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Brands: Whats in a name?

Careful consideration of brand


valuation issues can improve
dealreporting
March 2013
A publication from PwCs
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
tradenames.

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
ofassets?
What are the accounting differences
between a business combination
and acquisition of an asset or group
ofassets?

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
berecognized?
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
acquiredassets?
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

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
assembledworkforce.
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
businesscombination.

Potential aspects of a brand


Trademarks
Trade names
Product formulations/recipes
Marketing materials
Style guides
Websites and URLs
Unique packaging/tradedress

Brands: Whats 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 returneither 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
wasand was notacquired can
help determine whether the business
combination criteria have been met.

Yeah but what did I


reallybuy?

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
becomplex.

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 forimpairment.

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

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 assetassuming 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.

Brands: Whats 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
amortizationexpense.
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 productswhich
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
componentsindividually.

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
theproduct.

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
companys customer relationships help
contribute to the sales process and the
manner in which a return for these
relationships should be reflected in
thevaluation 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
thebrands.

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 assets 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
quitecomplex.
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
retailrevenues.

PricewaterhouseCoopers LLP

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
licensingtransactions.

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 companys 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

Brands: Whats 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 brands
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 acquirers 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 buyers
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

Useful lives and


amortization
Economic and useful lives are key
inputs into both the valuation
and subsequent impact to
income of acquired assets. Key
considerationsinclude:
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
usefullife
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
industrytrends
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,
IntangiblesGoodwill and Other.
Having no foreseeable limit to the
period over which the asset is expected
to contribute to the entitys 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: Whats 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
netincome.

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
lessburdensome.
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
impairmentcontext.

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 companys 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
transactionclose.
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
futuresurprises

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


dealconsiderations, please
contact one of our regional
leaders or your local
PwCpartner:

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

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