Portfolio acquisitions: Valuing intangibles
Portfolio acquisitions: Valuing intangibles
Does your private equity firm have the experience, expertise, and internal resources necessary toperform the valuation of intangible assets of a portfolio company? While many of our non-private equitycorporate clients may be involved in only a few transactions over their entire career, our private equityclients often have several transactions in a single quarter. Due to this extensive expertise, many of themperform these valuations, satisfying the accounting requirements of Accounting Standards Codification805 (ASC 805), Business Combinations. The following article provides our observations of best practicesin ASC 805 valuation analyses.
Common intangible assets
The intangible assets most commonly acquired as part of a typical acquisition include: trademarks andtrade names, proprietary (or patented) technology, customer-related intangibles, non-competeagreements, and workforce in place. Although the workforce in place asset is included as a componentof goodwill on the opening balance sheet, its fair value is determined as it impacts the fair value of thecustomer-related intangibles.
When determining the fair value of these intangible assets, it is necessary for our clients to analyze a significant amount of data to support their conclusions.
Some of our clients have elected the Private Company Council (PCC) alternative with regards to ASC 805.When electing the PCC alternative, the customer-related and non-compete agreement intangible assetsdon’t need to be separately recognized from goodwill. Some clients have elected the PCC alternative tosimplify their financial reporting, while many others continue to maintain the status quo and account forall intangibles as in the past, in order to maintain optimal flexibility and avoid any costly restatements offinancial statements in the event of a future public offering or possible sale to a publicly tradedcompany.
Information Reviewed to Perform ASC 805 Analyses
When determining the fair value of these intangible assets, it is necessary for our clients to analyze asignificant amount of data to support their conclusions. Information Commonly Reviewed for ASC 805
Critical supporting analyses
Development of an implied internal rate of return
In order to test the overall reasonableness of the fair value of the purchase price relative to the financialprojections and utilized in the ASC 805 analyses, it’s best practice to calculate the internal rate of return(IRR) that is implied based on the combination of the financial projections and the transaction purchaseprice. It’s appropriate to select the discounted cash flow (DCF) method in order to determine the IRR.
The application of the DCF method requires the development of discrete cash flow projections for thesubject company. The determination of the relevant cash flows involves adjusting estimated futureearnings to arrive at debt-free cash flow, which is the cash flow available for all capital holders – bothdebt holders and equity holders. Included in these adjustments are anticipated reinvestments requiredfor future growth, such as working capital and capital expenditures. Most if not all of our private equityclients have already developed these projections to support the purchase price of the subject company.
An illustration of an IRR analysis is included in Schedule A of the example. The implied IRR shouldreconcile with the market participant weighted average cost of capital (“WACC”) calculation, as well arethe weighted average return on assets (“WARA”) calculation – both of which are discussed below.
Development of a weighted average cost of capital
An important part of the discounted cash flow method is the development of a discount rate for use indetermining the present value of the cash flows generated by a market participant. The reasonablenessof the IRR described above should be tested by developing the subject company’s WACC from a marketparticipant’s view. The WACC represents the weighted average return expectation for a company’sinvested capital or its operating assets, including a normal level of working capital. The development ofan appropriate WACC requires estimates of both an equity rate of return and a debt rate of return.Thus, the WACC is a function of both the required return on equity/debt and the mix of thosecomponents in the capital structure.
The most common methods for determining the equity rate of return are the capital asset pricing modelor the build-up method. We find that many of our private equity clients utilize the build-up method, anillustration of which is included in Schedule B of the example >>
Weighted average return on assets
The weighted average return on assets (WARA) analysis reconciles the fair values of the netassets/liabilities acquired (and the returns assigned to those assets as a part of the ASC 805 analysis)with the overall return associated with the subject company as a whole. This analysis is typically used asa reasonableness check to verify that the results of the fair value analyses are reasonable in comparisonto the overall transaction. When the sum of the individual asset weighted returns (i.e., the WARA)closely matches the IRR and WACC, it helps support the conclusions of fair values. An illustration of theWARA analysis is included in Schedule C of the example >>
Commonly used methods to value intangible assets
Relief-from-royalty – Trademark/Trade names
This method is commonly utilized to value both trademark/trade name and proprietary (or patented)technology intangible assets. The relief-from-royalty method is a hybrid form of both the incomeapproach and the market approach. The premise of the relief-from-royalty method is that the owners ofthe company would be compelled to pay the rightful owner of the intangible asset for the right to use it,if they didn’t already own the intangible asset. Since the legal right to use the intellectual propertyrelieves ownership from such payments (royalties), the financial condition of the company is enhanced.
In order to measure the payments avoided, an appropriate royalty rate (usually expressed as apercentage of revenue) is selected based upon publicly available royalty data from third-party licenseagreements, relative profitability of the company due to the intangible asset, and management’sassessment of the overall importance of the intangible asset. A royalty rate implied from this analysis isthen often compared to a “profit split rule of thumb.” This rule of thumb estimates that 20–33 percentof the licensee’s profits are typically the share to be paid as the royalty to the licensor. However, thisrule of thumb should be utilized as a reasonableness check and never utilized as the primary method fordetermining the royalty rate. After determination of an appropriate royalty rate, a stream is developedfor the products or services that utilize the intangible asset to which the royalty rate is applied. Then thepresent value of the after-tax royalty savings over the economic useful life of the asset is calculated. Anillustration of the relief-from-royalty method is included in Schedule D of the example >>
Multi-period excess earnings – Customer-related intangibles
The fair value of customer relationships is typically estimated using a variation of the income approach,specifically the multi-period excess earnings methodology (MPEEM). The MPEEM is based on theprinciple that the value of an intangible asset is equal to the present value of the incremental after-taxeconomic earnings attributable to that intangible asset. Debt-free future earnings associated withcustomer relationships are typically estimated consistent with the IRR supporting analysis. In addition,the required returns on the other contributory assets employed by the business (e.g., net workingcapital (cash-free, debt-free), net fixed assets, assembled workforce, and other identifiable intangible assets) are then deducted from the discounted future earnings. These deductions account for the useand contribution of other assets employed that are necessary (in addition to the customer relationships)to achieve the projected excess earnings.
Some of the critical assumptions of the MPEEM include:
- Estimating annual revenue associated with existing customers based upon certain factors,including historical customer attrition patterns and projected revenue growth from existingcustomers.
- An EBITA margin for the existing customers is developed based upon projection data estimatedby management. Due to differences in levels of selling, marketing, travel and entertainment,and other expenses among existing customers and attracting new customers, the margin ofexisting customers can be incrementally higher than the company as a whole.
- After-tax contributory asset charges for the use of the tangible and identified intangible assets.Examples include net working capital, fixed assets, trademark/trade names, workforce in place,etc.•
- The present value of the after-tax economic earnings associated with the customer relationshipsis calculated using a discount rate that incorporates the increased riskiness of the intangibleasset relative to the company as a whole.
- An illustration of the valuation of a customer related intangible asset utilizing the MPEEMmethod is included in Schedule E of the example >>
With and without – Non-compete agreements
A technique of the income approach commonly referred to as the “with and without” method isgenerally used most often to determine the fair value of the non-compete intangible assets. (However,it can also be used to determine the fair value of other difficult to value intangible assets.) This methodcompares the expected cash flows of the company “with” the non-compete agreement in place to theexpected cash flows of the company “without.” To apply this method, the present values of theexpected cash flows to be derived from the company under each scenario are compared. The “with”scenario is the same scenario utilized in the IRR analysis and contemplates the revenue and cash flow ofthe company with the non-compete agreement in place. The “without” scenario usually alters therevenue and, consequently, the cash flows, as if there wasn’t a non-compete agreement in place. The“with and without” cash flows are typically limited to the duration of the non-competition agreement.The sum of the present value of the difference in cash flows is calculated to determine the raw value ofa non-compete agreement. The raw value is multiplied by an estimate of the likelihood of competitionto arrive at an indicated fair value of the non-compete agreement. An illustration of the “with andwithout” method is included in Schedule F of the example >>
Cost approach – Workforce in place/internally developed software
Although ASC Topic 805 states that the value of an assembled workforce acquired in a businesscombination should not be recorded separately from goodwill on a company’s opening balance sheet, itis necessary to estimate the fair value of the workforce asset so that an appropriate contributory assetcharge relating to the workforce in place asset can be applied in the multi-period excess earningsmethod used in measuring the fair value of the customer-related intangibles. Significant expendituresfor recruiting, selecting, and training would be required to replace a company’s existing employees. Theinclusion of the fully trained and efficient workforce in a transaction allows a company to avoid theexpenditures that would be required to hire equivalent personnel. The value of the assembledworkforce is typically represented by the sum of costs avoided.
To determine the total costs, employee data as of the date of the transaction is analyzed bymanagement, including the total number of employees, stratification of employees by job description,salary, bonus, and benefits. Then cost estimates are developed by management for items such astraining period, training productivity factor (costs associated with employee inefficiency capture theamount of time inefficiently used by a new employee during the initial training period on the job), andacquisition costs (interview time, headhunter fees, advertising, etc.). An illustration of this method fordetermining the fair value of the workforce in place is included in Schedule G of the example. The costapproach is also utilized in the valuation of other intangible assets, such as internally developedsoftware.
There is no question that the valuation of intangible assets for ASC 805 purposes can be a complexexercise. However, many of our clients – especially those in the private equity industry – have been ableto develop internal procedures and analyses required to assign fair value measurement to the acquiredintangibles on the opening balance sheet.