During the first quarter of 2016, domestic asset-based lenders experienced their slowest period in two years as reported by Thomson Reuters LPC. The $16 billion committed during the quarter was down from the approximately $20 billion reported for the first quarter of 2015, and included less than $4 billion of new money. As a result, competition for new mandates is as high as it has been in recent memory. In order to remain competitive, asset-based lenders are frequently entertaining the notion of including intangible assets in the proposed borrowing base. One such asset that is frequently contemplated is a company’s brand.
Given their intangible nature, brands offer unique opportunities for asset-based lenders, and care must be taken in determining appropriate collateral coverage. Unlike traditional collateral such as inventory or machinery and equipment, where liquidation values for asset types can be tracked through going-out-of-business sales and comparable equipment auctions, each brand possesses one-of-a-kind features. Though there are numerous examples of brands being sold in a liquidation, the underwriter must rely on experts that can provide insight on what the data implies when applied to the brand being considered for collateral. In order to provide appropriate underwriting, lenders often rely on brand appraisals, based on sound financial theory, with consideration given to comparable liquidation results. In an effort to accurately underwrite loans with brands as collateral, lenders should insist that their appraised values include a comprehensive analysis on the brand’s relative position in the marketplace, as well as an understanding of the appropriate exit strategy.
When valuing a brand, an appraiser will likely consider several valuation methods encompassed in the cost, market, and income-based approaches. The cost approach would entail an analysis of the historical marketing and brand development costs incurred by the company to date. While it is certainly necessary to analyze these costs to gain an understanding of the level of support the brand receives, this basic analysis often fails to consider the return on investment those expenditures are expected to generate. In addition, one must go beyond tabulating costs and uncover how effective the branding initiatives have been. A dollar spent does not necessarily equal a dollar of value generated. Given its shortcomings, the cost approach by itself often yields valuation results that are inconsistent with what a buyer would pay for the brand.
In a perfect world, the best measure of a brand’s value would be the sale of an identical brand, under circumstances identical to those contemplated in the appraisal, and occurring on the effective date of the report. Unfortunately, the perfect world with respect to brand valuation does not exist. While sales of similar brands can offer some guidance, and should never be ignored, the appraiser must make adjustments to account for the unique features of the company’s brand relative to the observed transaction, and differences in the circumstances of the sale. For instance, if the comparable sale was forced, it may not be applicable to an orderly liquidation sale, or a fair market transaction, without proper adjustment. In addition, if the comparable sale occurred during a period of industry consolidation, or economic expansion, the comparability to the effective date of the appraisal may not be relevant.
Brand valuations oftentimes utilize what is called a “relief from royalty” analysis to determine the value of the brand. This method is an income-based approach operating on the assumption that by owning the brand, the company does not have to pay royalties to a third party, and as such, the value of the brand is equal to the present value of the net stream of royalties that the company does not have to pay. The mechanics of this approach are fairly simple. A royalty rate (usually a percentage of sales) is applied to forecasted revenue resulting in a saved royalty expense, which is then tax-effected and discounted to the present utilizing a selected discount rate. While simple in theory and mechanics, an appraiser must utilize a deep understanding of the relevant industry, competitive landscape, and market position of the brand for this approach to yield accurate results. When reviewing appraisals of brands, lenders should ask many questions, some of which may include the following:
- How was the forecast determined? Did the appraiser consider alternative scenarios including situations of financial distress?
- How was the royalty rate determined? Did the appraiser utilize comparable licensing contracts to come up with the rate?
- When determining the royalty rate, did the appraiser make any consideration for the brand’s relative strength compared to its peers? Where does the brand rank in its market perception and acceptance?
- Did the appraiser consider the profitability of branded products when selecting the royalty rate? Is there room in the branded profit margin to pay the royalty?
This list of questions is not all-encompassing by any means, but rather provides some color as to the extent of the analysis that should be performed. To properly understand the value of a particular brand, questions well beyond a superficial analysis must be answered.
In addition to a comprehensive analysis, a brand appraisal should also provide a roadmap outlining the exit strategy the lender can follow if required to take possession of the brand. This roadmap should go well beyond providing a list of potential buyers. When compiling this list, consideration should be given to both strategic and financial acquisitions where there is a good fit. The appraiser should understand the brand’s positioning as it relates to various distribution models, whether it be traditional retail, online, or wholesale, and be able to ascertain which opportunities provide the best potential for synergies within a portfolio of brands. While brands are sometimes sold through an auction proceeding, it is most common that they are acquired in a process similar to that utilized by investment banks when selling an entire company, and as such, sufficient time must be allowed in order to achieve the desired results.
In an effort to achieve the highest recovery, brands are best sold in combination with other complimentary assets such as inventory and technology. For instance, if a brand’s appeal and market recognition is directly linked with patented technology, or product designs, a buyer of the brand would also desire the technology and designs in order to protect the market’s perception of the brand. Similarly, if a premium brand is being sold while steep discounts are being applied to its products in inventory liquidation, care should be taken to ensure that the pricing message communicated to the market is not damaging the perception of the brand. For premium brands where price position relative to its competition is essential in preservation of value, it is appropriate to include the relevant inventory when courting potential buyers in order to maintain current market perceptions attached to the brand. Understanding how the liquidation of inventory impacts the long-term perception of the brand, and taking care to run the liquidation process with consideration for how the two assets work together is essential in order to maintain the recovery for what is often the liquidation’s most valuable asset.
The utilization of brands as collateral poses opportunities to the lender beyond those inherent in inventory and machinery and equipment. However, ensuring that the brand appraisal goes beyond superficial financial analysis and outlines an appropriate exit strategy is essential in helping to properly underwrite a potential loan.
Gregg Johnson is a director with Great American Group’s Corporate Valuation Services practice, which specializes in the valuation of intangible assets utilized in asset-based loans. He has 17 years of experience in the appraisal industry and during that time has not only provided more than a thousand intangible asset appraisals, but also has experience valuing business interests, debt securities, and complex derivative instruments for both accounting and tax purposes.
To learn more, visit greatamerican.com/rightonthemoney