The Evolution of the Distributor Method
(Estimated reading time: 4 minutes 10 seconds)
The article in brief:
- The Distributor Method was originally considered a unique approach to determining the fair value of customer related assets as part of a purchase price allocation in a business combination.
- The Method has now become a mainstream methodology and has evolved into a foundational analytical tool used to assist in determining cash flow, discount rates, and the value of customer-related assets.
- Case studies illustrate how the method can be used in non-consumer packaged goods industries.
VRC Co-CEO and Senior Managing Director PJ Patel and Managing Director Jason Storbeck recently presented to the Business Valuation Association in Chicago on the evolution of the Distributor Method for valuing customer relationships. The methodology, which uses market observations for inputs when valuing customer relationships, was pioneered by VRC nearly a decade ago.
The Distributor Method gained widespread acceptance, initially for valuing customer relationships in the consumer packaged goods (CPG) space. The impetus for a better methodology was the frequent unexpected value attributed to customer relationships in a handful of CPG industry mergers in the early 2000s that seemed to be inconsistent with management’s deal rationale and general understanding of the drivers of the acquired business.
The method has since evolved into a foundational analytical tool that can be applied in a variety of contexts, including purchase price allocations, tax projects, and, in some cases assessing the risk profile of a target company and reasonableness of the discount rate used to value it.
Patel and Storbeck focused on how the Distributor Method has matured from a best practice to a prevailing application and included case studies to illustrate how the method can be used in non-CPG industries.
“Today I use it as an analytical tool literally on every purchase price allocation that we do,” said Patel. “So, if I’m looking at the data and margins and characteristics of the company, I’m trying to understand, Are these customers transactional or contractual? What’s the nature of the relationship? How sticky are they and where in the continuum should we be? And what is the appropriate margin for the customer related assets after accounting for contributory asset charges.”
A Continuum of Customer Assets
Storbeck delved further into the idea of a continuum, where the Distributor Method is one of several options available to valuation professionals. On one end of the spectrum are customer assets where there is no meaningful relationship between the company and customers—for example, a company might own a mailing list that has some nominal worth, but such an asset can be readily valued using a simple cost method.
On the other end of the continuum are relationships that are contractually binding, where, in some cases, a Multi-Period Excess Earnings Method, or MPEEM, approach alone is preferred.
Between those two extremes, however, there are numerous applications for “putting a stake in the ground” and using the Distributor Method to assign value to the customer relationships—which in some cases turn out to be de minimis—and then moving on to analyze other presumably more mission-critical tangible and intangible assets such as brand name, intellectual property and human capital.
The method has since evolved into a foundational analytical tool that can be applied in a variety of contexts, including purchase price allocations, tax projects, and, in some cases assessing the risk profile of a target company and reasonableness of the discount rate used to value it.
Case Studies
A consumer products maker. The first example was a relatively straightforward branded consumer products manufacturer, harkening to the original application of the Distributor Method. In this case, the company used some outside distributors to get its product on shelves, but also had direct customer relationships with stores. It operated at a 20% product margin compared to 5% for food and beverage distributors and 5% for comparable generic products. Ultimately that 5% figure was deemed a defensible proxy as an input in valuing the company’s customer relationships.
A cosmetic technology company. The second example was relatively trickier—a cosmetic technology company with 20% margins that sold its treatments through dermatologist offices and high-end health spas. Storbeck observed that on the surface those customer relationships—with doctors and high-end health spas, all of them trained to use the equipment—would seem to be extremely valuable. Mitigating against their value, however, was the fact that, in the end, the product delivery was still transactional as the end consumer drove demand. Indeed, the owners of the company themselves saw much of the upside in developing a home-use version of the cosmetic technology, thereby eliminating the need for the network of professionals that comprised the current customer base. Ultimately VRC looked to a combination of value-added resellers/distributors and traditional technology distributors to come up with comparables for valuing the company’s customers.
A government contractor. In this case, the challenge was explaining why the company’s margins were nearly twice that of diversified public companies, especially when the sole customer was the U.S. government and contracts were highly competitive. The answer ultimately was found not in the customer relationships, but in the company’s well-educated personnel, many of whom also had high-level security clearances. In the end, Patel said, VRC used margins of the market participants to value customer relationships and assigned much of the purchase price to the assembled workforce.
The Distributor Method has come a long way in the decade or so since it has been around and is being applied in a host of new contexts.
A value-add testing lab. This lab testing company had above-average margins for the category that were ultimately attributed for the most part to the specialized nature of its techniques. One mitigant against assigning more of the value to customers was determining who the customer was—Doctors? Insurers? Patients? Ultimately, the Distributor Method was employed using traditional testing labs as comparables. Then the MPEEM was used to assess the relatively more interesting question of what was so special about the lab’s technology and techniques.
A tech company with value-added customers. In the case of a tech company where the customers were adding significantly to the end value, VRC determined that yes, the relationships were transactional, but they were “transactional plus,” and were, thus more valuable. VRC ended up using a group of value-added resellers to quantify these relationships within the Distributor Method framework.
Summary
The Distributor Method has come a long way in the decade or so since it has been around and is being applied in a host of new contexts. Patel and Storbeck left the audience with some advice:
Start with a review of the qualitative attributes of customer assets:
- Are they transactional like those of a distributor?
- Are they more than a distributor providing limited service (i.e., VAR/VAD)?
- Are customers contractual?
- Where do they fit on the continuum?
Then ask a few more questions:
- Is there a reasonable market proxy for the customers being valued (distributor, value-added reseller, other market proxies?)
- Are the customers the primary asset or can you “put a stake in the ground” and then use MPEEM to value another asset?
- Does the value of the customers make sense from an economic perspective—profit/cash flow allocation, value relative to other assets?
More Perspectives: The Distributor Method
Distributor Method: An Alternative Technique for Valuing Customer Relationships
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Using the Distributor Model to Value Customer Relationships
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