decline in actual or planned revenues or earningsEntity-specific eventsChanges in management or key personnelChanges in strategy or customersBankruptcy or litigationEvents affecting a reporting unitA change in the carrying amount of net assets (write offs)Plans to sell or dispose of a portion or all of a reporting unitTesting for recoverability of a significant asset group within a reporting unitRecognition of goodwill impairment in a component of the reporting unitA 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 accountStep 2: Determine the valuation premiseStep 3: Identify the potential marketsStep 4: Determine market accessStep 5: Determine the fair value
62 Assigning Assets and Liabilities to a Reporting Unit- Additional Considerations Debt recognized at the corporate levelDeferred taxes related to assets and liabilities of a reporting unitCumulative translation adjustmentContingent consideration arrangementsNon-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 assetsBest practice: consider the interrelationships or synergies among the reporting units to determine the fair value of eachDiscounted 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 PFIIssue: Planned acquisition activityIn general assumptions should not include planned acquisition activityIssue: Working CapitalAdjustments may be necessary if not at normal levelsIssue: Deferred RevenuePFI should be modified to reflect cash flowsIssue: Non-operating assets and liabilitiesPFI 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 taxesBest practice: in most cases the discounted cash flows should be calculated on an after-tax basis to ensure consistency with market participant assumptionsDepreciation and amortization amounts:Issue: depreciation and capital expenditures are usually equal in the terminal periodBest 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 compensationBest 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
Your consent to our cookies if you continue to use this website.