Brands: What’s in a name? Careful consideration of brand valuation issues can improve deal reporting March 2013 A publication from PwC’s Deals practice At a glance • Within the consumer products sector, brands are typically the most significant assets recognized in acquisition accounting under ASC 805. • Supportable valuation and accounting for the acquired brands is an essential step in acquisition accounting. • Valuation methodologies for brands may vary, but all require significant industryspecific judgment and expertise to ensure supportable measurement and to avoid audit surprises and the risk of restatement. Introduction For many consumer products companies, M&A transactions are often driven by the underlying brands. New brands can help fuel global expansion. On the flip side, brand divestitures can help hone product portfolio growth and profitability. However, brand-rich transactions can be fraught with accounting complexities. The main reason is that the term brand typically encapsulates multiple components above and beyond just simple trade names. Planning brand transactions with a careful eye on the valuation and purchase accounting issues can provide better insight into the potential accretive or dilutive impact of a deal, help improve and streamline postdeal accounting and even reduce the risk of impairment in some cases. Overlooking the complexities can result in unwanted surprises, audit delays and possibly even increased risk of impairment. Identifying the issues Some of the valuation and accounting issues acquiring companies face in light of this multifaceted nature of brands include: • If an entire company is not acquired, do the acquired brands constitute a business under ASC 805 (see box to the right) or should they be accounted for as an asset or group of assets? • What are the accounting differences between a business combination and acquisition of an asset or group of assets? Acquisition accounting basics • How should companies identify the unit of account for the assets acquired in a brand purchase? • What methodologies are appropriate in valuing acquired brands, particularly when customer relationship assets will also be recognized? • How will the valuation methodologies and inputs impact the assessment of useful lives, ongoing amortization and subsequent period earnings? • How will the initial valuation assumptions impact ongoing impairment testing for the acquired assets? • How should these valuation and purchase accounting considerations impact my due diligence process? FASB Accounting Standards Codification (ASC) 805 (formerly known as FAS 141R), Business Combinations, provides the framework for: • identifying the occurrence and timing of business combinations; • accounting for the consideration paid in connection with the acquisition of a business; and • allocating the consideration paid to the individual assets acquired and liabilities assumed. PricewaterhouseCoopers LLP 3 What did I buy? Purchase accounting first requires determining whether you acquired a business or simply an asset or group of assets. The answer guides how consideration is treated (as is the case for earn-outs) and the allocation method. For example, only a business combination can give rise to goodwill, and only in an asset acquisition can value be recognized for an assembled workforce. ASC 805-10-55-4 says that a group of acquired assets can be considered a business if the assets form an integrated set of activities capable of being conducted and managed for the purpose of providing a return to investors or other stakeholders. These criteria set a fairly low bar for classifying a transaction as a business combination. Potential aspects of a brand • Trademarks • Trade names • Product formulations/recipes • Marketing materials • Style guides • Websites and URLs • Unique packaging/trade dress 4 Brands: What’s in a name? For example, assume you acquire control of a group of assets. If you could generate a return with these assets either in isolation or by combining them with assets already owned or rented, a business combination would likely result. The acquisition accounting guidance under ASC 805 would apply in this example. Acquisitions within the consumer products sector typically involve the transfer of not only brands, but also additional assets such as an assembled workforce and manufacturing facilities. Therefore, most consumer products companies are able to generate a return—either from the assets acquired in isolation or by leveraging the acquired assets along with those assets already owned. Thus, these types of brand purchases often fit the criteria of a business combination. Although uncommon, certain brand acquisitions may be viewed as asset purchases rather than business combinations. If, for example, the only asset acquired is the rights to the brand itself, the criteria of a business combination may not be met. In rare circumstances, this conclusion could result even if the acquired rights included access to not only trade names and trademarks, but also product formulations, advertising materials or other components of what is typically considered a brand. Determining what constitutes an asset beyond the brand can be subjective. Clearly documenting exactly what was—and was not—acquired can help determine whether the business combination criteria have been met. Yeah… but what did I really buy? there is a single unit of account (i.e., an all-inclusive brand asset) or multiple separate units requiring individual valuations. This unit of account decision could consider, among other things, the extent to which these components have similar remaining economic lives. Whether the transaction is accounted for as an asset purchase or a business combination, the acquirer must sort out the various units of account to select the appropriate valuation methodologies and assumptions. When dealing with acquired brands, this unit of account question can often be complex. As an example, consider a company that determines the long history and expected perpetual use of the acquired trademarks would warrant an indefinite life. At the same time, the ever-changing nature of the product recipe lends itself to a finite life. These two components would need to be separately valued, amortized (for the finite-lived asset) and monitored for impairment. The complexity arises from the fact that brands in the consumer products sector typically include a range of components (see callout on page 4). More than one of these elements may be present in the purchase. Therefore, acquirers should determine whether In this context, acquirers should also distinguish between various types of brands within the acquired business. For example, when determining whether aggregation or disaggregation of assets is appropriate, an overarching corporate brand may have a different useful life and require different treatment when compared to a product-level brand. The latter is more likely to be heavily tied to specific recipes, marketing, etc. These aggregation decisions could have a sizeable impact on ongoing amortization and, therefore, net income. Intangible assets arising from consumer products acquisitions Acquired business Tangible assets Marketing related Identifiable intangibles Customer related • Trademarks • Distributor relationships • Trade names • Retailer relationships • Marketing materials • Order or production backlog • Style guide (unique color, shape or package design) • Mastheads • Contractual and non-contractual customer relationships • Domain names Other balance sheet items Technology related Contract related • Trade secrets, such as secret formulas, processes or recipes • Supply contracts • Patented and un-patented technology • Licensing and royalty agreements • Computer software • Lease agreements • Databases • Construction permits • Advertising, management and service contracts • Franchise agreements • Non-competition agreements Primary intangible assets for consumer product acquisitions PricewaterhouseCoopers LLP 5 Valuation methods The methodologies used to value an acquired brand will ultimately depend upon the components determined to be included within its unit of account. The two most common models for valuing marketing-related intangibles such as brands are: 1. the Excess Earnings method and 2. the Relief-from-Royalty method. These two methods are forms of the Income Approach, in which value is equated to a series of cash flows and discounted at an appropriate riskadjusted rate. The Excess Earnings method calculates the value of an asset based on the expected revenue and profits related to that asset, less the portion of those profits attributable to other assets that contribute to the generation of cash flow (e.g., working capital, fixed assets, assembled workforce, etc.). The Relief-fromRoyalty method, on the other hand, is based on a hypothetical royalty (typically calculated as a percentage of forecasted revenue) that the owner would otherwise be willing to pay to use the asset—assuming it were not already owned. In theory, the two methods should arrive at the same value. However, valuation specialists will typically reserve the Excess Earnings method for intangible assets deemed to be the primary driver of profits. The Relieffrom-Royalty method is often used for intangible assets deemed to be of secondary significance. 6 Brands: What’s in a name? In the consumer products sector, determining the “primary” acquired asset can be challenging. Both marketing-related intangibles (such as trademarks and trade names) and customer-related intangibles (such as distributor relationships and retailer relationships) can play key roles in driving product sales. The Excess Earnings method and the Relief-from-Royalty method can, at times, result in different values. Therefore, the selection of the appropriate methodology can have a meaningful impact on the ultimate valuation and ongoing amortization expense. To that end, an in-depth understanding of the landscape in which the brand competes and the key revenue drivers is needed to select an appropriate valuation methodology for each acquired asset. Additionally, because the two valuation methodologies have different inputs, the disclosure requirements can differ as well, something appraisers and filers need to consider when selecting an approach. Analyzing the promotional strategy of the acquired business is one way to determine the most appropriate methodology for acquired assets. As an example, brands themselves are often deemed to be the primary asset for “pull” market products—which distributors and retailers often feel pressured to carry because of highend customer demand. On the other hand, customer relationships are often primary for “push” market products for which significant promotional effort is usually required to gain shelf-space with distributors and retailers. These distinctions are not always easy to make. However, an all-inclusive brand asset that encapsulates all of the components mentioned previously (trademarks, trade names, formulations, style guides, etc.) is more likely to be considered a primary asset than any one of those components individually. Although outside the scope of this publication, various alternative methodologies may be appropriate in specific circumstances. Examples include methods that calculate the cost associated with recreating these relationships or another that utilizes the profit margin one would expect from a limited-risk distributor of the product. Examples of brand-rich transactions Acquirer Brand Seller Kellogg Pringles Proctor & Gamble Fila Titleist Fortune General Mills Yoplait n/a* Tempur-Pedic Sealy n/a* For illustrative purposes only *Complete company acquisition Application of the Excess Earnings method As noted previously, the Excess Earnings method values an asset based on expected future income, adjusted for the returns of other assets contributing to cash flow (i.e., “contributory assets”). When the brand is the primary asset and the Excess Earnings method is used to determine its value, careful consideration should be given to how the acquired company’s customer relationships help contribute to the sales process and the manner in which a return for these relationships should be reflected in the valuation of the brand. The Excess Earnings method cannot be used to value both brands and relationships due to the doublecounting of cash flow. Therefore, an alternative method should be applied to value these relationships. These alternative approaches might lower the value of customer relationships when compared to the Excess Earnings method. Reason: These relationships are deemed to be of secondary importance relative to the brands. A word on the Relief-fromRoyalty method All valuation methodologies require some level of subjectivity and judgement. However, the prevalence of the Relief-from-Royalty method and its perceived simplicity in valuing marketing-related intangibles often gives rise to some common pitfalls. As mentioned previously, the Relieffrom-Royalty method involves forecasting the asset’s revenue stream and an assumed royalty rate that a hypothetical third-party would be willing to pay for use of the asset. The latter input can often lead to a number of complications. Specifically, in making their rate selection, most practitioners will look to rates paid in arms-length licensing transactions for assets comparable to the one being valued. Although this method of selection may sound straightforward, determining what constitutes comparability can be quite complex. Practitioners should consider the comparability of the following factors, among others, when analyzing royalty rates observed in the market: • Assets. For example, a royalty rate paid for a trademark in isolation would likely be lower than one for a bundled asset including trademarks and product formulations. • Rights (e.g., geography, term and usage). All things being equal, a royalty rate paid for the right to use an intangible asset within a limited geography or specific customer channel for a limited time would likely be different than that paid for perpetual rights with unfettered usage. Similarly, consider the rights to use a trademark or trade name associated with a specific type of product. Usage rights in a unique context (e.g. the right to use a trademark associated with a popular brand of candy on a line of apparel) would not be truly comparable to using it within its own normal context (e.g. using the candy trademark on a candy product). • Economic returns. Typically, assets providing higher returns will warrant higher royalty rates. This issue may arise when comparing royalty rates paid at different points in the supply chain. Returns on wholesale revenues can differ significantly from those on retail revenues. PricewaterhouseCoopers LLP 7 The use of simplified rules of thumb may lead to inappropriate conclusions and create significant hurdles during an audit or regulatory review. • Upfront fees or ongoing cost sharing. Licensees who are willing to pay an upfront fee or share in future marketing or advertising expenses may be able to negotiate a lower royalty rate. but the same company or another in the industry earns only 12% on the sale of otherwise substantially similar unbranded products. The difference of 8% could be viewed as the incremental profit associated with the brand. These issues are just a sampling of those required to properly identify and analyze comparable licensing transactions. As an alternative analysis, start with the overall operating profit margin of the business and subtract returns for activities not specifically related to the brand. Such activities may include the manufacturing, selling and distribution functions, among others. The use of comparable agreements is one source of royalty rate information, but a number of alternative approaches also exist. One popular technique, often referred to as the Profit Split method, attempts to isolate the proportion of a company’s profit margin that can be specifically attributed to the brand itself. Valuation practitioners often use a number of “rules of thumb” to determine this proportion, but these shortcuts do not typically stand up well to scrutiny by auditors and regulators. Rather, acquirers should consider more case-specific information in making these determinations. Comparing profit margins for branded products relative to generic, or unbranded, products is one way to determine the profit associated with a brand. For example, consider a company that earns an operating profit of 20% on its branded product sales 8 Brands: What’s in a name? Representative returns for these non-brand functions can be gleaned from margins earned by outsourcing companies that perform these functions in isolation. Once the returns for these functions are subtracted from the overall profit margin, the remaining profit can be viewed as a proxy for the incremental margin attributable to the brand itself. The result can form the basis for selecting a royalty rate. Selecting an appropriate royalty rate for use in the Relief-from-Royalty method can be complex and requires significant valuation and industryspecific judgment and support. While common in practice, the use of broadly comparable licensing transactions or simplified rules of thumb may lead to inappropriate conclusions and create significant hurdles during an audit or regulatory review. Alternative valuation approaches Income-based methodologies are most prevalent in the valuation of marketing-related intangibles. However, certain aspects of a brand’s value can, at times, be estimated with alternative approaches. A Cost Approach may be most common for brand components that can be readily reproduced, such as product formulations. Even trade names can, in certain rare instances, be valued with such an approach if they were recently launched and have not yet been established in the marketplace. Again, the distinction between “push” and “pull” marketing may help guide the decision as to whether a Cost Approach is appropriate, as the cost to replicate a name or mark is a more relevant metric for “push” marketed products. Although extremely rare, a Market Approach can be considered to value the components of a brand that have an active market. In each instance, acquirers should carefully consider the facts and circumstances surrounding the transaction at hand. A note on defensive assets Defensive assets are generally intangible assets that an entity does not intend to use, but whose economic returns will be derived by withholding the asset from the market. A common example in the consumer products sector would involve the acquisition and retirement of a competing brand in an attempt to increase market share of the acquirer’s existing product. The valuation and selection of an appropriate amortization period for defensive assets can be highly challenging. As a general rule, the valuation assumptions should be based on the manner in which a market participant would expect to generate returns from the asset. These assumptions can vary significantly depending on whether other market participants would also use the asset strictly for defensive purposes. For example, if market participants would be expected to use an asset in a more traditional, non-defensive manner, the valuation should reflect this use and would likely take the form of a more typical asset valuation. But what if market participants similarly used the asset for its defensive purposes only or discontinued the brand outright? Then, the valuation should reflect only those economic benefits associated with this form of use (i.e. increased market share, ability to increase prices, etc.). Identifying market participants, determining expected asset use and quantifying defensive use benefits all require substantial industry expertise and judgment. Valuation should be performed from a market participant perspective, but amortization should be based on the buyer’s expected use of the asset. As a result, the life of the cash flows used to value the asset may be unrelated to the amortization period assigned to it. Specifically, the acquirer should consider the period over which economic benefits from its defensive use of the asset are derived. Generally, defensive assets are not expected to diminish in value immediately, but over a period of time due to the lack of support for the asset (e.g. lack of advertising and marketing efforts to maintain the asset, etc.). To that end, defensive assets are rarely assigned an indefinite life. PricewaterhouseCoopers LLP 9 Useful lives and amortization Economic and useful lives are key inputs into both the valuation and subsequent impact to income of acquired assets. Key considerations include: • The period over which the asset is expected to be used and to contribute to cash flow • Any legal, regulatory or contractual provisions that may limit the useful life • Historical experience in the use of similar acquired assets • The impact of anticipated changes in consumer demand and tastes as well as other economic and industry trends • The level of expenditures (including ongoing marketing and advertising) required to maintain the asset • The life of other related assets Furthermore, acquirers should consider whether any of the acquired assets qualify for indefinitelived treatment under ASC 350, Intangibles—Goodwill and Other. Having no foreseeable limit to the period over which the asset is expected to contribute to the entity’s cash flows Acquirers should exercise as much foresight as possible at the initial measurement date to set a robust framework for impairment testing in future periods. 10 Brands: What’s in a name? is the key criterion for such classification. Well-known brands within the consumer products sector often meet this hurdle, as companies usually expect to continue supporting these assets with ongoing marketing efforts. The factors that impact the amortization period of an asset are similar to those that should be considered in determining the economic life of the cash flows used to value that asset. For that reason, companies will typically look to the period over which the cash flows used in the assets’ valuations are forecast to select an appropriate amortization period or indefinite-life classification. Reconciliation (but not necessarily equivalence) between the valuation forecast term and the amortization period is often required in the eyes of auditors and regulators. The selection of the appropriate amortization period can play a large role in postdeal dilution. Therefore, acquirers and valuation specialists should strongly consider the interplay between the valuation assumptions and the resulting impact on ongoing net income. Impairment testing Supportable initial valuations and the selection of appropriate amortization periods (or determination of an indefinite life) are critical not only for post-deal dilution analysis, but also for ongoing impairment testing. The initial assumptions and methodologies used to value an asset in purchase accounting typically form the basis for how that asset is assessed for impairment in later periods. To that end, acquirers should exercise as much foresight as possible at the initial measurement date to set a robust framework for impairment testing in future periods. With regard to the useful life determination, the impairment test for indefinite-lived assets differs significantly from that of finite-lived assets. Specifically, indefinite-lived assets are usually tested for impairment under ASC 350 on an asset-by-asset basis, whereas finite-lived assets are only tested for recoverability (a significantly lower hurdle to overcome than the fair value test for indefinite-lived assets) under ASC 360. They are often grouped together with other assets into an asset group for testing purposes, potentially providing additional protection from impairment. As a result of these differences, brands assigned a long (but finite) life are typically less prone to impairments than those assigned indefinite lives. Furthermore, indefinite-lived assets must be tested at least annually for impairment. Finite-lived assets are only tested upon the occurrence of a “triggering event”. To that end, testing finite-lived assets is typically less burdensome. It is also worthwhile to note that the valuation considerations noted above regarding selection of the appropriate valuation methodology and assumptions also come into play when determining the fair value of brand-related assets within the impairment context. How does this impact pre-deal diligence? To structure and communicate acquisitions effectively, companies must understand the impact of purchase accounting on the newly merged company’s earnings. A focus on more robust pre-acquisition valuation helps mitigate the risk of purchase accounting estimates being significantly different from what is ultimately recorded at transaction close. This is more important than ever as a result of the new accounting standards increasing the potential for post-close earnings volatility. Companies will be better positioned to assess the accretive or dilutive impact of a transaction if an effective preacquisition valuation is performed during the due diligence phase. Thoroughly thinking through the valuation and purchase accounting issues during the due diligence phase of a deal provides a number of benefits: • Better insight during due diligence on the accretive/dilutive impact to EPS and financial reporting considerations for the proposed transaction Conclusion Acquisitions in the consumer products sector give rise to a number of valuation and accounting issues that require strong familiarity with the technical accounting guidance as well as deep industry experience. A number of these complications arise as a result of the large role that multifaceted brands play within the industry. Classification of the transaction as a business combination or asset acquisition, determination of the unit of account for the acquired assets and the assignment of useful lives all necessitate a deep understanding of the applicable accounting guidance. The identification of market participants and the selection of appropriate valuation methodologies and assumptions require substantial technical valuation and industry expertise. The combination of these two skill sets will allow for better planning for post-deal dilution, a more streamlined review by auditors and regulators, and a robust framework when considering the possibility of any future impairments. • Greater efficiency resulting from more up-front valuation analysis that can be more easily converted to a post-transaction valuation • Improved communication with stakeholders to help set the right expectations upfront and avoid future surprises PricewaterhouseCoopers LLP 11 www.pwc.com/us/deals To have a deeper conversation about how this subject may affect your business, please contact one of our retail & consumer specialists: For a deeper discussion on deal considerations, please contact one of our regional leaders or your local PwC partner: Andrew Pappania Principal, Deals Valuation Services (646) 471 0538 andrew.pappania@us.pwc.com Martyn Curragh Partner, US Deals Leader (646) 471 2622 martyn.curragh@us.pwc.com Reto Micheluzzi Partner, Deals Accounting Advisory Services (415) 498 7511 reto.micheluzzi@us.pwc.com Reuven Pinsky Director, Deals Valuation Services (646) 471 8231 reuven.pinsky@us.pwc.com Gary Tillett Partner, Deals New York Metro Region Leader (646) 471 2600 gary.tillett@us.pwc.com Scott Snyder Partner, Deals East Region Leader (267) 330 2250 scott.snyder@us.pwc.com Mel Niemeyer Partner, Deals Central Region Leader (312) 298 4500 mel.niemeyer@us.pwc.com Mark Ross Partner, Deals West Region Leader (415) 498 5265 mark.ross@us.pwc.com PwC provides tactical and strategic thinking on a wide range of issues that affect the deal community. 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