Determining the Economic Benefits of Customer-related Intangible Assets

Posted on July 18th, 2024 in Business Valuations

This is the second article in a series on intangible assets and the various valuation methodologies and considerations. First article: Unlocking the Value: Understanding Intangible Assets in Business Valuation

Customer-related intangible assets present insight on customers and their buying patterns. This can be analyzed to execute the development of new products or services, align a company’s strategic initiatives, or expand to new markets and geographic locations. Examples of customer-related intangible assets include customer lists, customer relationships, and customer contracts.

Organic growth vs. Inorganic growth

A business can grow through two categories: organic growth and inorganic growth. Organic growth is natural growth from existing operations, such as selling more products, reducing costs, or improving efficiency.

In contrast, inorganic growth is rapid growth of a business through acquisition or expansion resulting in an immediate increase in market share. Through a business acquisition, a competitor’s customer-related intangible assets can also be obtained to gain a competitive advantage. Accordingly, customer-related intangible assets are a commonly identified intangible asset in a business acquisition.

In this article, we address some of the nuances in valuing a customer-related intangible because of a business acquisition.

Customer lists vs. Customer relationships

A customer list contains customer information, such as personal, behavioural, or demographic data and can even potentially be re-sold. A purchaser can use this information to determine a target demographic when marketing new products and services or expanding existing product offerings.

A customer relationship is based on a history of sales transactions. The value of a customer relationship depends on how often purchases are made, the friction or costs to find and replace customers, and how dependent those customers are on the business. The benefits of a strong customer relationship include customer retention, loyalty, referrals, and satisfaction. A contract does not need to exist for a customer relationship to have value, as long as there is an expectation of the relationship to continue.

Customer contracts

Customer contracts not only provide an estimate of future profits, they can also provide economic reassurance to the purchaser during a business acquisition. A contract can exist in various forms such as verbal, written, express, or implied. An intangible asset can exist as long as the contract is legally enforceable. The specific contract terms are reviewed when determining the value of a customer contract.

In addition, customer’s purchasing patterns, length of the relationship, and potential of renewal also need to be reviewed to meet specific financial reporting and accounting standard requirements when valuing intangible assets in relation to the definition of fair value.

Customer attrition rate

Customer attrition is the expected future loss of customers or decline in future customer purchases and is based on historical revenue or customer count to provide an indication of future expectations. The selection of the customer attrition rate is based on historical data, future forecasts, and the following factors:

Customer segmentation: Separating customers based on their as personal, behavioural, or demographic data will improve accuracy of the customer attrition rate.

Loss occurring at a variable or constant rate: The rate of customer loss can occur early in the relationship, later in the relationship, or be constant regardless of the age of the relationship. The telecommunication industry has a high rate of customer loss early in the relationship because of competition and relative ease for customers to switch providers.

When a customer is considered “lost” can vary depending on the product or service offered. For a music or video streaming service, a customer may be considered lost after cancellation as the relationship can end very easily. However, for a home appliance or home furnishings store, a customer may not be considered lost until five years have passed with no sales due to the periodic and large nature of purchases from those stores.

If you have any questions or require assistance regarding business combinations and valuing customer-related intangible assets, please contact a member of our Financial Services Advisory Team (FSAT) team.