Valuation Research Corporation (VRC) has developed a unique approach to determining the fair value of customer relationships as part of a purchase price allocation in a business combination. Frequently, when valuing customer relationships, companies were surprised by the magnitude of the value allocated to customer relationships. In arriving at their value conclusions, valuation professionals have historically relied on traditional valuation methods. These methods were often applied mechanically, and did not consider whether the value conclusion was consistent with a market participant’s view of the customer relationships. In many industries, customer relationships are not the most important asset, but traditional valuation methods would reflect customer relationships as a primary asset. A point that is often overlooked is that customers often purchase products or services because of the presence of intellectual property – the brand, or the technology – not due to the presence of a relationship.
In light of the inconsistency between the qualitative attributes of the customer relationships, and the value derived with traditional valuation techniques, VRC researched and analyzed fundamental data (earnings, margins, working capital levels, fixed assets levels, etc.) and observed differences in margins, working capital levels and fixed asset levels between companies involved in manufacturing, sales and marketing, and ownership of IP. For example, in the consumer products space, VRC observed that while some companies sold direct to retailers, others sold only through distributors and most sold product through multiple channels i.e. both direct and through distributors. VRC observed that the margins for distributors in this space were extremely low, thus supporting a qualitative assessment that customers in this space were of minimal value and that mechanical application of traditional valuation methods may lead to the customer relationship value being overstated. This led to the development of the distributor method (DM) to value customer relationships. The DM is becoming accepted as a best practice in the valuation community, and will be part of a soon-to-be-released industry practice aid on the valuation of customer relationships. VRC professionals led the development of this practice aid.
The DM uses market observations of both wholesale and distributor operations for inputs when valuing customer relationships. The DM utilizes wholesale and distributor related companies, for whom the primary asset is not customer relationships. It is assumed that the relationships held by a distributor with its customers are similar to those held by a company whose primary asset is something other than customer relationships, i.e. brands, technology, capital assets. Distributors and the company being acquired (target company) have the same key driver, the ability to provide the desired product or service in a timely manner. As such, distributor inputs are a reasonable proxy when valuing the relationships of the target company.
Consider two companies selling their products via a supermarket. One has a low value brand and earns an 8% profit margin. The other has a dominant brand and earns a 20% profit margin. What drives the difference? Are the relationships more valuable? More likely, the second product earns a higher margin largely due to the strength of the brand.
More recently, we have been able to extend use of the DM outside of the consumer products space into other areas where appropriate market based evidence can be found as a proxy for inputs used in valuing customer relationships.
1) A leading manufacturer of branded food products engaged VRC to estimate the fair value of certain intangible assets acquired in a business combination. The acquired company was a leading manufacturer and distributor of snacks and the acquired brands were iconic in their region.
VRC, in cooperation with management, applied multiple valuation techniques to isolate the value of the brands from other intangible assets including goodwill. The brands were found to have an indefinite life and a significant portion of the purchase price was ascribed to them. Customer relationships, due to their nature, were considered of limited value, and were valued using the DM.
2) A laboratory testing company engaged VRC to analyze the fair value of certain intangible assets acquired in a business combination. The acquired company offered a range of proprietary tests used to diagnose rare diseases. The company earned a substantial margin because its proprietary tests allowed physicians to directly diagnose a disease that otherwise would have been identified by ruling out more common diseases, a timely and costly undertaking. While the key business driver is the portfolio of proprietary tests, the company benefits from a network of physicians who recommend the tests. The physicians do so because of the tests’ unique benefits.
VRC, in cooperation with management, determined that there was substantial value to the proprietary tests and limited, though material, value to the physician relationships. VRC applied an extension of the distributor model to value the physician relationships. By using inputs for testing companies with limited-to-no proprietary technology, VRC was able to isolate the value added by the tests. Because these companies demonstrated a more limited margin but have similar physician relationships, they are a reasonable proxy for this function. This allowed the incremental margin, and thus value, to be attributed to the proprietary tests.
The DM is beneficial in situations where traditional valuation methodologies over-estimate the value of customer relationships. This is especially true when traditional methodologies are applied mechanically. In applying the DM, the goal is to arrive at a value conclusion for the customer relationship that is consistent with a market participant’s (and often management’s) viewpoint. For more information contact a VRC professional.