Valuing customer relations highlighted yesterday at BVR CPE event

Yesterday 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 Multi-Period Excess Earnings Method, or MPEEM). Of course, the approach and method used will depend upon the amount of usable data an 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 an asset will generate over its remaining useful life.)

Customer-related intangible assets are those intangible assets 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 Intangible Assets and Their Remaining 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, applying 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.

There will be other assets that “contribute” to the benefit stream from Customer Relationships, the “contributory assets.” That part of plant and equipment, working capital, etc., that is used in the production of 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, affected primarily by two key factors:

1.        Inherent advantage: a customer gains specific advantage over its competitors, through monopoly, unique attributes, etc.;

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, there are two types of attrition analyses available to the analyst.

1.        Constant rate attrition analysis: using the attrition rate calculated for each period customer purchase information is available, appraisers develop a single rate to be used through the forecast period;

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 to 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 or 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 (see Benchmarking).