Intellectual Property: A Valuation Primer

Sunday, August 1, 2004 - 01:00

As intellectual capital continues to develop, so too does the offspring of intellectual capital - also known as intellectual property. In fact, it is widely recognized that intellectual property is playing an increasingly important role in both our domestic and global economy. During the past few years, several countries have strengthened their laws and regulations regarding intellectual property rights. These stronger intellectual property regulations provide the incentive for innovation. Subsequently, this innovation is leading to increasing returns on investments made in developing intellectual property assets. Clearly, this is a win-win situation for all involved.

As intellectual property assets form a larger base of an entity's asset pool, a spirited and passionate debate has arisen concerning patent protection of products and inventions in several industries including the pharmaceutical and the biotechnology sector. As evidence of this development, several new firms in these industries were established and existing firms experienced significant growth during the 1990's. These firms, including many others in different industries, rely on patents and trademarks to realize the value and the investment returns that are generated by their creations. In addition, research and development groups within these industries often leverage the existing patents to produce second-generation technologies that further increase the value of the intellectual property.

Statistics from the United States Patent and Trademark Office corresponding to 2001 (the latest available data) reveal that the total number of patent applications increased from approximately 176,000 in 1990 to 346,000 in 2001, an annual growth rate of approximately 6 percent. In that same period of time, the total number of patents granted rose from approximately 99,000 to 184,000. Inventors in California claimed approximately 21 percent of the patents created by all U.S. residents, followed by inventors from New York and Texas with approximately 7 percent each, and New Jersey with approximately 4 percent.

It is widely recognized that intellectual property is an intangible asset that deserves special legal recognition and protection. Under this distinct criteria are intangible assets that encompass patents, trademarks, trade names, and copyrights. Other intangible assets, such as customer lists, non-contractual customer relationships, and unpatented technologies often have economic value but not necessarily distinct legal rights. Intellectual property, and intangible assets in general, can be valued for financial reporting, litigation, tax, and market transaction purposes. For the purpose of this article, we focus on the first two.

Respecting the valuation of intellectual property for financial reporting and litigation matters, an experienced valuator of intellectual property is an essential part of the professional team. In general, an experienced and qualified valuator relies on several techniques to analyze and assess the value of intangible assets. Specifically, intellectual property valuations can be based on the income, market, and cost approaches. Often times, a valuator will utilize any and all of the above methods in assessing the value in the instant matter. Of course, the experience of past valuations may also guide the valuator in assessing the value of intellectual property.

The issuance of Financial Accounting Standards No. 141 & 142 (SFAS 141 & 142) by the Financial Accounting Standards Board (FASB) highlights the importance of intellectual property matters for financial reporting purposes. These two standards introduce and mandate important fundamental changes in the recognition of intangible assets for financial reporting purposes. SFAS 141 addresses the treatment of intangible assets acquired in a business combination that arise from contractual or legal rights. SFAS 141 indicates that the intellectual property assets should be recognized as an asset apart from goodwill - regardless of whether those rights are transferable or separable from the acquired entity or from other rights and obligations. FASB provides several examples of intangible assets that meet the contractual-legal criterion such as trademarks, Internet domain names, patented technology, and computer software.

SFAS 142 states that an intangible asset acquired either individually or with a group of other assets should be initially recognized and measured (apart from goodwill) based on its fair value. Further, an intangible asset with a finite useful life, as defined within SFAS 142, is amortized while an intangible asset with an indefinite useful life is not amortized. In both circumstances, a qualified valuator will assess the assets' appropriate value and will note the proper requirements for financial reporting purposes as dictated by SFAS 141 and 142. In addition, FASB requires that any intangible assets recognized in financial statements be subject to amortization and should be reviewed for impairment annually, or more frequently if impairment indicators are evident. According to FASB, an essential reason for issuing SFAS 142 was to mandate better and more useful financial information about intangible assets be made available to the users of the financial statements. Both SFAS 141 and SFAS 142 require the determination of the fair value of intangible assets. Inherent in both Statements is the notion that the fair value of an asset is the amount at which the asset could be bought or sold between willing parties.

Intellectual property can also be valued for litigation purposes. In disputes involving infringement of patents, trademarks, trade names, trade secrets, and copyrights, the valuation of a company's intellectual property may be needed. In these cases, a qualified and experienced valuator of intellectual property with the necessary skills and understanding of accounting, finance, and applied microeconomics will be an essential element of the litigation team. Examples of the types of intangible assets that are valued for litigation purposes include the determination of an appropriate royalty base in a patent, trademark, or trade name infringement case, or the provision of testimony regarding damages sustained by an infringement of intellectual property. Infringements of intellectual property are not rare. Settlements in these matters can be for hundreds of millions of dollars. In April 2004, Microsoft paid approximately $440 million to settle a patent infringement dispute with Intertrust over digital rights management. Similarly, Caesar's Palace won a court order requiring a Las Vegas beauty salon to desist from operating under its trademark "Scissors Palace." When the valuation of intellectual property becomes needed for the purpose of litigation, the independence of the valuator is essential for credibility. Often times the appointment of a valuator is mandated by the Court both in terms of settling the matter and educating the participants.

The Sarbanes-Oxley Act of 2002 ("SOX") highlights a further extension of the importance of valuing intellectual property issues in the current realm. SOX states that non-audit services (that is, valuation and consulting activities) by external auditors should be restricted in order to prevent real or perceived conflicts of interest that cast doubt on audit integrity (Sections 201, 202 and 206 of SOX). According to a survey conducted by Robert Half International Inc. in July 2003, many private companies were limiting or separating services provided by their external accounting firm to avoid potential conflicts of interest. Among the 1,400 CFOs of privately held corporations that participated in the study, approximately 60 percent of the respondents indicated that their companies were responding to accounting regulations by implementing new practices, and approximately 25 percent of the respondents indicated that they were hiring an independent firm for valuation and consulting work. Although SOX legislation was aimed at public companies, many private firms could benefit from the adoption of SOX's key provisions. Privately held corporations that adopt the measures will likely benefit from increased confidence and lower monitoring costs supported by their stakeholders.

The valuation of intellectual property is a complex task to be performed by a qualified and experienced valuator with the necessary skills, experiences and education. As stated earlier, the independence of the valuator will add credibility to the valuation. To value intellectual property in accordance with SFAS 141 or 142, compliance departments should look to independent outside consultants with the necessary skills to perform the valuation. In dispute cases, a thorough valuation of intellectual property by an expert who can apply accounting, finance, and applied microeconomics concepts will prove extremely helpful to the litigation team.

Howard Fielstein, a Partner of Margolin, Winer & Evens LLP, heads up the Litigation and Valuation Services Practice Group and holds the CPA/ABV, CFE, CIRA and CTP designations. He can be reached at hfielstein@mwellp.com. John F. Lemanski, a Manager in the practice group, holds an MBA degree and the CFE designation. He can be reached at jlemanski@mwellp.com.