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The valuation of customer relationships. By Hugh Osburn

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5th Jun 2007
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This article is the tenth in a series which examines the implications of the valuation provisions in the new accounting standards from the perspective of their impact on both tax and financial reporting. Importantly, implications of the new accounting standards can impact not only the large quoted companies but also small and medium sized companies.

Basic concepts

“Lifing” the customer relationships

The key factor in being able to value customer relationships is to be able to determine their remaining useful economic life, or "life" them. If one is unable to life them then, strictly, they should be regarded as unlikely to be a separately identifiable intangible asset – and so merely form part of the goodwill of the business. We will return to the issue of how to life these relationships later on.

Contractually-based versus casual customers and/or passing trade

In order to value intangible assets for financial reporting purposes, they need to be separately identifiable. In the case of Customer Relationships, this requires that these should be of an essentially contractual nature – with the services or products supplied having been invoiced, and probably with these having been the subject of purchase orders placed by the customer in the first place. Additionally it is important that the business separately identifies these customers in its accounting records.

Any customer relationships not satisfying the above criteria are likely to be more correctly classified as causal or “passing trade” – and therefore merely forming part of the Goodwill and, as such, not forming part of a separately identifiable intangible asset.

Customer relationships do not exist on their own

While customer relationships can be valuable, seldom can these be regarded as existing only in their own right. They need to be underpinned by something else which causes the customers to want to maintain their relationships with the business in question – such as superior technology, better service, unique skills, preferential location, or even much cheaper and/or more effective processes or facilities.

Where the customer relationships are perceived to be sufficiently important to be valued separately, therefore, one can generally expect that these should not be the only assets being valued (i.e. apart from goodwill).

Factors influencing customer attrition rates
Inherent advantage: Where a customer gains no specific advantages from purchasing from a given business instead of from its direct or potential competitors, then that business is likely to suffer much higher customer attrition rates than those businesses which do offer their customers some distinct, specific advantages.

Nature of the business: On the other hand, often the nature of any particular business tends to be a principle driver for customer retention. For example, certain businesses work on an engagement by engagement basis and may supply goods or services which are of a capital nature, e.g. infrastructure upgrades, which may not be required by smaller customers every year. Such businesses can expect to have lower customer retention than other businesses which provide services on a contracted and on-going annual basis (such as, for example, maintenance support contractors).

Contracts, orders-in-hand and customer relationships
Customer relationships theoretically include existing customer contracts and orders-in-hand, though the latter are usually valued on a different basis. For example, customer contracts are valued over the anticipated life of those contracts, while the value of the on-going customer relationships is determined by the probability of those contracts being “rolled-over”. In consequence, the cash flows associated with the customer relationships are perceived to be more risky than for the contracted cash flows, and so their valuation generally requires use of a higher discount rate. On the other hand, where customers can break their contracts with little penalty, then it may be more realistic not to separately value such contracts.

With orders-in-hand, one needs to be careful to not double-count values already included in the work-in-progress figures. In valuing such orders separately, moreover, their risk (and hence applicable discount rate) is also generally perceived to be lower.

Valuation methodologies

Residual income approach
Normally one values Customer Relationships on a Residual Income basis, i.e. after identifying and valuing all the business’s other significant “contributory assets” -including tangible fixed assets, net working capital and specific intangible assets - and then deducting an economic return on the value of all such “contributory assets” in valuing the Customer Relationships.

In the above context, note that one generally also values the Assembled & Trained Workforce (generally on a “cost-to-recreate” basis) and includes it along with the other “contributory assets”. This applies despite the Workforce subsequently being re-classified and its value included in the figure for Goodwill.

Market approach
Broadly comparable guideline companies can generally be used to value a subject business enterprise using the Market Approach, which approach effectively values the subject business’s whole “bundle of assets” as one entity. On the other hand, the Market Approach is unlikely to provide a credible framework for trying to value Customer Relationships.

The main reason for the above is that customer relationships do not exist in isolation and are generally associated with other assets which underpin their value. The varying nature of different businesses even within the same market sector, moreover, makes it unlikely that one can identify guideline companies which are sufficiently comparable to each other and to the subject company in all respects except for their customer relationships, to enable their use in a comparative market valuation of just this one intangible asset.

Cost approach
For any given business entity, it is only practicable to value one asset on the above-mentioned “residual earnings” basis. So, in a situation where it was determined that it would be more appropriate to value another asset on this basis – such as proprietary technology and/or know-how, say – then it would be necessary to value the Customer Relationships using the cost approach.

The main disadvantage with the cost approach is that it is very easy to undervalue the true costs associated with trying to acquire (and retain) customers as, invariably, the inexperienced appraiser is likely to try to quantify the costs in terms of the effort and resources required to attend a certain number of meetings, including the travel involved, assessed as necessary to secure a new customer. Often overlooked is all the effort involved in subsequently earning the customer’s trust and in instilling in him sufficient confidence to place follow-on orders with the business in future years.

As a pragmatic alternative approach, one can look at the full costs of the existing business development and customer service functions, and make an assessment of how high (or how low) a proportion of the overall customer base these functions are responsible for gaining and retaining, on average, during any one financial year. One does of course need to include in this estimate an appropriate share of the full costs of other senior executives involved in these activities, even although they may not formally be included within the designated departments. Then use this annual cost estimate and the assessed proportion of the customer base so affected, to give the overall assessed value of the business’s customer relationships.

Tax amortisation benefit
Although it may be felt obvious that Customer Relationships with longer lives should be more valuable than those with shorter lives, this is not always necessarily so. This is because in those cases where the identifiable assets of the business have been purchased, the value of these assets can be written off for UK tax purposes over the identified remaining economic life of those assets. The shorter this life, the greater the associated tax amortization benefit.

Countering the above effect, of course, is the impact of a shorter life in terms of a lower original value to be amortized in the first place. Under certain situations, however, the two influences can balance one another – so the net outcome may not be immediately apparent.

The lifing analysis

Introduction and historical perspective

As mentioned at the start of this article, the key factor in being able to value Customer Relationships is to be able to life them. Nevertheless, particularly in the USA, a commonly held view is that more superficial lifing analyses are tolerated for financial reporting purposes than was previously the case when such analyses were conducted for tax purposes (which, owing to a change in the applicable law, are no longer required).

While we may accept the above observation as valid, nevertheless simply analyzing changes in customer turnover levels from one year to the next can result in the occasional highly suspect and often very misleading indications of the relevant average customer lives. On balance my experience shows that, provided one is geared up to undertake a more rigorous lifing analysis in the first instance, one generally ends up expending less time and effort than in trying to rectify the obviously flawed results of what may have been initially intended to be more superficial, and quicker, approach.

Key steps and factors to consider in the lifing analysis:

1. The customer lifing analysis is conducted to identify the effective customer attrition rate, which itself can generally be anticipated to vary with the age of the relationship. For example, the probability of recently acquired customer relationships being terminated is often much higher than that of older, well established relationships.

2. From a pragmatic standpoint, use annual customer revenue figures.

3. Where price inflation may be a problem – say anything higher than 4% or 5% per annum – then it is worth adjusting the historical data to remove the effect of inflation before commencing the analysis.

4. While at least two year’s data (which yields one data point) is clearly better than none at all, try to obtain at least 6 years’ historical data.

5. Six years of annual customer revenues will yield five data points and so provide an acceptable stub curve, to which the most appropriate trend-line can readily be fitted using Excel’s built-in functions.

6. By judicious use of the “Sort” function (provided within Excel and most other spreadsheet packages), sort the customer revenue data into annual tranches, identifying the customer revenues commencing in each successive year.

7. Starting with the earliest annual tranche, then further split these tranches down into those customer relationships lasting over one, two, three, four, five and six years respectively. Of course, each successive annual tranche will drop a year, until the most recent tranche will consist of just one year’s (or less) customer revenues.

8. Note that with six years’ historical data, the probability of a customer relationship being terminated after, say, two years will actually be determined as the average of four separate calculations – with each being based on the data provided by successive annual tranches.

9. In situations where there can be significant fluctuations in a given customer’s revenues one year to the next, it may be appropriate to identify those cases where there is such a significant reduction in the annual revenues that the previous relationship should be regarded as having been terminated (and perhaps a new relationship having been established, albeit at a much lower level).

    a. As a general rule of thumb, a reduction to less than say 15% of the previous year’s revenues, provides a pragmatic indication of such an event having occurred.

    b. An alternative approach is to specify an appropriate level of revenues as a cut-off point for the purposes of the analysis, where any revenues below that level are ignored and left out of the analysis. Such cut-off points may sensibly be linked to management authorisation levels, though preferably should be chosen so as to exclude not more than say 10%-15% of the total customer revenues during any one year.

10. Where a number of separately identified customer accounts form an integral part of one decision-making unit, it may be more appropriate to group these accounts together and treat them as just one “reporting customer” unit.

11. Where monthly data is available, and/or one can identify those customer relationships which were already established as of the first available historical data, then it may be possible to add an additional data point the stub curve – which can be particularly useful should one only have just four year’s historical data i.e. which would normally yield just three data points on the stub curve.

12. In a similar manner, monthly data may allow one to distinguish between those customer relationships which have already terminated prior to the end of the latest available set of annual data and those which are still continuing. Once again, therefore, one may be able to add a further data point to the stub curve.

13. The availability of monthly data, moreover, may also allow other more intelligent adjustments to be made to data – such as may be appropriate where a significant acquisition has occurred part way through a year. Remember that one is identifying the average customer revenues obtained over the specified number of years. Any figures based only upon unadjusted partial years’ results, therefore, may well introduce an unacceptable distortion into the overall analysis.

Forecasting the customer revenues

It may seem to be an obvious point, but the forecast of customer revenues needs to be built up by forecasting each annual tranche of customer revenues separately. The reason is that every tranche consists of customer relationships at a different point along the lifing curve – and so, typically, one can expect the older, well established customers’ revenues to decline at a lower rate than those of the newest customers.

© retained by ADOPT Training

Hugh J Osburn
ADOPT Training
e-mail: [email protected]
Tel/Fax: +44 (0)1257 272899

Previous articles

Negative goodwill and valuation of buildings with trading potential
Valuing R&D projects in the biotech sector
Share-based payments: Valuing the impact of performance conditions
Valuing your unquoted company's shares - updated
The valuation of employee share options and share-based payments
The valuation of technology
The valuation of brands
The new accounting standards and valuation

The management of brands to maximize value

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