Valuation Of Intellectual Property

Sunday, February 1, 2004 - 00:00

Intangible assets refer to all non-physical assets owned by an entity comprising both intellectual property and other intangibles. Intellectual property is an intangible asset that enjoys special legal recognition and protection such as patents, trademarks, copyrights, know-how and trade secrets, as compared to other types of intangible assets that may enjoy economic rights but no legal rights. The nuances involved in accounting for intellectual property has garnered considerable attention in the wake of Financial Accounting Standards ("FAS") 141 and 142 issued by the Financial Accounting Standards Board in 2001, dealing with the recording of assets acquired in a business combination. FAS 141 requires all business combinations to be accounted for as acquisitions under the purchase method. Accordingly, the purchase price paid by an acquiring company should be allocated across the fair value of all acquired assets, including intangible assets that meet the specified recognition criteria, and all acquired liabilities of the acquired company. The Standard provides a comprehensive list of intangible assets, covering all industry sectors, including trademarks, patents and customer relationships to name a few. Once these intangibles are valued, companies have to amortize the value of such intangibles over their useful lives. Thus, valuation of intangibles and specifically, intellectual property has acquired increased significance in view of recent accounting standards.

Valuation of intellectual property is influenced by the following variables:

The standard of value. The standard of value depends on the intended purpose and use of the valuation. In other words, the standard of value would depend on the answer to a simple question - value to whom? Some of the common standards of value include fair market value, fair value, investment value, acquisition value, use value, investment value, owner value, insurable value, collateral value and ad valorem value.

The premise of value. The premise of value defines the assumed circumstances under which the subject asset is valued. Various premises of value include - value in continued use as a part of a going-concern business enterprise, value in place but not in current use in the production of income, value in exchange as part of an orderly disposition and value in exchange as part of a forced liquidation.

Approaches to value. The value of the subject property is estimated based on consideration of all three approaches to value, namely, the cost approach, market approach and the income approach which are discussed in a somewhat greater detail below.

All of the above variables can significantly impact the value of intellectual property. Essentially these variables are governed to a large extent by the unique characteristics of the subject property being valued and the scope and purpose of the valuation. The three basic approaches to valuation are:

Cost Approach. The fundamental concept under the cost approach is that a willing buyer would pay a price for the subject property that is equivalent to what that buyer would pay for a property with comparable utility. Under the cost approach, the value is influenced by:

(a) The cost to construct or develop the property including material, labor, overhead costs and the expected profit from developing the subject property;

(b) Changes in supply and demand that cause a change in the costs of various types of intellectual properties;

(c) External factors that cause an intellectual property to be worth more or less than its cost;

(d) Functional obsolescence due to failure in deriving the function or utility the subject property was originally designed or created for; and

(e) Improvements in technology which make the subject property less productive or desirable.

The two most common types of definition of cost include - reproduction cost and replacement cost. Reproduction cost is based on the cost of the construction or purchase of a property that is an exact duplication of the subject property. Replacement cost is based on the cost to recreate the functionality or utility of the subject property, in a form or appearance that differs from the subject property.

Reproduction cost is a function of the total cost that would have to be incurred, at current prices, to develop an exact replica of the subject property using the same materials, standards, design and layout as the subject property. Replacement cost, on the other hand, is a function of the total cost that would have to be incurred, at current prices, to develop an asset that provides equal utility as the subject property. It is important to note that the replacement cost is based on the current standards, state-of-the-art design and layout and the highest quality. As a result, the subject property may have less utility than the replacement property which would necessitate an adjustment to the value of the subject property. The replacement cost is also adjusted for functional, technical, economic and location obsolescence.

Market Approach. Under the market approach, a market value estimate for the subject property is developed based on an analysis of the market values of similar intellectual properties that have been recently sold or licensed. This approach is considered extremely useful in deriving value conclusions for television or radio broadcast licenses, franchise operations, credit card portfolios, trademarks and other types of intellectual properties for which there is adequate market transactional data. One of the difficulties of the market approach is the challenge associated with gathering and selecting market transactional date. In addition to market values, it is very important for the valuator to gather the following data with respect to the selected guideline transactions to adequately compare the guideline intellectual properties with the subject property:

(a) The bundle of legal rights conveyed in the selected guideline transaction;

(b) Special financing arrangements between the buyer and the seller;

(c) Whether the transaction was arms-length or not;

(d) The economic conditions prevailing at the time the transaction was consummated;

(e) The term or duration of the guideline transaction;

(f) The obsolescence factors effecting the guideline property;

(g) Whether the guideline property was part of a bundle of assets that was sold by the seller to the buyer; and

(h) Other unique characteristics of the guideline transaction.

The valuator develops a market value estimate for the subject property by first calculating value multiples for the guideline intellectual properties. A multiple is the price of the guideline transaction divided by a meaningful or relevant economic measure such as sales, units produced, gross profit or cash flows. Once value multiples for the guideline intellectual properties are calculated, the valuator needs to adjust these market multiples by thoroughly analyzing the above factors to account for the differences between the subject property and the guideline transactions in arriving at the market value estimate for the subject property under the market approach.

Income Approach. The income approach is based upon the principle that the value of an intellectual property is measured by the value of all future expected economic benefits or income that can be earned from owning the property, discounted to the present. There are numerous measures of economic income based on revenue, gross profit, operating income, net income, cash flows and cost savings.

The economic benefit of owning the subject property and the bundle rights associated with it can be based on any one of the following methods:

(a) The incremental or additional economic income enjoyed by the owner of the subject property as a result of owning the subject property, as compared to not owning the subject property;

(b) The benefits from savings in capital expenditure or costs generated by the subject property;

(c) The amount of hypothetical royalty or license payment the property owner saves as a result of owning the subject property, based on what the property owner would willingly pay an independent third party for the use of and legal rights to the subject property; or

(d) The difference in the value of the business enterprise as a result of owning the subject property, as compared to not owning the property.

The two analytical approaches applied to the above methods in arriving at the value under the income method are the Direct Capitalization approach and the Discounted Future Economic Benefits approach.

Under the Direct Capitalization approach, the economic income for one period is estimated and divided by an appropriate capitalization rate. The capitalization rate may be based on a perpetual period of time or a finite period of time, based on the duration of the economic income. Under the Discounted Future Economic Benefits approach, the economic income is projected for the discrete time periods over which the economic income is expected to be received. Unlike the direct capitalization approach, the economic income varies from one time period to the other. The projected economic income is discounted to its present value by applying a discount rate. The length of the projected period and the residual value of the subject property is a function of the valuator's expectations relating to the duration of the economic income.

The discount or capitalization rate depends on the general level of interest rates, and financial risk and business risk that would be perceived by a hypothetical owner of the subject property. The discount rate derived should be indicative of the rate of return that an investor would require for investing in the subject property. The capitalization rate is determined by subtracting the projected growth rate of the economic income from the discount rate.

The final value estimate is based on a blend of the value indications obtained under each of the approaches used by the valuator. In this final stage, the valuator objectively evaluates the data, techniques, methods and the logic used for consistency. Although one or more approaches may have greater significance in valuing the subject property, the valuator should, where possible, use more than one approach. Inconsistencies among the different approaches used by the valuator must be reconciled before comparing the value conclusions derived under each method. In arriving at the final value conclusion, the valuator must be guided by factors such as bundle of rights conveyed, standard of value used and the purpose of value. Arriving at the final value conclusion generally requires considerable professional judgment based on the experience of the valuator in valuing intellectual property in general.

Howard M. Fielstein, a Partner of Margolin, Winer & Evens LLP, holds a CPA/ABV, CFE, CVA and CBA. He may be reached at hfielstein@mwellp.com. Vijay Krishnamurthy, a Consultant, holds an MBA and ACA. He may be reached at vkrishnamurthy@mwellp.com.