Global merger and acquisition activity plummeted in the first quarter of 2020, and it’s easy to understand why.
With valuations down, many business owners have simply decided to wait for a more advantageous time to sell their companies. Buyers are conserving cash and are wary of investing in declining businesses that may not have reached bottom. Then, there’s also the practical issue of how to negotiate and perform due diligence while adhering to social distancing guidelines.
It’s not a question of if this trend will reverse, but when. Until it does, rationalizing the value of acquired assets has never been more important.
We offer the following guide related to accounting for acquired intangible assets, appraisal methodologies and some thoughts about how COVID-19 might impact asset values.
Identifying Intangible Assets
Intangible assets, by definition, lack physical substance. They must also meet certain criteria to be recognized and valued. Intangible assets may be derived from contractual or legal rights, or they may be separated from the business and transferred.
The list of possible intangible assets acquired in a business combination is a long one. FASB’s list of the more common intangible assets classifies them as contract-related, technology-related, etc. Some industries have intangibles unique to their particular type of business, such as franchise agreements or newspaper mastheads, but nearly every company we have encountered has some form of customer-related intangible asset.
Trademarks and trade names
Intangibles may have indefinite lives, but the vast majority are assigned a useful life. In the past, trademarks and trade names were often considered to have an indefinite life, but this has changed over time, and most are now assigned a useful life and amortized.
The exception may be well-known brand names like Kleenex or Coca-Cola. Regardless of what life is placed on them, trademarks and trade names represent a common intangible asset recognized in connection with a business transaction.
Customer-related intangibles deserve special mention because of their ubiquity and the fact that they often take different forms. There are at least three distinct types of customer intangibles:
- Customer contracts: These may be long-term contractual arrangements and reflect what we might call “backlog.” Government programs are a source of revenue for many contractors and meet the legal criteria for valuation.
- Customer lists: At the other extreme, a customer intangible may simply be a list of names, email addresses and phone numbers. Customer lists are more common with retail businesses. Their value is usually limited, but they should still be identified.
- Customer relationships: Most common are customer relationships under short-term contracts or purchase orders. If such customers have a history of repeat purchases, they almost certainly should be valued as an intangible asset.
Many acquisitions include provisions for non-competition agreements with management and other key employees. The buyer may acquire existing agreements or enter into new ones in connection with the transaction. Either way, these are normally considered acquired intangible assets, and their value is recorded on the balance sheet.
Other contracts may meet the criteria for asset recognition. Supply contracts and even lease agreements may be identified and valued, particularly if their payment terms are determined to be above or below market.
The value of a company’s assembled workforce may be huge—particularly for a service-oriented business. It is often thought to meet the requirements for recognition as an intangible asset; after all, most employees sign an employment agreement when joining the company.
Under current rules, the workforce is not recorded as a separate intangible asset in business combinations (it is considered part of goodwill). However, it may be recognized in the case of asset acquisitions.
Valuing Intangible Assets
Intangible assets are assigned a portion of the purchase price based on “fair value.” ASC 805 defines fair value as “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.”
Probably the most important element of the definition is the “market participant” standard. This simply means the valuation of the intangible assets should not be based on how a “specific” acquirer would use the asset. Instead, it should reflect how a “typical” company in the industry might treat the asset.
For example, a buyer may decide to use a customer list differently from how other companies might use it. This could be because the buyer already has access to the list of customers, or otherwise finds little value in the list.
The point is, if other companies would use the asset to its utmost potential (also known as its “highest and best use”), then it should be valued on that basis.
In valuing intangible assets, the appraiser will use one of three standard methods:
- Income approach: The income approach is typically used when the appraiser can draw a straight line between the asset and how revenue is generated—such as with customer relationships. However, with intangibles like trade names or patents, it is much more difficult to quantify the extent to which the asset contributes to income.
- Market approach: The market approach is not often used to value intangible assets because most intangible assets (particularly intellectual property) are unique. The market approach requires a comparative analysis of the asset with similar assets for which pricing evidence is available. This is typically not possible with intangibles.
- Cost approach: The cost approach is rarely used in the valuation of going-concern businesses, but it is widely applied in valuing intangible assets. In most cases, this means a “cost to recreate” the particular intangible asset. Using this approach, though, requires special considerations. For example, how do you treat taxes when measuring total costs?
Special Considerations for Valuing Different Types of Intangible Assets
Fortunately, the appraisal industry has developed some best practices for dealing with various valuation complexities.
Valuing company trade names is relatively straightforward. Most often, appraisers use a “relief from royalty” method. The analyst discounts a future stream of hypothetical royalty revenue that the owner is “relieved” from paying (since he/she owns the asset). Estimating the royalty rate can be tricky, but this is where some market evidence is useful.
People tend to overestimate the value of trade names. COVID-19 has demonstrated the weakness of many names in the retail sector, where centuries-old brands like Macy’s and JCPenney were not enough to save those companies. Since value is tied to revenue, the value of most trade names has declined in the current environment.
Customer relationships are valued using a variant of the income approach called the “multi-period excess earnings model” (MPEEM). The MPEEM begins with a projection of future earnings. However, the earnings, in this case, are specifically tailored to represent only the amounts directly attributable to the customers. Application of this technique usually requires several adjustments:
- Reduce revenue and earnings for the expected attrition of customers over time. Unlike a DCF model, which reflects business growth over time, the future cash flows eventually trail off to an insignificant amount. Estimating customer attrition requires extensive analysis of past trends and future expectations.
- Take deductions for the required returns on other assets that contribute to producing cash flows. This includes inventory, property plant and equipment and other intangibles. The results are “excess earnings” solely attributable to the customers. Rates of return vary depending on the riskiness of each asset class.
- Make other adjustments to reflect market participant assumptions as opposed to company-specific assumptions. Carefully examine synergies embedded in the forecast and consider the market participant assumption described earlier.
In the end, the future cash flows are present valued. The selected discount rate used to value customers should reflect the riskiness of the asset and not the overall business. Assessing the level of risk requires consideration of the contractual versus non-contractual nature of the customers, along with other factors.
We expect to see a significant deterioration of customer-related intangible asset values due to the disruptions of COVID-19. The method used to value this asset relates mostly to future cash flows, and, to the extent an acquired company has lost customers, earnings derived from the asset will decline.
Although the assembled workforce is not recognized as a separate intangible asset in business combinations, it may still need to be valued because workforce contributes to revenue and profits. It is a “contributory asset,” and a return on that asset must be deducted from customer cash flows.
Assembled workforce is typically valued based on the cost to recreate the asset. If employees were laid-off or furloughed prior to the transaction, we expect to see a reduction in the value of this asset, which is (hopefully) only a short-term phenomenon. Note, as the deduction for workforce charges decreases, this may have an impact on customer value.
In our experience, technology assets are among the most difficult intangible assets to value. This is because they take such different forms: no patents or software programs are the same.
There are some general guidelines for how to consider technology assets:
- Patents: Patents are intellectual property that is embedded in a product. Consequently, valuing patents should look at the future revenue and profits generated from the sale of those products. A relief from royalty approach (like that used with trade names) may also apply. The trick is determining what royalty to use and what portion of the overall product sales relates specifically to the patents.
- Software: There are several ways to value software programs. They are typically monetized through sales or subscription agreements, so an income approach may be appropriate. However, software is most often valued using the cost approach. What would the buyer have to expend (in programming man-hours, hardware costs, etc.) over what period, to replicate the software product or obtain a reasonably similar facsimile?
COVID-19 has had an interesting impact on technology assets. Future revenue and profits may decline with customer losses, but the demand for automation software programs is likely to increase as employee costs are rationalized.
The huge uplift in the value of ZOOM during Spring 2020 may be a short-term trend, or it may be indicative of what technology investments are most attractive in the post-pandemic business environment. Our crystal ball is cloudy.
Non-competition agreements are valued using a form of the income approach, but one that requires extra consideration due to subjectivity involved. Appraisers commonly use the “with and without” technique. In this method, the appraiser develops two models: one assuming the non-compete agreement is in place, and one assuming the agreement is not in place. The difference between the two is a measure of the asset’s value. Note that given the individual nature of the non-compete asset, the appraiser may have to perform this technique for virtually every employee covered by an agreement.
Reconciling Asset Values and Purchase Price
After identifying and valuing all the intangible assets in a purchase price allocation, more remains to be done. The analyst typically prepares a pro forma balance sheet using the indicated fair values to determine the residual goodwill amount. They also use their judgment to determine whether the goodwill, measured as a percentage of purchase price, appears reasonable.
The analyst may also compare publicly available statistics. Some industries naturally reflect higher levels of intangible assets, including goodwill, than others. For example, high-growth technology companies might be expected to have more goodwill than a mature consumer products company.
Appraisal industry best practices dictate other considerations, such as reconciling asset rates of return with the internal rate of return (IRR) implied by the deal. These calculations can get complex since a market participant IRR may differ from the implied transaction IRR. The point is that some sort of additional analysis is required to rationalize the intangible asset values.
If you have questions about the information mentioned above, contact your Warren Averett advisor or ask a member of our team to reach out to you.