New Privacy Regulation and Valuing Customer Intangibles
Financial reporting and developing valuation practice
In financial reporting contractual and non-contractual relationships are recognised separately from goodwill if they can be identified independently from the entity, or from other rights and obligations. Customer lists and database are clearly separable if for example they support a loyalty scheme.
Our view –a reasonable test for separability is to consider whether the asset is capable of a third party licence.
Customer and Data Intangibles – Valuation Methods
Historically valuation techniques often addressed these assets by way of a residual income basis after the contribution and economic returns of other intangibles, intellectual property and fixed assets – often referred to as the “multiple period excess earnings model” (“MEEM”). The market approach has been found to be more useful than usual in the intangible folder. Unlike many intangible asset categories sales of discrete customer intangibles and data occur (for example on price per customer) and are sufficiently identifiable to provide some comparison. Cost methods are also helpful (say in securing a customer and similar) and so much with data is measurable development and maintenance (advertising, calling, mailing, entertaining, recording etc), and opportunity cost (time) in creation. Such costs are easily underestimated and under-recorded and it is wise to cross check valuations with the overall business development function cost across marketing and senior executive positions.
While the how long and useful life applications during these processes acknowledge that obsolescence is difficult to quantify; age profiles will reflect survivor curves, functional life will reflect such as the maintenance and age of ‘directories’ and digital indexing, technological life (possibly relying on complex algorithms and code) determines speed and efficiency, and economics will consider state of art in the specific competitor subject market.
Income approaches and the economic return calculations of customer longevity will adapt discounted cashflow methods and adopt relative probability weightings of erosion (lapse ratios), profitability and include various segmentations to such as repeat long relationships against such as new business with perhaps a riskier customer profile. This will mean various forecasts to various portions of customers and data, each with difference lives and risk, each with a different valuation.
Having said that, it is easy to under-record data costs, particularly in highly integrated and managed businesses when valuing customer relationships and data. In purchase price allocations under IFRS3 and FRS 102, companies have been surprised by the magnitude of the value allocated to this asset category. This has challenged valuation professionals using traditional methods, methods which are often applied too mechanically and have not considered sufficiently whether the value conclusion is consistent with a market participant’s view of the customer relationships.
Our view –in many industries customer relationships and data is not the most important asset, and traditional valuation methods could too easily reflect customer relationships as a primary asset, overlooking that customers often purchase products or services because of the presence of intellectual property and intangible assets, say the brand or technology reputation; not due to the presence of a relationship or simply being on a database.
Identifying inconsistency between the qualitative attributes of the customer relationships and the value derived using traditional valuation techniques can be advanced by researching and analysing fundamental data (earnings, margins, working capital levels, fixed asset levels, etc.) to observe differences in these ratios, fixed asset levels and ownership of IP between companies involved in manufacturing, sales and marketing. For example, in the consumer products sector, while some companies sell direct to retailers, others sell only through distributors and most sell products through multiple channels, both direct and through distributors. Margins for distributors in this sector are extremely low supporting a qualitative assessment that customers may be of minimal value and suggesting that mechanical application of traditional valuation methods may indeed lead to the customer relationship and data value being overstated. These findings have led to the development of a distributor method (DM) to cross check the valuation of customer relationships.
Valuation Practice is Evolving – Distributor Method
When it is relevant, DM avoids dual multi period excess earnings calculations in using market observations of both wholesale and distributor operations for whom the primary asset is not customer relationships. In this it is assumed that the relationships held by a distributor with its customers are similar to those held by a company. So, the primary asset is something other than (and or substantially additional to) customer relationships; for example a brand, technology and capital assets dominant business. If distributors and the subject company have the same key driver - the ability to provide the desired product or service in a timely manner - distributor inputs are a reasonable proxy when valuing the relationships of the target company.
VRC colleagues in the US some time ago considered two companies selling their products via a supermarket. One had a low value brand earning an 8% profit margin; the other had a dominant brand earning a 20% profit margin. What drives the difference? Are the relationships more valuable? It was found more likely that the second product earns a higher margin largely due to the strength of the brand. Practitioners have been able to extend use of the DM outside of the consumer products space into other areas where appropriate market based evidence can be found as a proxy for inputs.
Our view –the method is generally beneficial to consider in situations where common-sense and the view from a buyer or provider of same service or product in the same general marketplace suggest traditional valuation methodologies may overestimate the value of customer relationships. In applying the DM, the goal is to arrive at a value conclusion for the customer relationship that is consistent with a market participant’s (and often management’s) arm’s length viewpoint. DM use should be balanced with the value proposition of relationships between a company and its distributors which, as well as being various and often dissimilar, create valuable customer relationships and B2B brand value at distributor level in their own right.
Recent case law, data protection and privacy laws will cause valuation a headache
Two cases (we could have picked others) highlight issues. In Optical Express v Information Commissioner (EA/2015/0014) a detailed Judgement considered the high volume of complaints about the Appellant sending unsolicited marketing texts relating to laser eye surgery, and also the list of contacts obtained from Thomas Cook who had completed travel surveys and had ticked a third party marketing box, both potentially in breach of the Privacy and Electronic Communications Regulations 2003. The Appeal against an Enforcement Notice was rejected for numerous reasons. In brief summary, if the data subject does not know what products might be marketed then how can you exercise the right to object? In reporting on this case DMA forewarned that this is not a one-off and there would be more of a robust stance against the misuse of data particularly when Nuisance Calls and Texts Task Force 2014 begins to bite more widely.
More recently and equally relevant for valuers, employers may be held vicariously liable for data breaches caused by rogue employees following Axon v Ministry of Defence and NGN (2016EWHC787QB). While the Judge found that the Claimant did not have a reasonable expectation of privacy and no claim for breach of confidence he discussed the hypothetical question of whether the MoD as employer could have been found vicariously liable for an employee’s action and highlights that risk, and that it is prudent to take steps as an employer to minimise and manage through, for example, strong information security measures and good training for employees handling personal data.
Data protection regulation, law and case precedent is not as some may have dreamt a few years ago, falling by the wayside; au contraire. While quantitative analysis is an important process in all business and IP valuation, increasingly more time must be spent on qualitative due diligence, working with in-house Data Protection Officers and their lawyers, in a similar way to our market and technology due diligence process when valuing a trademark, brand, patent and software, when we work alongside Patent and Trademark Attorneys and those expert in patent and brand analytics.
This thoroughness will become acknowledged as essential in the process of valuing customer intangibles and data; it will assist in risk profiling and analysis, and determination of such as discount rates in the financial modelling for valuations.
There are also considerable implications for our general share and company valuation work where standard checklists need also to be focused on how clients adopt data protection policies and practices, to ensure compliance and to identify the challenge of dealing with such as a data/privacy breach and or reputational damage. ICO can levy fines of up to £500,000 and non-compliance generally can attract fines as high as 4% of a company’s global annual turnover, and can potentially have significant valuation impact if there is any prospect and or the probability needs to be weighed.
EU’s Governing Bodies have recently reached agreement in respect of the general data protection regulation which will replace the existing EU Directive GDPR and comes into effect on 25 May 2018. Regulations will apply to both public and private entities within and outside the EU where activities may affect EU subjects.
Our view – understand case law precedent and discover a clients’ framework for accountability, policies and procedures for data breaches and management of personal data. Privacy will include assessment of risk by asking questions about data flows, past or pending breaches, personal and sensitive data processed, consent procedures, rights to commercially exploit a database and cyber risks. The Information Commissioner’s Office 12 step checklist provides a good understanding of some of the questions we would be seeking answers about in the due diligence stage of our valuations process https://dpreformdotorgdotuk.files.wordpress.com/2016/03/preparing-for-the-gdpr-12-steps.pdf
Brexit and any ‘go it alone’ UK data laws would create further challenges for businesses operating throughout EU and valuation