Customer Relationships Valuation – FAQ | IFRS

Customer relationships valuation

Introduction

Customer relationships valuation is based on valuation model. Here such a valuation model is presented to value customer contracts and the related customer relationship and the non-contractual customer relationships, as per IFRS 3 Business Combinations.

References (to familiarise yourself with the subject):

Customer contracts and the related customer relationships
Non-contractual customer relationships
Order or production backlog

What are the inputs to the model?

Revenue

Revenue – represents revenue from existing customer relationships for existing products. Includes contractual and non-contractual relationships (even those without current backlog or commitments). Separate valuation of a backlog revenue intangible asset can be considered if and when such backlog exists.

The model assumes a “market participant” point of view, therefore revenue/earnings assumptions should not include the impact of synergies specific to Acquirer Co., rather only those synergies that would be realized by any market participant.

Revenue growth

Revenue growth on a stand-alone basis, i.e. without Acquirer Co.-specific Synergies – this is to value the existing sales force of the acquired business. This could be based on sales forecasts made by the acquired business in the process of being sold or new estimates, but synergies should not be included (synergies are included in the remaining amount of goodwill). This means growth from existing and new customer relationships for existing and new products but without new customer relationships or new products coming from the acquirer’s customer/products portfolio.

So ending revenue year 1 is 10,624 x (1 + 3.9%) = 11,039 beginning revenue year 2.

Turnover/Attrition

Turnover/Attrition – represents an estimate of the percentage of existing customers that are expected to turn over each year. For example, 10% means 10% of turnover is not returning in the next year from existing customer relationships for existing products, or in other words, in 10 years all customer relationships at acquisition date are replaced by new customer relationships.

So turnover/attrition is 15%, or 12,500 x 15% = 1,875 decrease in (annual) revenue, or beginning revenue is 12,500, minus 1,875 is ending turnover 10,625.

Terminal value

Terminal value – also called residual value, is the value of the business remaining after year 15, customer relationships and products are expected to continue generating value for an indefinite period of time.

This is the after tax cash flow from year 15, divided by the Present Value Factor/Discount Facto corrected for the turnover/attrition in year 15 (plus) and revenue Growth without Acquirer Co.-specific synergies in year 15 (minus), or

EUR ‘000 175 / (14% + 15% – 3%) = EUR ‘000 674

Net margin

Net margin – represents estimated EBITDA margin, adjusted for/increased by sales/marketing relating to new customers (likely 1%-2%). As a result this EBITDA margin is normalised based on past performance and current operations, again without specific synergies!

Inventory write-up

Inventory write-up – represents purchase accounting write-up of Inventory, if any. Amount should be deducted herein to avoid overvaluing the customer intangible asset. It is deducted completely in year 1.

If a Backlog intangible is valued, this deduction would be only that amount of the step-up relating to uncommitted orders, since the backlog valuation would be reduced for inventory-step up relating to inventory to be used in the orders in backlog (i.e. committed orders).

Contributory asset charge

Contributory asset charge – represents the cost for the use of other assets of the business such as net working capital, fixed assets, and assembled workforce. For this case, a pre-tax charge of approximately 5% of average revenue is considered reasonable on the basis of past acquisitions.

This factor should only be changed if the revenue stream is expected to require a higher or lower than normal use of these assets to be achieved.

Charge for trade names

Charge for trade namesTrade names can be valued using a benchmarked revenue stream from a trade name branded product. Revenue and growth rates should only be reflective of “market participant” synergies, not synergies specific only to Acquirer Co. The royalty tradename rate should correspond to the estimated rate that would be required by a 3rd party to utilize the subject tradename.

If and when the trade name(s) are separately valued as intangible assets, this income stream has to be eliminated from the customer relationships valuation component by using this line as costs in this part of the model.

Charge for other technology

Charge for other technology – Represents revenue relating to patented/unpatented proprietary technology. It may be a subset of total business revenue. Revenue and growth rates should only be reflective of “market participant” synergies, not synergies specific only to Acquirer Co. The royalty technology rate should correspond to the estimated rate that would be required by a 3rd party to utilize the subject technology.

If and when other technology items are separately valued as intangible assets, this income stream has to be eliminated from the customer relationships valuation component by using this line as costs in this part of the model.

Income tax rate

Income tax rate – this should reflect the estimated effective tax rate for the acquired business (the rate would not be revised for any benefits that would be specific to Acquirer Co.).

Unit of measurement

Unit of measurement – the functional currency of the acquired business in units or ‘000 units, so for example EUR ‘000 or USD ‘000.

Partial first year factor

Partial first year factor – when the first year is not a full year, the factor has to be for example 10/12 if first time inclusion is beginning March of the year under review. Here the first year is a full year or 12/12 = 1.

Present Value Factor

Present Value Factor/Discount Rate – takes into consideration the Weighted Average Cost of Capital (WACC), Internal Rate of Return (IRR), and the Weighted Average Return on Assets (WARA). Note that the discount rate used for the intangible asset valuations should generally reflect a premium of 100 to 300 basis points over the WACC determined for the overall acquisition.

The present value factor is then calculated as follows: 1 / ((1 + i%)^n), i is the discount factor, 14.0% and n is year 1, year 2, …….. year 16, so year 1 = 1 / ((1.14)^1) = 0.8772 and year 16 = 1 / ((1.14^16) = 0.1229.

Present value of after-tax Cash Flow

Present value of after-tax Cash Flow – calculated as follows:

Year 1: after tax cash flow x Partial first year factor x Present Value Factor or Customer relationships valuation

412 x 1 x 0.8772 = 361,

Year 2: after tax cash flow x Present Value Factor or Customer relationships valuation

787 x 0.7695 = 606

Present value of tax benefits

Present value of tax benefits – calculated as follows: Customer relationships valuation

Year 1: Amortisation of present value of after tax cash flows x Present Value Factor x Partial first year factor x Income tax expense% or Customer relationships valuation

206 x 0.8772 x 1 x 25% = 45

Year 2: Amortisation of present value of after tax cash flows x Present Value Factor x Income tax expense% or Customer relationships valuation

206 x 0.7695 x 25% = 40

Valuation template

Here are the inputs etcetera for the first years and the excel sheet for reference: Customer relationships valuation

Customer relationships valuation

Excel sheet: Valuation Intangible asset Customers relationships

See also: The IFRS Foundation

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