Issue #19-1 | December 6, 2012

Using MPEEM to value the customer relationships intangible asset in business combinations

Last week, hundreds of valuation analysts signed on to hear Thomas Zambito, ASA, senior vice president, BDO Valuation Advisors LLC, and Poonam Vaidya, ASA, CBA, Crowe Horwath LLP, discuss best practices in valuing customer relationships in a business combination. Not surprisingly, when asked what valuation method was preferred, the audience voted overwhelmingly (84%) in favor of the multiperiod excess earnings method, or MPEEM. Of course, the approach and method used will depend on how much usable data the analyst can gather.

MPEEM, a discounted cash flow model, is one of the options in the income approach to fair value measurement. (The current value is based on the expected future economic benefit an asset will generate over its remaining useful life.)

Customer-related intangible assets are those that occur as a result of interactions with outside parties. Customer relationship intangible assets should be identified as separable in the company’s accounting records: customer lists, customer contracts, rewards members, national accounts, etc. Order backlog is usually treated separately, as evidenced in BVR’s Benchmarking Identifiable Intangibles and Their Useful Lives in Business Combinations, and it will have a shorter remaining useful life (and lower associated risk).

MPEEM requires analysts to use management income projections attributable to existing customer relationships and apply knowledge of the business and markets to assess the projections for reasonableness. Analysts do not make their own forecasts, but they need to test management assumptions, and they need to make adjustments so that the customer relationship assets are not burdened by any sales and marketing or other expenses not needed to earn a return.

Other assets, the “contributory assets,” will “contribute” to the benefit stream from customer relationships. The part of plant and equipment, working capital, etc. that is used in the production of the economic benefit for customer relationships should be charged an appropriate discount rate.

Importantly, a remaining useful life of the customer relationship assets must then be applied, developing an attrition factor through careful analysis of quantitative and qualitative factors. Attrition is generally an annual “churn” or “decay” of the existing customer relationships that is affected primarily by two key factors:

  1. Inherent advantage: A customer gains specific advantage over its competitors, through monopoly, unique attributes, etc.; and
  2. Nature of the business: If a customer’s business model relies primarily on long-term contracts, its attrition rate is likely to be lower than that of a company without stable, recurring revenue streams.

Analysts must get to know the inherent advantages of the company to analyze the stickiness of the customer relationships. They must also spot the threats. For example, is the market becoming more competitive? Is the market growing more alternatives to the client’s product? The more prevalent the competition, the greater the risk tied to the customer relationship asset.

Depending on the data available, two types of attrition analysis are available to the analyst:

  1. Constant rate attrition analysis: Using the attrition rate calculated for each period for which customer purchase information is available, appraisers develop a single rate to be used throughout the forecast period; and
  2. Actuarial attrition analysis: Requiring considerably more data, appraisers take into consideration variations in attrition rates based on the age of the customer relationships.

In either case, the analyst needs historical data. Many times the decision between using one rate of attrition or multiple rates will depend upon what data is available. Other times, more practical reasons dictate which way to go (time constraints, budget, etc.). Analysts should be cognizant of the main shortcoming to using the constant rate: There is no distinction made between customer relationships based on size and those based on age.

To complete the MPEEM process, once the attrition rate(s) is calculated, apply the charge to the projected economic income of the existing customer relationships to determine “excess earnings,” discount to present value using a discount rate that matches the risk associated with the excess earnings attributable to the asset, and apply IRC §197 Tax Amortization Benefit to Present Value.

Finally, appraisers need to assess the reasonableness of the result, comparing fair value to overall project costs and the ratio of the value of the customer relationships asset to the value of other intangible assets.

Do employees and contractors understand the meaning and importance of intellectual property?

John Villasenor surveyed his graduate engineering students at UCLA to test their “awareness” of intellectual property. Of the nearly 60 students who completed the survey, 68% could not answer the question “what is a trade secret?” He found similar results with other IP:

  • Trademarks? 51% could not answer;
  • Copyrights? 32% could not answer; and
  • Patents? 21% could not answer.

The ramifications of this are huge and widespread, from the political consequences to national security. Ignorance can be costly. As Villasenor states, “An engineer who doesn’t understand trade secrets and the obligations that accompany them is far more likely to walk out the door with proprietary computer code on a USB stick when he or she moves to a new job.”

Though the solution may be as Villasenor recommends, mandatory instruction on “IP basics” at the graduate level in colleges, more immediate to the business sector is the need to define terms in employment contracts and employee manuals. Employers should not take for granted that their new hires and contractors understand signed NDAs and IP assignments. Since over 72% of the average company’s assets are now intangible and future benefit streams likely will flow from intellectual properties, employers must take seriously the need to educate their researchers on IP value. Analysts compensating for risk should look for evidence that employers are aware of this threat.

For a small shop, protecting IP value can present a daunting set of financial realities

Last week, a Seattle news organization reported on graphic designers/illustrators who allegedly caught Disney with its hands in the unauthorized-use-of-copyrighted-materials cookie jar, only to confront what IP Value Wire calls the “willingness and wherewithal” to protect what IP really means. It’s a story valuators can file away to help explain the realities of IP ownership and value and how dependent that value is on the owner’s ability to defend it.

Modern Dog, a book copyrighted by graphic designers Robynn Raye and Michael Strassburger, contains several sketches of dogs. A close look at the sketches shows remarkable similarities to illustrations of dogs found on t-shirts promoting Disney’s movie Sharpay’s Fabulous Adventure and sold domestically nationwide at Target stores. It was reported that “some [of the illustrations used by Disney] simply appear to have been flipped electronically so that a dog is looking left instead of right.”

Here’s the lesson: To fight what they consider obvious unauthorized use of their IP, the designers sued Disney, and to do that, Raye had to sell her house. It gets worse, as Raye says the suit now threatens to bankrupt the pair.

IP Value Wire has written numerous times about the direct relationship between IP value and the owner’s willingness and wherewithal to protect it. Analysts need to account for these factors when valuing IP. Sometimes a case study such as this can frame the question.

Head of USPTO announces plans to resign

David Kappos, the highly respected director of the United States Patent and Trademark Office, announced he will be leaving the position in January 2013 after more than three years of service.

IP value is at last a boardroom discussion

IP value is finally finding its way onto boardroom agenda items, though perhaps not as much through discussion of opportunities as through mitigation of risk. A new Innography white paper identifies six IP-related risk categories that should concern today’s companies:

  1. There is a large M&A risk for acquirers (infringement, inaccurate valuation of IP assets during the due diligence process, lingering litigation);
  2. IP Value Wire has written often about the sometimes crippling costs that attach to IP-associated legal risk;
  3. It is important to know the validity of IP claims, including proof of ownership, made by potential partners or licensors;
  4. A company’s R&D program inherently carries with it technology (R&D) risk, “including the loss of competitive position, technology obsolescence and barriers to enter new markets”;
  5. Competitors can severely limit market access in a given segment by wielding a heavy IP hammer; and
  6. Today, the threat of “game-changing innovations” is a very real market risk.

In BVR’s Benchmarking Identifiable Intangibles and Their Useful Lives in Business Combinations study, intangible property was found to be 72% of the acquired companies’ total assets in the 360 purchase price allocations reviewed in early 2012. It is the dominant asset class in business. The above list of risk factors serves as a good checklist for discussions with management as valuators of IP perform due diligence.

 


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