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6. Business Combinations

12 Months Ended

Dec. 31, 2018

6.	BUSINESS COMBINATIONS

Acquisition of NetSpective Webfiltering

On January 1, 2017, Grom Holdings acquired the assets of NetSpective Webfilter, a division of TeleMate.net Software (“TeleMate”). Under the terms of the agreement, Grom Holdings paid $1.0 million in consideration in the form of a $1.0 million redeemable, convertible promissory note. The note bears interest at 0.68% per annum. All note principal and accrued interest is payable January 1, 2020. The note is convertible at the election of TeleMate into the Company’s common stock at a conversion rate of $0.78 per share. Furthermore, if not previously converted by TeleMate, the note may be converted by the Company into shares of the Company’s common stock at a rate of $0.48 per share commencing on November 1, 2019.

TeleMate had the opportunity for contingent, earn-out payments of up to $362,500 if certain net cash flow thresholds are achieved during the one-year post-closing period. The earn-out payments, if made, shall be payable entirely in common stock.

Consideration Paid:
Cash and cash equivalents	$	–
Common stock, 41,700 shares paid with letter of intent		32,500
Senior, secured promissory notes		1,000,000
Financial liabilities assumed		521,735
Contingent purchase consideration		362,500
Fair value of total consideration	$	1,916,735

Recognized amount of identifiable assets acquired, and liabilities assumed:
Financial assets:
Intangible asset
Brand name	$	69,348
Software		1,134,435
Customer relationships		74,004
Financial liabilities:
Deferred revenues		(521,735	)
Write-down of purchase consideration		463,978
Goodwill		696,705
	$	1,916,735

Additionally, since the valuation report reflected that the earnout threshold would not be reached, and the earnout was achieved, the Company recorded an additional expense of $362,500 related to the acquisition of Netspective.

In determining the fair value of the convertible promissory note issued, the Company considered, among other factors, the market yields on debt securities for similar time horizons and level of perceived risk of the investment. Based on the conversion factors and interest rate contained in the note, the Company believes the note represents fair value.

We used a lattice model to estimate the fair value of the contingent consideration. We forecast future up and down movements based on the 9.7% historical volatility of “Net Cash Flow” which includes the years 2014-2016. The weighted average probability of each scenario was calculated and since it did not reach the earnout threshold, we did not record any contingent consideration provision.

The fair value of the internally developed software was estimated using a replacement cost approach similar to the Constructive Cost Model (“COCOMO”) II. The model is an algorithmic software cost estimation tool that estimates the cost, effort, and schedule of a hypothetical software project. We estimated costs based on total lines of code in the program and labor cost rates for the required personnel, in addition to a profit component. Although this is a replacement cost model, we believe it represents fair value from a market participant perspective. The key assumptions used include average labor rates, total estimated labor hours, and an income tax rate of 40%.

In determining the purchase price allocation, the Company considered, among other factors, how a market participant would likely use the acquired assets. The estimated fair value of intangible assets was based on the income approach for customer relationships and tradename and a replacement cost method for the software programs. The income approach requires a projection of the cash flow that the asset is expected to generate in the future. The projected cash flow is discounted to its present value using a rate of return, or discount rate, which accounts for the time value of money and the degree of risk inherent in the asset. The expected future cash flow that is projected should include all of the economic benefits attributable to the asset, including the tax savings associated with the amortization of the intangible asset value over the tax life of the asset. The income approach may take the form of a “relief-from-royalty” methodology, a cost savings methodology, a “with and without” methodology, or excess earnings methodology, depending on the specific asset under consideration. The replacement cost model uses estimated current costs at the Measurement Date, plus a profit component.

The “relief-from-royalty” method was used to value the trade names acquired from TeleMate. The “relief-from-royalty” method estimates the cost savings that accrue to the owner of an intangible asset that would otherwise be required to pay royalties or license fees on revenues earned through the use of the asset. The royalty rate used is based on an analysis of empirical, market-derived royalty rates for guideline intangible assets. Typically, revenue is projected over the expected remaining useful life of the intangible asset. The key assumptions in the prospective cash flows include a 15% compound annual sales growth rate over the five years period subsequent to the acquisition. The royalty rate is then applied to estimate the royalty savings. The key assumptions used in valuing the existing trade names acquired were as follows: royalty rate of 1.0%, discount rate of 17.1%, and a tax rate of 40.0%. The trade names are expected to be used indefinitely and the value includes a terminal value, based on a long-term sustainable growth rate of 2.0%, of the after-tax royalty savings determined using a form of the Gordon Growth model.

The fair value of customer relationships was valued using an income method. Net Operating Profit After Tax (“NOPAT”) per customer is a function of the gross profit margin of the Company, applicable contributory assets (i.e., working capital, fixed capital, workforce, brand, IPR&D) charges, and the discount rate reflecting the riskiness of the asset undervaluation. NOPAT per customer was used to estimate the value of customer relationships. The key assumptions used include a revenue attrition rate of 10%, an income tax rate of 40%, and a discount rate of 17.1%.