Best Practices for Valuation of Business Combinations for Technology Companies
Accounting principles require organizations undergoing a merger that meets the accounting standard definition of a business combination to identify the assets involved in the transaction. This requirement, codified under ASC Topic 805, involves the valuation of identifiable intangible assets that can be separated from goodwill, including acquired trade names, customer relationships, and proprietary technology. Proprietary technology assets can be particularly difficult to value. Companies in the technology sector may want to factor in some additional time to the valuation process for a number of reasons.
The first challenge in technology valuation is selecting an appropriate methodology. Income-producing intangible assets are normally valued using some form of the income approach. For technology, the two primary method candidates are the relief-from-royalty (RFR) method and the multi-period excess earnings method (MPEEM). Making the correct selection comes down to identifying the primary intangible asset for the acquired business.
In its publications, the American Institute of Certified Public Accountants (AICPA) and the Appraisal Foundation (TAF) each indicate that the MPEEM should be reserved for valuation of the primary intangible, which they describe as having the most direct relationship to the revenues and cash flow streams. Moving from these sources to their application in practice, the intangible with the most direct relationship to revenues and cash flows will have the highest fair value when all of the dust settles.
Whether technology is valued using the MPEEM or the RFR method, certain characteristics of the asset must be understood in order to credibly forecast the associated future revenue stream. Key considerations include the technology’s post acquisition expected useful life and the portion of the company’s future revenue that will be attributable to the acquired technology versus new technologies.
The projected year-by-year division of future revenue between the acquired technology and new technologies is something the valuation practitioner will reflect in a migration curve. Generally, the revenue attributable to the acquired technology is close to 100% at the acquisition date, but decreases over time as the acquired technology becomes obsolete and new replacement technologies become increasingly responsible for revenue generation.
In establishing the post-acquisition useful life, there again are a number of critical considerations. These include the following:
- Historical or normal useful lives for technologies in the company’s industry
- Historic life cycle of past similar company technologies
- Age and maturity of the technology in the seller’s hands prior to acquisition
- Maintenance R&D and new development R&D efforts and expenditures
- Timing or cadence of expected upgrades and eventual replacement of the technology
Historical lives of past company and industry-specific technologies are a good place to start in estimating the overall life span. Next, we will want to determine how much of this life span occurred before the transaction date and how much is left for the future.
Given this general framework, however, management’s support of the technology in the form of maintenance R&D can significantly impact the useful life. Companies with successful technologies often have a robust R&D function that gathers customer feedback on marketed products. Gathered feedback is used to make improvements and modifications, which find their way back to new and current customers in form of regular released updates, monthly, quarterly or otherwise. Toward the end of a technology’s life, management may make the decision to quit supporting it, at which point the useful life is nearly complete. However, such a decision may signal the pending release of a new or replacement technology.
The release cadence described above is a normal part of the technology life cycle for long-lived companies. Whether new technologies are internally developed or acquired, they must be found if the company is to continue to prosper. Accordingly, observation of a company’s past release cadence, including timing and predictability, can help provide a reasonable basis for a technology’s useful life.
Considering the above factors, management will often develop a technology roadmap that articulates its expectations for existing technologies and release dates for new technologies. If such a roadmap is available, it can serve as a valuable starting point for establishing the useful life and a migration curve for the acquired technology.
Having established the useful life and migration curve, the valuation practitioner must translate these assumptions into either an MPEEM or a RFR model. Either way, the goal is to isolate projected revenue attributable to the acquired technology. In a RFR model, this revenue will be multiplied by an appropriate royalty rate. In an MPEEM, it will be multiplied by either an EBITDA or an EBIT margin, followed by the application of contributory asset charges.
Impact of the Buyer’s Motivation
In addition to the above considerations, one should also understand the buyer’s motivation for the transaction. Specifically, does the acquired technology represent new capability, or did the buyer already have this or similar technology but was primarily interested in the seller’s customer base. Setting buyer motivation aside, more often than not the customer relationships will win out over technology as the primary intangible and be valued using the MPEEM. Customer relationships often have longer lives than technology, and their attrition curves are often smoother and flatter than technology migration curves. These factors often cause a customer MPEEM model to extend well beyond the relatively short lives of most technologies. Accordingly, the asset that motivated the transaction may or may not be the primary asset for valuation purposes.
Technology-centric company acquisitions represent a greater percentage of total mergers and acquisitions today than they did in previous years. Consideration of the use of the technology and a general understanding of how management intends to replace, maintain or upgrade the technology post-acquisition is important. Those considerations coupled with the appropriate method will lead to a more reliable, defensible and repeatable valuation.
Related Reading Published on September 10, 2020