Opening the Kimono on Contract Valuation

Attempting to value contracts can be akin to an inaugural space exploration without the benefit of a travel plan or telescope. Your assessment can be in the right general direction, but still light-years away from any known landmarks.

One of the challenges with valuing contracts is that the valuation analyst does not have the benefit of a body of research to act as a roadmap. However, we can embark upon what many have described as “Mission Impossible” by making a determination as to whether one or more of the primary valuation methods (cost, market, income) provides a suitable framework for valuing contracts.

The Cost Method

The cost method would suggest that a contract’s value is a function of the cost of producing it. This is not appropriate because the costs associated with drafting a contract are untethered to its value. When Henry Kravis was negotiating the acquisition of RJR Reynolds, RJR’s Board could not decide which of its suitors it should sell itself to by the deadline that Mr. Kravis gave them. RJR’s Board asked for more time to contemplate Mr. Kravis’ acquisition offer. Mr. Kravis agreed and he and his lawyer quickly scribbled out a handwritten agreement on a legal pad that granted RJR’s Board another 45 minutes to deliberate in return for $45 million option payment. Warren Buffett said that he made the decision to invest $5 billion in Goldman Sacks within a few hours as he was eating jelly beans and sipping Cherry Coke. On the other hand, business is rife with companies paying tens of millions of dollars in legal fees for business ventures and acquisitions that deliver negative shareholder returns.

The Market Method

The market method does not work for valuing contracts since there is no market for contracts. The limited efforts at selling contracts have been retarded by several factors. Charles McCormick, a lawyer with McCormick & O’Brien, LLP in New York City, points out that:

• Customer contracts can be terminable upon relatively short notice (30 – 90 days) for any reason. This optionality works against the potential transferor.
• Many contracts hold that such contracts can be immediately terminable by the customer if the vendor becomes insolvent or declares bankruptcy. (However, such provisions are not always enforceable due to the ipso facto principle.)
• Commercial contracts are not always assignable. Some contain outright restrictions on assignment. In other cases, various state court decisions (such as those in New York) have held that if the services to be performed under a contract are such that the customer is relying on some particular or unique aspect of the provider, assignment may require the customer’s consent. Seeking customer consent may also present an opportunity for the customer to renegotiate the contract, which could ultimately make the contract less valuable to the performing party.

Income Method

Contracts are both legal documents and intangible assets from which benefits are expected to be derived. In light of their definition and by process of elimination, the income method is most appropriate for valuing contracts.

The abbreviated formula for valuing contracts is:

Contract Value = Deposits + ((Anticipated Value of Contractual Income – Deposits) * Discount Rate) + Value of Ancillary Economic Benefits + (Recoveries * Discount Rate) – Transactions Costs

 

Overview of Contract Valuation Exercise

The complexity of valuing contracts can be crystallized by discussing a simple example that parallels an assignment that I recently completed.

Let us suppose that Seating Sisters has executed a contract with Bicycle Brothers in which the former will supply the latter with bicycle seats over the next four years, with an option to extend the contract by an additional two years.

A summary of this contract is provided in the chart below:

 

 

 

 

 

DEPOSITS

The first step in determining the value of a contract is to assess whether the buyer has made any deposits to the seller. Any such deposits made shortly after the execution of the contract should be recorded without any discounting for the time value of money. In our case study, deposits total $125,000.

Anticipated Value of Contractual Income

The anticipated value of contractual income can be broken into two parts—performance related and contingency related. The performance related value is the product of prices that the buyer agrees to pay and the number of units the buyer agrees to purchase throughout the term of the contract. In our case study the total revenues anticipated to be received from Bicycle Brothers are $26,513,157. These total revenues are reduced by deposits, fixed costs, variable costs and taxes.

The contingency value is determined by first assessing the expected values that could be derived if contract contingencies were exercised. The second step is to multiply these expected values times the probabilities that such contingencies will be exercised.

In our example, there are three contingencies that affect Seating Sisters contract value—renewal options, rights of first refusal on supplying bicycle seats to new markets, and retraction clauses that could result in Seating Sisters losing some of its markets if it does not deliver according to contract terms. Revenues associated with these contingencies are $7,438,046, $4,666,361 and ($2,191,225), respectively.

The difficulty in valuing contingencies lies in estimating their probabilities of occurrence. The following are among the indicators that can be assessed to determine the odds of the occurrence of such contingencies:

• Historical Performance – What has Bicycle Brother’s history been with respect to expanding its market geographically?
• Expected Market Conditions – Seating Sister’s willingness to exercise its option to renew its contract with Bicycle Brothers will be a function of expected economic conditions. Its contract calls for delivering its seats to Bicycle Brothers for an annual 6% discount. If costs of raw materials rise—

or decline less than 6% a year—the renewal option may not be worth exercising.

• Changes in Business Plans – Have the parties changed their business plans? Perhaps, Bicycle Brothers has decided not to offer children’s bicycles outside of its legacy markets. Thus, Seating Sisters’ right of first refusal would be worthless.
• Success of Competitors in the Industry – What is the magnitude of product improvements expected to be introduced by competitors? If competitors’ products render Seating Sisters’ products uncompetitive, Bicycle Brothers could exercise its right to retract the markets currently awarded to Seating Sisters.

Guidance on these issues can be obtained through both first-hand and secondary research. The valuation analyst should interview industry authorities (such as executives and trade association officials) and conduct channel checks by speaking with suppliers, distributors, and retailers. This fundamental due diligence should be complemented by reading the trade press, local newspapers, relevant blogs and results from Internet searches.

Discount Rate

A discount rate should be applied to the Anticipated Value of Contractual Income in order to reflect Seating Sisters’ costs of capital, opportunity costs and risks of inflation eroding the value of future income. To this value should be added the risks of the contract being violated. To gain more specificity as to what can go wrong with a contract—and thus what needs to be priced into the discount rate—I interviewed more than two dozen leading business, litigation and contracts lawyers. Among the most helpful in constructing a discount rate model for assessing contract value were Robert J. Feinberg, Shareholder with Giordano, Halleran & Ciesa in Red Bank, NJ and Francis J. Sullivan, Partner at Hill Wallack LLP, in Newtown, PA.

Based on interviews with seasoned contracts lawyers, I posit that the Model for Calculating Discount Rates for Contracts is:

Discount Rate = Risk Free Rate + Exposure to General Economic Factors + Exposure to Industry Economics + Exposure to Counterparty’s Internal Factors + Impact of Legal Factors – Available Remedies

Risk Free Rate – The risk free rate is a fundamental underpinning of cost of capital analysis. It is equivalent to the yield on the U.S. government debt with a duration that most closely matches the duration of the contract under review.

Exposure to Economic Factors – As recent years have demonstrated, all companies are at risk of being impacted by a deep recession. Companies that produce products for which their customers have an elastic demand (meaning they buy drastically less when income levels fall) will fare worse than companies whose customers have an inelastic demand for their products. Thus contracts covering customers who have elastic demand should have higher discount rates than contracts which cover end users who have inelastic demand.

The formula for elasticity is change in demand divided by change in price (or income). The analyst can review the extent to which demand was affected by past price hikes or drops in national income and project such trends on to future discount rates. Caution must be taken to avoid double discounting. Thus, if the Anticipated Value of Contractual Income part of the model factored in a recession, a smaller addition to the discount rate should be applied.
Exposure to Industry Economics – Entire industries are exposed to common competitive factors, legislation, regulation and government retribution. The more pressure that these externalities place on an industry’s profits, the less economic it becomes to comply with the affected companies’ contracts.

There are a host of competitive factors that can squeeze out an industry’s profits including rising costs of materials or labor. Price wars—such as the incipient one between Amazon.com and Wal-Mart in the book space—and a company viewing its competitors’ primary market as a loss leader can rapidly devastate the profitability of an industry. An entire industry can face a bleaker future when its suppliers forward integrate or its customers backward integrate. A scandal rocking a leading industry player or the announcement of it incurring a massive loss can make it much more difficult for other industry players to secure necessary capital. Technology can erase the rationale for an entire industry as happened to pagers when mobile phones became de rigour.

Structural issues that impact the profitability of an industry are low switching costs (the less expensive it is for customers to switch vendors, the more competition will ensue) and the stakes of the existing players (the higher the stakes of the industry participants, the more fiercely they will compete). Low barriers to entry—such as nominal capital requirements or non-existent regulatory hurdles—are forerunners to more competitors. High barriers to exit accentuate inter-company rivalry and occur when government regulations (e.g. prohibiting insurance companies to fold-up their operations) or stranded costs (e.g. when a company has expensive machinery that it cannot liquidate) essentially force companies to remain in business.

Legislation and regulations—such as those requiring more environmental safeguards or facilitating the unionization of an industry’s workforce—can raise costs of doing business for entire industries. When the government targets industries for higher taxes and less freedom of operation—as has happened to health insurance, pharmaceutical and oil companies in recent months—the profitability for the entire industry will be suppressed.

The analyst must keep current with news relating to the industry under review so as to determine the likelihood of these kinds of events impacting the reviewed company’s (Seating Sisters) and its counterparty’s (in our case Bicycle Brothers) ability to remain in compliance with their contracts.
EXPOSURE TO COUNTERPARTY’S INTERNAL FACTORS – A company that includes its contracts among its assets is vulnerable to the prevailing internal dynamics occurring with its counterparties. Foremost among the factors to consider in this regard is the likelihood that the counterparty will breach or cease to honor the contract. Companies are more likely to break their contracts under the following scenarios:

The demands placed upon them by their shareholders. If a privately held company sells part of its equity to a private-equity or hedge fund, its new institutional investors will push management to deliver more dramatic earnings growth. This pressure may cause management to reevaluate its contracts.

Number of internal influencers at counterparty. Companies that have many access points for outside parties to influence changes in policy are more likely to break contracts than companies that have few decision makers. This is because it is easier for a special interest group to create internal pressure for a change in policy if the targeted counterparty has a large board of directors, foreign subsidiaries and franchisees than it is to effect change at a company whose sole shareholder makes all of the import decisions.

An example of how special interest groups can cause internal pressure is provided by Greenpeace’s success in stopping Shell from dumping its Brent Spar oil rig in the North Sea in the mid-1990s. Even though Shell’s UK operations were responsible for Brent Spar, Greenpeace targeted Shell stations in Germany because that nation’s citizens were deemed to be more sympathetic to environmental causes. The result was that Shell stations in Germany suffered a 50% contraction in revenues which caused Shell’s German operations to pressure Shell’s UK operations to reverse course on the Brent Spar matter.    

Peer companies’ contracts have been broken without consequence. In our example, if other bicycle companies have broken their contracts with suppliers without any negative repercussions, then Bicycle Brothers may feel less risk and stigma with breaching its contracts with Seating Sisters. This is even more true when other customers have broken agreements with the company in question (i.e. Seating Sisters).

Better alternatives become available. If a better product or a product of comparable quality priced more competitively becomes available, the counterparty will become more inclined to find a reason to terminate the contract.

Reduced ability to perform. If Seating Sisters were to deliver faulty seats to Bicycle Brothers, Seating Sisters could be in breach of its contract. However, even when a vendor fails to perform to expectations in one dimension of its relationship with its customer, that lapse can be used as a justification to break a different contract. Mr. Sullivan explains that companies that cannot adhere to “meet or release” contract provisions are at risk of losing their contracts. Such meet or release clauses typically hold that suppliers (Seating Sisters) must either meet their customer’s (Bicycle Brothers) volume and/or price demands or they must release their customers from their contracts.

The company in question has a known no litigation policy. Some managements have publicly stated that they are in the (bicycle seating) business, not in the litigation business. The articulation of this policy disinhibits counterparties (e.g. Bicycle Brothers) in terms of breaking their contracts.

Vendor’s financial dependence on the contract. Customers who realize that their vendors are dependent on a contract are more likely to believe that they can breach various provisions of it without penalty. This situation could arise if the customer realizes that it is one of the vendor’s largest customers; that the vendor would be in breach of its loan covenants if it lost its contract; or, that the vendor’s shareholders could move to replace management if it lost the contract in question.

Disparity in size. When the customer is much larger than its vendor, the customer is more likely to breach the contract because it will believe that the vendor has no recourse. One factor in this decision is that the vendor would not be able afford to defend itself against its much larger customer in litigation.

New management at counterparty’s company. New management teams often want to shake things up. Foremost among the items to be shaken up are contracts with vendors. Holders of contracts (e.g. Seating Sisters) are especially vulnerable if the new management team (e.g. Bicycle Brothers) has worked with competitors to the contract holder for an extended period of time.

Likelihood of counterparty becoming acquired. If Bicycle Brothers were to be acquired, Seating Sisters would be confronted with a larger possibility of having its contract abrogated. This is due to the new management risk factors discussed above as well as the possibility that the acquiring company might wish to consolidate its bicycle making operations; terminate its bicycle making operations; or, renegotiate with Seating Sisters so as to exercise its enhanced bargaining power resulting from its larger scale.

Reputation of the counterparty. Counterparties who have a reputation for entering into contracts with no intention of honoring them carry tremendous risks for companies that consider their contracts to be assets.

 

 

The following are among the scenarios in which a counterparty is less likely to break contracts with its vendors:

Unacceptable concentration of suppliers. A dominant customer may not wish to injure its vendor (even if it could do so without triggering litigation) when doing so could result in remaining potential vendors having excessive power over the customer.

Proprietary technology. Bicycle Brothers is less likely to break its contract with Seating Sisters if Seating Sisters has proprietary technology.

Customers associate value with the supplier’s products. If a supplier advertises its components and creates demand for them, it then becomes more difficult for a customer to break an agreement and use another vendor. For instance, when Intel created quite a bit of demand for its semiconductors via its Intel Inside advertising campaign, the use of competing semiconductors by computer manufacturers would have been perceived as using lower quality processors.

Cross ownership. Contracts are less likely to be broken when cross ownership exists between customers and vendors. The same is true when there is overlap among the companies’ boards of directors.

Relatively small component. Bicycle Brothers would be less likely to break its contract with Seating Sisters if such contract represented a small percentage of its purchased parts. Companies generally attempt to enhance their profitability rather than damage their competitors (let alone suppliers) and there is less upside to renegotiating small contracts.

Length and integration of business relationship. A customer would be less inclined to breach a contract with a long-term vendor, especially when the two companies depend on one another for a variety of products and services.

Position in the customer’s value chain. Parts that are crucial for enabling the sale of end products are less vulnerable to contract renegotiation. For instance, a brakes manufacturer would typically have more leverage over an auto maker than a producer of coffee cup holders. Companies that manufacture parts that are installed at the beginning of an assembly process are less vulnerable to contract breaches than parts that are manufactured at the end of assembly lines.

Inability to accumulate inventory. Customers that have difficulty accumulating inventory produced by a particular vendor are less likely to violate their agreements with such vendors. Included in the characteristics of inability to accumulate inventory are services (such as air travel and consulting), products that have short shelf lives and products that are expensive to warehouse and insure.

 

LEGAL ISSUES – A host of legal issues can impact the probability that a contract will be violated or terminated. Among the metrics that can be used to estimate such probabilities are:

Construction of the contract. Typically, contracts that are shorter (in terms of word or page count) reflect a longstanding business relationship between the two signatories. On the other hand, longer contracts may indicate a lack of fundamental trust between the parties and are more exposed to human error in drafting. Thus, as a sweeping generality, shorter contracts (relative to contracts covering similar situations) are deserving of lower discount rates than longer contracts. Similarly, highly specific contracts are easier to break since there are more conditions that can be violated. In my experience, older contracts are more susceptible to being violated as the players that negotiated the original contract move on (and no longer administer it) and as economic realities deviate from the expectations underpinning the contract.

Who drafted the contract. Law firms that have an expertise in writing similar contracts and large law firms that bear the accoutrements of success signal that their contracts are more difficult to violate. Lawyers who have represented the client—or similar clients in the same industry—for an extended period of time are more likely to draft contracts in light of possible points of contention. If lawyers are integrated into initial rounds of business discussions, their comments can be more congruously woven into the agreements as opposed to when business people reach an agreement and then hand it off to lawyers to draft accompanying contracts.

Governing jurisdiction. The jurisdiction in which contract litigation is likely to be heard has an impact on the propensity of a counterparty to violate a contract. If contract disputes between Bicycle Brothers and Seating Sisters were to be heard in Seating Sisters home city, juries may be more sympathetic towards Seating Sisters. Thus, Bicycle Brothers may be more reluctant to violate its contract with Seating Sisters. However, if a judge were to hear the same litigation in a district where neither of the litigants had a major presence, Bicycle Brothers may believe that it has a better chance of convincing the judge of the merits of its actions. Thus, as Mr. Feinberg points out, it is important to ascertain which party (if either) has the right to select venue and whether a judge or jury will rule on the dispute.

Termination features. Contracts that allow one party to terminate the agreement merely by notifying the other party—say 90 days beforehand—have a higher risk of expiring prematurely than contracts that have more onerous termination provisions.

Potential damages. If there is a risk that a party that violates a contract will be liable for treble damages, there is less risk in a counterparty breaking the contract. Another factor that impacts the likelihood that a contract will be broken is the ability to cause a class action.

Personal guarantees and insurability. Contracts that require personal guarantees by principals of one party are less likely to be violated by that party. Contracts which are covered by insurance policies could be more likely to be violated by the party which has obtained the insurance because of adverse selection and moral hazard issues.
REMEDIES – The incidence of contracts becoming violated and the associated costs are mitigated when there are effective remedies for handling violated contracts. Among these remedies are:

Ability to transfer the contract. The easier it is to transfer the contract to another supplier, the larger should be the negative discount rate factor.

Reputation of contract holder. Contract holders that have earned reputations for their willingness to mount vigorous and sustained litigation against business partners that violate their contracts often benefit from the shield of deterrence to future violations of their contracts.

Politicization of potential litigation. While larger companies may feel freer to break their contracts with small suppliers, large companies are quite sensitive to the media attention that may accompany such litigation. A senior executive of Ford Motor told me that his company takes measures not to attract media attention. Larger companies have more to lose from media attention as they have more customers, are more exposed to regulators and have shareholders that would hold management accountable for attracting such media attention.

Game theory remedies. If Seating Sisters had side agreements that—in the event that Bicycle Brothers violated its contract—enabled it to invoke remedies based on Game Theory, there would be less risk of its contracts being violated. Such permutations of Game Theory could include:

• Upon signing the contract, both parties could agree that each quarter that Bicycle Brothers remitted payment as stipulated by the contract, Seating Sisters would donate a small percentage of the proceeds to a charity of importance to Bicycle Brothers. A violation of the contract would result in a cessation of such charitable donations. Seating Sisters would have the right to disclose the reason for the cessation of donations.
• A violation of their agreement by Bicycle Brothers, would allow Seating Sisters to publish a letter of resignation by Bicycle Brothers from its trade associations. Such letter would have been previously signed by Bicycle Brothers and would declare that Bicycle Brothers did not uphold business practices acceptable to the trade associations.

The total discount rate in our case study was computer to be 35%. (See Insert 3.)

 

 

VALUE OF ANCILLARY ECONOMIC BENEFITS

Contracts represent value to businesses beyond the expected discounted earnings they are projected to deliver. Securing customers and vendors, as evidenced by executing contracts, enhances the predictability of sales and delivery of supplies. This predictability reduces volatility in earnings which is rewarded by the financial community. Contracts lend credibility to the signatories and buttress the reputations of the firms involved. This reputation enhancement can carry over to many facets of the signatories’ businesses. The following are among the ancillary economic benefits that result from winning contracts:

Access to capital. Companies that can demonstrate to investors and creditors that they have binding contracts have an advantage in securing capital. This is a crucial consideration as the availability of capital and credit is often the difference between a company surviving and perishing.

Elevated market capitalization. The announcement of an important contract win can cause shares of a publicly-traded company to spike upwards, elevating the contract winner’s market capitalization. One method for determining the extent of any market capitalization enhancement resulting from a contract win is to take the average share price twenty days prior to the contract win and subtract from that amount the average price of the stock five days after the announcement of the contract. This difference should be multiplied by the number of shares outstanding.

New accounts wins. Winning contracts from reputable industry players validates the contract winner and makes it easier to win future accounts. This is especially true when the initial clients agree to serve as reference accounts for their vendors. Winning important contracts can also give existing customers the confidence to purchase other products from the contract winner, thus providing the company with more cross-sell opportunities.

Retention of key personnel. A company that is making progress in executing its business plan is not only attractive to investors and customers, but also to its own employees. Companies that win accounts also give their employees further reasons to remain with the company. Thus, contract wins can reduce the turnover of valued employees.

Enhance operating efficiency. Securing business from customers enables vendors to operate their factories and other assets at higher utilization levels. These higher utilization levels, in turn, reduce the costs of unit production which enables the firm to be more price competitive.
The value of ancillary economic benefits was calculated to be $2,472,610. (See Insert 4.)

 

 
RECOVERIES

In situations where contracts are broken, all is not always lost. Recoveries in the form of collecting business interruption insurance proceeds, settlements (minus lawyers fees) and the proceeds from affected liquidated inventories should be added back to the value of the contract. We derive these values by multiplying pre-tax earnings by the product of risk of contract termination, percent of contract expected to be lost if contract is terminated and the percentage of contract recovery. Total recoveries are projected to be $201,850, (See Insert 5.)

 
Transaction Fees

The value of the contract should be reduced by the amount expended on outside professionals (usually, lawyers and consultants) for their services in connection with consummating the transaction. In our case study, Seating Sisters incurred transactions costs of $235,000 in the first year of the contract and nominal $3,000 costs in the subsequent years. The net present value of these transaction fees in our case study is $241,660. (See Insert 6.)

 

 

TOTAL CONTRACT VALUE

In conclusion, we calculate the total contract value by applying the following formula:

Contract Value = Deposits + ((Anticipated Value of Contractual Income – Deposits) * Discount Rate) + Value of Ancillary Economic Benefits + (Recoveries * Discount Rate) – Transactions Costs

The total value in our case study is $8,396,763. (See Insert 7.)

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Conclusion

While business valuation analysts must always apply their judgment to the unique circumstances that they are confronted with when valuing contracts, I hope that the methodology discussed above provides some guidance as well as standards around which contract valuation can be more consistently applied.

 

About the Author: David Wanetick is a Managing Director at IncreMental Advantage, a business valuation and consulting firm based in Princeton, NJ. He teaches Valuation of Emerging Technologies and Negotiating Licensing Agreements at The Business Development Academy. He may be reached at dwanetick@incrementaladvantage.com.