Ed Hamilton and P.J. Patel are experts on valuing customer relationships for financial reporting. They will discuss alternative valuation methods including the multi-period excess earnings method, distributor method, and cost approach. Case studies will examine applying these methods to acquired companies with established customer bases. The appropriate valuation method depends on factors such as whether customers are the primary asset and assumptions needed.

1. Alternative Methods for Valuing
Customer Relationships
Webcast
November 13, 2012

2. Ed Hamilton, CFA
• Mr. Hamilton is a Vice President with VRC and specializes in the valuation
of businesses, assets and liabilities for financial reporting purposes.
• Mr. Hamilton is an active member of the AITF and is currently involved with the
Appraisal Foundation Working Group preparing a Practice Aid for the valuation
of customer relationships.
• Mr. Hamilton is a frequent presenter on valuation issues for financial reporting
purposes and has recently presented on valuation issues relating to ASC 805
(SFAS141R), ASC 350/360 (SFAS142/144), ASC 820 (SFAS157) and other
emerging issues.
Contact Information:
ehamilton@valuationresearch.com
Direct: 609.243.7018
Mobile: 609.221.8174
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3. P.J. Patel, CFA
• Mr. Patel is a Managing Director with VRC and specializes in the valuation of
businesses, assets and liabilities for financial reporting purposes.
• Mr. Patel is an active member of the Appraisal Industry Task Force (AITF).
• He is a member of the Appraisal Foundations Working Group preparing an
industry Practice Aid for valuing customer related assets.
• Mr. Patel is a frequent presenter on valuation issues for financial reporting
purposes and has recently presented on valuation issues relating to ASC 805
(SFAS141R), ASC 350/360 (SFAS142/144), ASC 820 (SFAS157) and other
emerging issues. In addition, Mr. Patel was on the Fair Value Panel at the 2008
AICPA SEC Conference. He has been quoted numerous times in the press
regarding valuation issues.
Contact Information:
ppatel@valuationresearch.com
Direct: 609.243.7030
Mobile: 609.240.1337
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4. Valuation Research Corporation
• Formed in 1975, VRC has nine U.S. offices and eight international affiliates.
• VRC provides fairness and solvency opinions in support of corporate
transactions, valuations of intellectual property and tangible assets for
financial reporting and tax purposes.
• VRC maintains relationships with corporations, lenders, accountants,
investment banks, private equity firms, and law firms.
• VRC was instrumental in forming the Appraisal Issues Task Force (AITF), a
valuation industry group that meets quarterly with representatives from the
FASB, the SEC, and the PCAOB to discuss valuation issues surrounding
financial reporting.
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5. Topics Covered in the Valuation Advisory
• Accounting Background and Overview
• Identification of Customer-related Assets and Value Considerations
• Valuation Methodologies
• Valuation Methodology Selection
• Other Considerations
• Appendix on Attrition Rate Calculations
• Appendix of Case Studies
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6. Continuum of Customer Assets
Recurring
Customers
Transactional Transactional customer
with long
Customer purchase customer relationships Take or pay
term
lists order based relationships with contracts
contracts
customers with MSAs switching
costs
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7. Identification of Customer-related Assets and Value Considerations
• Qualitative understanding of the relative importance of the
customer-related asset being valued:
• Industry Characteristics
• Company Characteristics
• Product/Service Characteristics
• Customer-related Asset Characteristics
• Other key factors to consider:
• Barriers to change
• Stickiness of customer relationships
• Switching costs
• Qualitative attributes are just as important as quantitative attributes
in determining the value of customer relationships
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8. Valuation Approaches
• Income Approach:
• Multi-Period Excess Earnings Method
• Distributor Method
• With-and-Without Model
• Cost Approach
• Market Approach
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9. Summary of Methods: MPEEM
MPEEM based customer cash flow
Company revenue/earnings
Less: Taxes
Less: Charges for contributory assets
Equals: Cash flows related to customer relationships
• Residual cash flow model
• Best used when:
• Customers are the primary assets or
• Margins are within a reasonable range of normal industry levels
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10. Sample MPEEM Cash Flow Calculation
Revenue Adjusted for Growth $100,000
Remaining After Attrition 95.0%
Revenue After Attrition 95,000
EBITA 19,000
20.0%
Less: Royalty Charge for use of TM (9,500) 10.0%
Adjusted EBITA 9,500
Less: Income Taxes 3,800
Debt Free Net Income 5,700
Debt Free Net Income Margin 6.0%
Contributory Asset Charges
Normal Working Capital (1,425)
Property, Plant & Equipment (1,900)
Workforce (1,045)
Return on Supporting Assets (4,370)
-4.6%
Net After Tax Cash Flows 1,330
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11. Summary of Methods: Distributor Method
DM based customer cash flow
Company Revenue
Earnings of market proxy
Less: Taxes
Less: Charges for contributory assets (based on market proxy)
Equals: Cash flows related to Customer Relationships
• Residual cash flow model but isolates cash flows relating to customer
relationships
• Best used when:
• Customers are NOT the primary assets or
• A reasonable market proxy exists for the customer relationships
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12. Sample Distributor Method Cash Flow Calculation
Revenue Adjusted for Growth $100,000
Remaining After Attrition 95.0%
Revenue After Attrition 95,000
EBITA 3,895
4.1%
Less: Royalty Charge for use of TM 0
Adjusted EBITA 3,895
Less: Income Taxes 1,558
Debt Free Net Income 2,337
Debt Free Net Income Margin 2.5%
Contributory Asset Charges
Normal Working Capital (684)
Property, Plant & Equipment (238)
Workforce (95)
Return on Supporting Assets (1,017)
-1.1%
Net After Tax Cash Flows 1,321
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13. Summary of Methods: With-and-Without
Value of business/entity with customer relationships
Less: Value of business/entity without customer relationships, where customer
relationships are recreated
Equals: Value of the Customer Relationships
• Best used when:
• Customers are NOT the primary assets or
• Customer relationships can be recreated
• Time to recreate the customer relationships is short and does not change the
structure of the business
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14. Cost Approach - Overview
• Premise is that a prudent investor would pay no more for an asset than
the amount for which the utility of the asset could be replaced.
• May be appropriate when the customer related asset isn’t the primary
asset and can be recreated in a short period of time.
• Time to recreate is critical – if time is significant may point to a value
greater than an accumulation of costs.
• May be used for early-stage companies that are unable to forecast
revenue with reasonable certainty or when other approaches are difficult
or not possible.
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15. Cost Approach – Costs
Direct Costs
Plus: Indirect costs
Plus: Developer’s profit – Reflects the expected return on the investment.
Should be a reasonable profit margin based on market inputs.
Plus: Opportunity costs – Profits lost while the asset is being created. Based on
a reasonable rate of return on the expenditures while asset is being created.
Applicable if asset cannot be used while being created.
Equals: Value of customer relationships
Taxes – Not tax affected. It is believed market participants view expenses on a
pre-tax basis.
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16. Cost Approach - Example
% of Total
Direct & Indirect Costs Value
Direct Costs 15.0 55.8%
Indirect Cost 6.0 22.3%
Total Costs 21.0
Developer's Profit
Developer's Profit Margin (1) 20%
Developer's Profit 5.25 19.5%
Opportunity Cost
# of Customers 1,000
Average Lead Time (Months) 3
Required Return 12%
Investment per Customer (2) 0.021
Opportunity Cost per Customer (3) 0.00063
Total Opportunity Costs (4) 0.630 2.3%
Total Cost 26.880 100.0%
Calculations
1 - (Cost / (1 - Margin) * Margin) such that the margin earned is 20%.
Profit / (Revenue) = 5.25 / (21.0 + 5.25) = 20% margin.
2 - Total Costs / # of Customers
3 - Lead Time in Years * Required Return * Investment per Customer
4 - Opportunity Cost per Customer * # of Customers
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17. Valuation Methodology Selection
Valuation Pros Cons Best Used When
Techniques
MPEEM • Consistent with PFI Sig. number of assumptions Customers are the primary asset
• Assumptions/inputs needed, i.e. LTGR, attrition of the business
available rate, etc
Distributor • Inputs are available • Market inputs can be Customers are a non-primary
Method • Reduces reliance on CACs subjective and require asset
• Some portion of goodwill not valuer judgment
included in value • Requires availability of
• Allows use of MPEEM to appropriate market inputs.
value primary asset
With-and-Without Underlying theory is intuitive Key assumptions are Customers are a non-primary
Method subjective and difficult to asset
support
Cost Approach • Objective, if good data is • Data difficult to find Customers are a non-primary
available • May understate the value asset and cost data is readily
• Goodwill not included in available
value estimate
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18. Case Study #1
GlobalCo is a multinational consumer products good (CPG) and acquires
RegionalCo for a purchase price of $160 million. RegionalCo sells products
under several key brand names. RegionalCo has developed customer
relationships over its 20 year history.
Acquisition rationale: acquisition of brands
Intangible assets present: brands, customer relationships
• Revenues: $100 million
• Profit margins: 20%
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19. Case Study #1
Value estimates:
• MPEEM - $10 million
• Distributor Method - $10 million
• With and Without - difficult to quantify lost revenue, earnings – Range of
value $5 million to $25 million
• Cost Approach – $1 million to $5 million based on S&M costs. But the
inputs are difficult to support.
Selected valuation methodology – MPEEM or distributor method
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20. Distributor Method vs. MPEEM
Distributor
Method MPEEM
Revenue Adjusted for Growth $100,000 $100,000
Remaining After Attrition 95.0% 95.0%
Revenue After Attrition 95,000 95,000
EBITA 3,895 19,000
4.1% 20.0%
Less: Royalty Charge for use of TM 0 (9,500) 10.0%
Adjusted EBITA 3,895 9,500
Less: Income Taxes 1,558 3,800
Debt Free Net Income 2,337 5,700
Debt Free Net Income Margin 2.5% 6.0%
Contributory Asset Charges
Normal Working Capital (684) (1,425)
Property, Plant & Equipment (238) (1,900)
Workforce (95) (1,045)
Return on Supporting Assets (1,017) (4,370)
-1.1% -4.6%
Net After Tax Cash Flows 1,321 1,330
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21. Case Study #1b
GlobalCo is a multinational consumer products good (CPG) and acquires
RegionalCo for a purchase price of $160 million. RegionalCo sells products
under several key brand names. RegionalCo has developed customer
relationships over its 20 year history.
Acquisition rationale: acquisition of brands
Intangible assets present: brands, customer relationships
• Revenues: $100 million
• Profit margins: 30%
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22. Case Study #1b
Value estimates:
• MPEEM - $50 million
• Distributor Method - $10 million
• With and Without - difficult to quantify lost revenue, earnings – Range of
value $5 million to $25 million
• Cost Approach – $1 million to $5 million based on S&M costs. But the
inputs are difficult to support.
Selected valuation methodology – Distributor method
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23. Calculations: Case Study #1b
Distributor
Method MPEEM
Revenue Adjusted for Growth $100,000 $100,000
Remaining After Attrition 95.0% 95.0%
Revenue After Attrition 95,000 95,000
EBITA 3,895 28,500
4.1% 30.0%
Less: Royalty Charge for use of TM 0 (9,500) 10.0%
Adjusted EBITA 3,895 19,000
Less: Income Taxes 1,558 7,600
Debt Free Net Income 2,337 11,400
Debt Free Net Income Margin 2.5% 12.0%
Contributory Asset Charges
Normal Working Capital (684) (1,425)
Property, Plant & Equipment (238) (1,900)
Workforce (95) (1,045)
Return on Supporting Assets (1,017) (4,370)
-1.1% -4.6%
Net After Tax Cash Flows 1,321 7,030
Implied Royalty Rate 1.4% 7.4%
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24. Alternative Calculations: Case Study #1b
Distributor
Method MPEEM
Revenue Adjusted for Growth $100,000 $100,000
Remaining After Attrition 95.0% 95.0%
Revenue After Attrition 95,000 95,000
EBITA 3,895 28,500
4.1% 30.0%
Less: Royalty Charge for use of TM 0 (19,000) 20.0%
Adjusted EBITA 3,895 9,500
Less: Income Taxes 1,558 3,800
Debt Free Net Income 2,337 5,700
Debt Free Net Income Margin 2.5% 6.0%
Contributory Asset Charges
Normal Working Capital (684) (1,425)
Property, Plant & Equipment (238) (1,900)
Workforce (95) (1,045)
Return on Supporting Assets (1,017) (4,370)
-1.1% -4.6%
Net After Tax Cash Flows 1,321 1,330
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25. Alternative Calculations: Case Study #1c
Distributor
Method MPEEM
Revenue Adjusted for Growth $100,000 $100,000
Remaining After Attrition 95.0% 95.0%
Revenue After Attrition 95,000 95,000
EBITA 3,895 14,250
4.1% 15.0%
Less: Royalty Charge for use of TM 0 (4,750) 5.0%
Adjusted EBITA 3,895 9,500
Less: Income Taxes 1,558 3,800
Debt Free Net Income 2,337 5,700
Debt Free Net Income Margin 2.5% 6.0%
Contributory Asset Charges
Normal Working Capital (684) (1,425)
Property, Plant & Equipment (238) (1,900)
Workforce (95) (1,045)
Return on Supporting Assets (1,017) (4,370)
-1.1% -4.6%
Net After Tax Cash Flows 1,321 1,330
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26. Case Study #2
ContractCo is an IT service provider to varying parts of the US government
and acquires SmallCo for a purchase price of $100 million. SmallCo is also an
IT service provider to varying parts of the US government has several multi-
year government contracts.
Acquisition rationale: customer relationships and workforce (with security
clearances)
Intangible assets present: customer relationships (including backlog) and
workforce
• Revenues: $200 million
• Profit margins: 8%
25

27. Case Study #2
Value estimates:
• MPEEM - $20 million
• Distributor Method – n/a since a reasonable market proxy is not available
• With and Without – difficult to quantify lost revenue, earnings – Range of
value $5 million to $25 million
• Cost Approach – $5 million based on S&M costs. But the inputs are difficult
to quantify since contracts are unique and difficult to replace. Cost data is
likely not a good proxy for the future benefit stream.
Selected valuation methodology – MPEEM
26

28. Case Study #3
BigCo is a national manufacturer of widgets and acquires SmallCo for a
purchase price of $500 million. SmallCo also manufactures widgets and sells
to similar customers. The widgets are a commodity product that are sold on a
transactional basis through distributors. SmallCo is able generate above
normal margins due to its state of the art facility as a result of historical cap ex.
Acquisition rationale: state of the art facility, customer relationships and
workforce
Intangible assets present: customer relationships, trademarks and workforce
• Revenues: $500 million
• Profit margins: 10%
27

29. Case Study #3
Value estimates:
• MPEEM - $150 million
• Distributor Method – $50 million
• With and Without - Range of value $20 million to $75 million. The with and
without method is still to quantify but is less subjective than in other
situations as customers (distributors) are not unique and time and cost to
re-create can be estimated.
• Cost Approach – $50 million. The cost approach is still somewhat difficult to
quantify but is less subjective than in other situations as customers
(distributors) are not unique and time and cost to re-create can be
estimated.
Selected valuation methodology – Distributor method, with and without
method or cost approach. MPEEM determined not to be appropriate given
difficulties in estimating cash flows related to customer relationships vs. PP&E.
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30. Customer Assets Evolve Out of Other Activities
Technology
Brands (including
R&D)
Customer
A&P
Service
Customer Quality
S&M Relationships Control
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31. Valuation Methodology Selection
• Method selection can be difficult
• The cost approach may not capture all future benefits
• The with and without method requires a significant number of inputs and is
typically subjective
• The income approach methods tend to be the most commonly used
methods in valuing customer relationships
• Value is based on the present value of expected future cash flows
attributable to the asset being valued
• Three primary factors
• Cash-Flow
• Life
• Discount Rate
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32. What is the appropriate level of Cash Flow: Review Business Functions
Determining the cash flow related to customer relationships is difficult and
has the biggest impact on value
Manufacturing
Sales & Distribution
Intellectual Property
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33. Continuum of Customer Assets
Recurring
Customers
Transactional Transactional customer
with long
Customer purchase customer relationships Take or pay
term
lists order based relationships with contracts
contracts
customers with MSAs switching
costs
Cost Distributor Model, With-and-Without, MPEEM MPEEM
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34. U.S. Office Locations
Boston Milwaukee Princeton
260 Franklin Street 330 East Kilbourn Avenue 200 Princeton South Corporate Center
Suite 530 Suite 1020 Suite 200
Boston, MA 02110 Milwaukee, WI 53202 Ewing, NJ 08628
617.330.1610 414.271.8662 609.243.7000
Chicago New York San Francisco
200 West Madison Street 500 Fifth Avenue 50 California Street
Suite 2110 39th Floor Suite 1300
Chicago, IL 60606 New York, NY 10110 San Francisco, CA 94111
312.957.7500 212.983.3370 415.277.1800
Cincinnati Pittsburgh Tampa
105 East Fourth Street Three Gateway Center 777 South Harbour Island Boulevard
Suite 1005 401 Liberty Avenue, Suite 1740 Suite 980
Cincinnati, OH 45202 Pittsburgh, PA 15222 Tampa, FL 33602
513.579.9100 412.246.9333 813.463.8510
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35. International Affiliate Office Locations
Buenos Aires London Monterrey
Vuelta de Obligado 2728 10 Greycoat Place Ricardo Cantu Leal #115
Piso 2 Victoria Colonia LTH
Buenos Aires C1428 ADT London SW1P ISB Col. Florida
Argentina United Kingdom Monterrey, N.L.
C.P. 64830
Frankfurt Luxembourg Mexico
Rennbahnstraße 72-74 31 Boulevard Marcel Cahen
60528 Frankfurt am Main L-1311 Luxembourg São Paulo
Germany Rua Paes Leme, 524 - 12° Andar
Madrid - Pinheiros
Alcalá, 265, Edificio 2 CEP 05424-904 São Paulo SP
Hong Kong
28027 Madrid Brazil
6/F Pacific Place Three
1 Queen’s Road East Spain
Toronto
Hong Kong
Melbourne 16 Dewitt Court
Level 16, 379 Collins Street Markham, ON L3P 3Y3
Melbourne, Victoria 3000 Canada
Australia
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