Can intangible assets bridge valuation gaps?
By Smith C. Lim
First Published in Business World (10/14/ 2013)
IN EY’S latest Capital Confidence Barometer, 1,500 senior executives in 41 countries were polled, and a quarter of the respondents said they will not do a deal because of the gap in the price expectations between sellers and buyers or investors.
For sellers, especially those operating either in fast-growing developing economies or in highly profitable or high-growth industries, their continuing expectation of rising revenues push their price expectations upward. Sellers usually demand a premium for their companies, which may consequently discourage potential buyers.
On the other hand, buyers or investors are usually unwilling to pay top money for acquisition targets due to the following factors:
• The risks of delving into new markets;
• Increased complexity in the business environment due to limited information; and
• Challenges in realizing anticipated synergies and other benefits of integration.
So, how can this gap in the valuation be bridged?
CONSIDER INTANGIBLE ASSETS
EY ASEAN Valuations & Business Modeling leader Andre Toh has said that the identification of intangible assets and the ability to communicate their role as growth creators and value drivers could bridge this valuation gap. He explains: “For investors, a clearer identification of intangible assets will provide better information to assess the intrinsic value of the target and rationalize the bid price. For vendors, they can better articulate value drivers and address the difference between pricing and value.”
Thus, while a seller cannot recognize internally generated intangible assets in its books, it can consider these during negotiations.
This supports the rationale behind Philippine Financial Reporting Standards (PFRS) 3, Business Combinations, requiring buyers or investors to separately recognize intangible assets in the purchase price allocation (PPA) process. Since accounting is the language of business, there is a need to clearly articulate to stakeholders the underlying reasons for a purchase price exceeding the fair value of a target’s recorded net assets by a significant margin. It is likely that intangible assets account for a substantial portion of this seeming “excess” in the purchase price.
PURCHASE PRICE ALLOCATION AS AN AFTERTHOUGHT
Unfortunately, for most buyers or investors, the PPA process is an afterthought given appropriate attention only after the deal has been closed. In some situations, performing the post-transaction PPA simply to comply with financial reporting requirements has led to the impairment of goodwill and/or other intangible assets shortly after the acquisition.
Buyers and investors realize the value of the PPA as they become more familiar with the process. This has prompted some companies to initiate a pre-close PPA as early as the due diligence phase. If sellers can detail the assets that are being sold as part of the transaction, and if buyers or investors can have a better appreciation of what they are buying, it is anticipated that the gap in valuation pricing can be better bridged.
DEFINING INTANGIBLE ASSETS
Philippine Accounting Standards (PAS) 38, Intangible Assets, defines an intangible asset as an identifiable non-monetary asset without physical substance. For non-accountants, an intangible asset is a non-monetary, non-physical asset which gives a company a competitive edge. Porter’s Five Forces Model is a useful tool for identifying intangible assets, viz:
• Buyers (e.g. customer contracts and relationships);
• Suppliers (e.g. exclusive distributorship agreements);
• Potential entrants (e.g. franchise, license, non-compete agreements);
• Industry rivalry (e.g. brand, trademark); and
• Substitutes (a combination of intangible assets from potential entrants and industry rivalry).
PAS 38, on the other hand, classifies intangibles by their nature such as:
• Marketing-based intangibles (e.g. brand, trademark);
• Customer-based intangibles (e.g. customer relationships);
• Contract-based intangibles (e.g. agreements);
• Technology-based intangibles (e.g. custom-made software); and
• Artistic-based intangibles (e.g. copyright)
To bridge the valuation gap, the first step is to identify potential intangible assets using either an analytical framework (such as Porter’s Five Forces Model), or by going through a checklist (as enumerated in PAS 38). By doing so, the value of the identified intangible assets can be estimated.
VALUATION OF INTANGIBLE ASSETS
The common methods used to value intangible assets are:
• Multi-period excess earnings method approach. This method attempts to isolate the intangible asset value by deducting “contribution charges” from other assets (such as fixed assets and working capital) that help the intangible asset in value generation. This is commonly used to value customer-related intangible assets and addresses the question: “Do my relationships with these customers generate value over and above my opportunity costs for fixed assets, working capital, and other assets?”
• Relief from royalty method. This attributes the value of an intangible asset from the theoretical royalty cost savings of owning said asset. This is commonly used to value marketing-related intangible assets and addresses the question: “How much royalty savings do I get from having my own brand instead of borrowing brands from others?”
• Greenfield approach. This attributes the value of an intangible asset from its hypothetical start-up value. This approach can be used to value a congressional franchise and addresses the question: “What would the standalone value of the intangible asset be — assuming I have to rebuild the infrastructure required to support its operation from scratch?”
In performing the valuation analysis, it is helpful to keep asking questions to further understand the source of the underlying value and substantiate the existence of such an intangible asset.
After considering the respective fair values of tangible net assets, and after intangible assets have been properly identified and valued, the “excess” purchase price is generally recognized as goodwill. PFRS 3 attributes goodwill to the following:
• The fair value of the going concern element of the target’s existing business. This represents the ability of the established business to earn a higher rate of return on an assembled collection of net assets than would be expected if those net assets had to be acquired separately. The value stems from the synergies of the net assets of the business, as well as from other benefits, such as factors related to market imperfections, including the ability to earn monopoly profits, and barriers to market entry (by potential competitors, whether through legal restrictions or costs of entry); and
• The fair value of the expected synergies and other benefits from combining the net assets and businesses of the buyer and seller. These are unique to each combination. Different combinations would produce different synergies and, hence, different values.
Why recognize separately?
Accounting separately for goodwill and other intangible assets gives buyers and investors a clearer view of the value proposition behind the transaction price. It also results in more transparent financial reporting as it separates values arising from intangible assets with definite lives from those intangible assets (including goodwill) with indefinite lives. This separation is critical as their post-recognition treatment differ.
An intangible asset with a finite useful life is amortized; whereas an intangible asset with an indefinite useful life is not. It is only subject to impairment testing. Amortization of definite-lived intangible assets gives earnings more predictability, as it reduces the risk of impairment. On the other hand, allocating the entire excess purchase price to goodwill increases the risk of impairment, which drives volatility of returns since impairment occurs normally during years of low income. Greater predictability reduces risk, which should ultimately decrease the required rate of return, which in turn, should drive up asset value.
Ideally, consideration of the proper accounting of the transaction price should be performed early in the transaction life cycle to reduce potential deadlocks in negotiations. It can also lessen the likelihood of impairment immediately after the acquisition. Attempting to bridge the valuation gap early on allows sellers and buyers to be on the same page as far as valuation and pricing expectations are concerned, leading to a better chance of agreeing on the transaction price, and eventually sealing the deal.
Smith C. Lim is a director in the transactions advisory services group of SGV & Co.
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.