Businesses recognize the value of contracts if they offer advantages in terms of lower operating expenses, competitive position, or critical asset retention for some period of time. Consider the important types often seen in successful companies:
- Leases of business premises.
- Supplier and other vendor agreements.
- Employment contracts with key staff members.
- Licensing rights.
- Franchise agreements.
How contracts can create value
Generally, employment contracts are terminable by either party at any time. But retaining key employees may be very important for a company. If the employee is paid below market, they are likely to quit. On the other hand, an above the market compensation package represents a liability for the business.
Being able to license intellectual property on an exclusive basis may make a difference as to whether the company can offer a line of products attractive for its customers. Such arrangements can help reduce competition, at least for some length of time. Avoiding the time and cost of developing alternative products is a benefit that has value.
Location often represents a critical element in a company’s success. So being in the right place for your customers often requires securing a lease on attractive terms. If competitors can’t do the same, the company benefits from higher customer traffic, lower advertising costs, and focus on building its position in the market.
Business contracts are intangible assets that definitely have value. To estimate the actual number you need to figure out the economic benefit of a contract and determine its useful life. The economic benefit can be quantified as the measure of additional earnings or avoidance of expenses as a result of the contract. For example, you can calculate the contract value as the present value of the additional income stream recognized over the contract’s term. The terminal value should be set to zero if the contract expires without a renewal.