In accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC“) Topic 805, Business Combinations, intangible assets acquired in a business combination must be recorded at their fair values on the acquirer’s balance sheet.
Customer-related intangible assets are one common type of intangible asset recorded in a business combination. Although numerous valuation methodologies may be applied to estimate the value of customer-related intangible assets, this article discusses the Distributor Method, which is a variation of the Multi-Period Excess Earnings Method (“MPEEM“).
The MPEEM and Distributor Method are described below:
MPEEM – A form of the income approach to valuation, the MPEEM measures the value of an asset by forecasting cash flows attributable to the asset and discounting them back to the present day using an appropriate rate of return estimated based on various market-specific, company-specific and asset-specific data. Cash flows related to the asset are also adjusted for appropriate returns for contributory assets (“CACs”) used by the business to support the asset’s revenue and earnings. This approach is applied in the valuation of customer relationships when the customer-related asset is the primary asset of the acquired business, or when the primary asset can be appropriately valued using another valuation methodology.
Distributor Method – The Distributor Method is a variation of the MPEEM that may be used when the acquired entity’s relationship with its customers is similar to the relationship between a distribution company and its customers. Specifically, the Distributor Method might be appropriate when strong brands or unique, high-value technology are driving customer demand and customer-specific efforts are limited. The Distributor Method utilizes margins and CACs consistent with a distributor within the applicable industry in order to isolate cash flow attributable to the customer-related assets.
Schneider Downs Consulting recently performed an intangible asset valuation related to the acquisition of a wholesale business (referred to as “WB”) operating in the food and beverage industry. The main driver for the acquisition, and primary intangible asset, was WB’s supplier relationships. WB essentially acted as a distributor to its customers, who largely decided to purchase from WB because WB had a reputation for sourcing products from only the highest-quality suppliers. Since the supplier relationships were the primary asset acquired, we selected the MPEEM to value the supplier relationships.
Although we originally considered the MPEEM to value WB’s customer relationship assets, the nature of the MPEEM does not allow for more than one asset of a business to be valued under this approach. Considering that WB essentially acted as a distributor to its customers, we determined that the Distributor Method would provide a reasonable indication of value for the customer relationships.
We then performed the following steps to estimate the value of the customer relationships using the Distributor Method:
Forecasted sales to existing customers – Management provided estimated sales forecasts for the customers in place on the acquisition date, which we adjusted for expected future annual attrition based on an analysis of historical attrition and management’s future expectations.
Forecasted earnings – Applied average distributor margins for the industry (obtained from relevant market databases) to forecasted sales to existing customers. We also adjusted for appropriate income taxes.
Contributory asset charges – Adjusted for the fair return on contributory assets supporting the customer relationships including working capital, property and equipment and workforce.
Discounted future cash flows to present day – We applied a discount rate (based on relevant market-specific, company-specific and asset-specific data) to the forecasted cash flows for the customer relationships.
Tax amortization benefit – We also considered the present value of the tax benefit that WB receives from amortizing the customer relationship asset over a 15-year period for tax purposes.
The resulting analysis of the customer relationships (and the valuation analysis of other intangible assets) was reviewed and accepted as part of the acquiring company’s annual audit to meet the requirements under ASC 805.
Schneider Downs has significant experience in determining the fair value of intangible assets acquired through business combinations in order to comply with ASC 805. For more information about Schneider Downs’ valuation and other business advisory services, please contact Stephen D. Thimons (412-697-5281; [email protected]) or Joel M. Rosenthal (412-697-5387; [email protected]).
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.