Customer relationships Distributor Method

Customer relationships Distributor Method is a valuation model to determine the value of the existing customer relationships portfolio in a business combination, in order to recognise it as an intangible assets other than goodwill. Customer relationships Distributor Method

The Distributor Method (DM) is not as commonly used as the Multi-period excess earnings method (MPEEM) to value the customer relationship asset, even though the DM is simply one application of the MPEEM. The main theory behind the DM is that “a business is composed of various functional components (such as manufacturing, distribution, and intellectual property) and that market-based data may be used, if available, to reasonably isolate the revenue, earnings, and cash flow related to these functional areas1.”

The DM assumes that the returns to a customer-related asset are comparable to the economic profits generated by a hypothetical intermediary (i.e., the distributor).

The DM is appropriate to use when another intangible asset (i.e., technology or trademark) other than the customer relationship asset is determined to be the primary asset of the company, while the customer relationship asset is determined to be the secondary asset. The DM is used most frequently in valuations where the brand is the primary asset. Customer relationships Distributor Method

The DM is also appropriate to use when relevant market data is available. In the DM, a royalty rate is determined for the customer relationship asset based on the profit margins of comparable distribution companies operating in the same industry and applied in an MPEEM. The determination of the appropriate royalty rate includes a downward adjustment for contributory asset charges.

When a company has strong-branded and recognisable products, retailers and distributors (i.e., the company’s customers) want to sell the company’s products due to consumer demand, not due to the customers’ relationship with the company. The relationship with the distributors is based on the company’s ability to provide the desired products in a timely and efficient manner, analogous to the distributor’s relationship with its customers in providing the products in a timely manner.

The distributor’s operating margin reflects the importance of intellectual property relative to the customer relationship. The distributor earns lower margins on more unique or proprietary products, which reduces the value generated by the customer relationship function. For products that are less unique, the customer relationship adds more value, which increases the distributor’s margins. Customer relationships Distributor Method

The initial inputs, revenue, growth, and attrition rates, used in the DM are similar to the inputs used in the MPEEM to value the customer relationships. After the initial inputs in the DM, the fundamentals (i.e., the margin and contributory asset charges) of a distributor in the same industry are applied to the resulting revenue stream associated with the customer relationship. Customer relationships Distributor Method

Since the margin and contributory asset charges are based on those of the distributor, the DM may be viewed as a profit split method. The margin of the distributor is already reduced by the cost of any other intellectual properties (e.g., technology and brands) captured within the distributor’s cost of goods sold.

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Since the cost of other intellectual properties is already included in the distributor’s cost of goods sold, contributory asset charges should include only charges for working capital, tangible assets, and assembled workforce. These contributory asset charges are expected to be low for distributors.

Distributors often have rapid turnover in assets, thus reducing the amount of working capital requirement. Tangible asset requirements are also expected to be low. This is because distributors typically do not manufacture any products and, thus, do not own such capital assets. The contributory asset charge for assembled workforce is expected to be lower as well, as only the contributory asset charges on the employees involved in the sales and distribution need to be accounted for.

Case study

A large consumer packaged goods company needed to value its acquisition of a leading manufacturer and distributor of snacks. The acquired brands were iconic in their region. Formal data and anecdotal evidence demonstrated the strength of the brand. Market research indicated strong brand equity, and anecdotal evidence abounded in support of the brands. There were tales of stores deciding not to carry the brand and losing customers. There were consumers who refused to go to stores that did not carry their favourite products. Customer relationships Distributor Method

Additionally, the company’s customers—retailers—carried the brand because of customer demand, not because of their relationship with the company. As such, the company does benefit from having an assembled base of retailers and the related ability to reach consumers. Customer relationships Distributor Method

Based on these factors as well as the similarity of the relationships the company holds with its customers and the relationships distributors hold with their customers, it was decided to apply the distributor method (use of distributor inputs in the MPEEM) to value the customer relationships.

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In turn, the MPEEM was utilised using the prospective financial information (PFI) to value the brand. It was determined that this method was less subjective than the traditional approach of trying to select an appropriate royalty rate from a list of royalty rates of limited comparability. Customer relationships Distributor Method

Calculation discussion

The value of the customer relationships is estimated by applying the fundamental data (margin and contributory asset charges) of a distributor to the revenue stream associated with the relationships being valued. In applying this calculation, the method dis-aggregates the value added by specific business processes/IP. This method may also be viewed as a profit split. Customer relationships Distributor Method

It’s important to note that the key inputs, and in particular the margin and contributory asset charges, are based on those of the distributors. The margin is lower than the brand margin since any IP, including technology and brands, is captured within the distributor’s cost of goods sold.

Additionally, contributory asset charges (CACs) are consistent with a distributor—fixed assets are those used in distribution, not manufacturing—and are typically lower than that of a manufacturer. Customer relationships Distributor Method

Working capital is that of the distributor and may be higher or lower than that of a manufacturer, depending upon working capital practices within a given industry. The CAC for use of the workforce is likely lower than for the IP-owner as it only includes individuals involved in sales and distribution, as opposed to IP-related functions including R&D and marketing. Customer relationships Distributor Method

For a distributor, the workforce CAC may even be immaterial. In this example, the income stream was not adjusted for a CAC for the use of the distributor’s trade name, as it was considered that the importance of this factor was immaterial. In other cases, it may be appropriate to apply a CAC for one or more of these assets. It is important, however, that they be the assets of the distributor (distributor corporate name or logistical software), not the assets of the brand/subject entity (brand name or proprietary manufacturing processes). Customer relationships Distributor Method

The incremental value (in this case largely reflected in a brand margin that substantially exceeds the margin used to value the customer relationships but also in differing contributory asset charges) is captured via other valuation methodologies and is ascribed to the appropriate asset (in this case, the brand).

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It’s important to note that application of the distributor method without use of a brand/company level MPEEM would likely leave a substantial portion of the margin/economic profit unaccounted for and thus include it as goodwill. In practice, the distributor method is not used that frequently to value the customer relationships if the MPEEM using the full PFI was not used to value another asset. Customer relationships Distributor Method

Other attributes of the DM are similar to the traditional MPEEM. Inputs such as revenue, growth rates, and attrition rates are needed. These inputs are typically the same whether viewed from a distributor or brand-specific perspective. The exhibit below illustrates the use of the distributor method (use of distributor inputs in the MPEEM) to estimate the value of customer relationships for a transaction in the consumer products industry. Customer relationships Distributor Method

Customer relationships Distributor Method

Customer relationships Distributor Method


Customer relationships Distributor Method

Customer relationships Distributor Method

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