Measuring a company to determine business asset valuation can include various aspects. One section typically includes a company’s intangible assets. Intangible assets lack physical property yet can provide competitive advantages. Examples of these intangible assets include trademarks, patents, copyrights, equities, securities, contracts and more. In this segment we will cover intangible assets in intellectual property.
Intellectual Property Asset Valuation
Determining an accurate intellectual property intangible asset valuation requires expert analysis including the market, income and cost approach. In order to have value, a common measurable amount must be determined. Expert patent valuation services is a critical aspect of any IP transaction and should determine the appropriate value of intellectual property assets. It is important to understand that reducing risk and increasing profitability must be the primary focus during a patent valuation. These valuations occur during a multitude of technology transfer transactions including the sale, licensing, or acquisition of any IP rights. Hence, the prices paid during an IP transaction must be evaluated for its perceived value, which is obtained through a detailed valuation process before it can be objectively understood by the potential buyer or seller. The necessary skill sets used in an IP valuation are cornerstones of our intellectual property consulting services and include: legal, financial, and technical experience.
A Simple Breakdown of the Three Intangible Asset Valuation Methods
The Income Approach
The Income Approach values assets based on the present value of the future income streams expected from the asset under consideration. The FASB Statement of Financial Accounting Standards No. 157 describes the Income Approach as follows:
The income approach uses valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present amount (discounted). The measurement is based on the value indicated by current market expectations about those future amounts.[1]
There are several generally accepted methodologies that fall within the Income Approach related to assessing the value of intellectual property including:
The Relief-From-Royalty Payment Method
The RFR Payment Method is based on the premise that a property’s value can be measured by quantifying the amount of income that could be generated from licensing the intangible asset. From the inbound license perspective, this method considers what the actual owner would be willing to pay as a royalty rate to a hypothetical owner who would inbound license the use of the intangible asset. From an outbound license perspective, this method considers what the actual asset would charge to a hypothetical licensee to license the asset to that third party. In both cases, the selected royalty rates typically are market-derived and are based on arm’s-length third-party licenses or Comparable Uncontrolled Transactions (“CUTs”). This method requires the determination of projected royalty payments, which are derived by multiplying a royalty base times a royalty rate. The lump-sum value of the subject patents may be quantified by applying a discount rate that reflects the risk of realizing the calculated income (or royalty) stream.
The Incremental Earnings Method
The Incremental Earnings Method is based on the premise that a property’s value can be measured by the incremental earnings achieved by the product incorporating the subject intellectual property relative to a comparable product that does not incorporate the subject intellectual property. The excess earnings may result from (a) the owner generating a greater amount of revenue (e.g, commanding a price premium or achieving larger sales quantities) by owning or operating the intangible asset compared to not owning or operating the intangible asset or (b) the owner generating lower costs (e.g., reducing production costs or decreasing required capital expenses) by owning or operating the intangible asset compared to not owning or operating the asset.
The Profit Apportionment (Split) Method
The Profit Apportionment Method is based on the premise of evaluating the share of the licensee’s anticipated profit a licensor may seek in return for providing the licensee with access to the intangible assets. This method considers what the owner provides (the intangible asset) and what the operator provides (the working capital assets, the tangible personal property and real estate assets, and the routine intangible assets used in the business). Each party (the owner and the operator) receives a split of the total business operating profit commensurate with their relative contribution to that business. Profit apportionment analyses attempts to divide the anticipated profit under a licensed product in a manner that is commensurate with the nature of the intangible asset and the risks assumed by each party to the transaction.
The Differential Income Method
The Differential Income Method is based on the premise of comparing the income (or another relevant measurement such as revenue, expenses, inventory balances, etc.) generated by a business and to compare that amount to a defined benchmark. The benchmark measure could be (a) the owner income without the intangible asset, (b) the owner income using a prior generation of the intangible asset, (c) an industry average level of profitability, (d) a level of profitability earned by identified guideline companies, or (e) some other benchmark income measure. The differential income measure does not necessarily have to be owner/operator operating income, net income, or net cash flow. Rather, the differential income could be measured by the difference in just about any owner/operator financial fundamental.
The Multi-Period Excess (Residual) Earnings Method
The Multi-Period Excess Earning Method (“MPEEM”) is based on the premise of assessing the total income of a business or product and then subtracting the expected values associated with the assets that are not subject to the valuation (“contributory assets”) over a relevant period. The total income less the total contributory asset charge equals the residual income which is the income associated with the intangible asset. This method considers the fair rate of return on investment for each contributory asset category (e.g., net working capital assets, real estate and tangible personal property assets, and routine intangible assets).
The Market Approach
The Market Approach values assets typically based on an analysis of arm’s-length sales or licenses of guideline intangible assets which are often referred to as Comparable Uncontrolled Transactions (“CUTs”). The Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards No. 157 describes the Market Approach as follows:
The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities (including a business). For example, valuation techniques consistent with the market approach often use market multiples derived from a set of comparables. Multiples might lie in ranges with a different multiple for each comparable. The selection of where within the range the appropriate multiple falls requires judgment, considering factors specific to the measurement (qualitative and quantitative).[2]
There are several generally accepted methodologies that fall within the Market Approach related to assessing the value of intellectual property including the following:
Sales Comparison Method
The Sales Comparison Method is based on the premise of relying on CUT sales of intangible assets comparable to the subject asset and calculating transaction multiples to be applied to the subject asset. This method is most applicable when the asset is the type of intangible asset that sells in the marketplace as a separate intangible asset. In other words, such assets transact as naked intangible assets (without any other tangible or intangible assets). This method is also applicable when there are sufficient arm’s-length sales of the subject intangible asset type.
Licensing Rate Comparison Method
The Licensing Rate Comparison Method is based on the premise of relying on CUT licenses of similar intangible assets. This method is applicable when the analysis objective is to determine an appropriate royalty rate. This method is appropriate when the subject bundle of rights is for a limited term and is a use (not a fee simple) right. This is due to the fact that typical intangible asset license agreements encompass a defined (and limited) bundle of rights, in a specific territory, for a specific use, and for a specific period of time.
Comparable Profit Margin Method
The Comparable Profit Margin Method is based on the premise of relying on comparable company profit margins. This method is most applicable when the owner has one extraordinary intangible asset that stands out as the reason for the owner success and for the owner’s excess profitability. This method is also applicable when there is a sufficient number of competitors that do not enjoy the benefit of the extraordinary intangible asset.
The Cost Approach
The Cost Approach values assets based on the cost to reproduce (create an exact replica) or replace (create an asset with the same or similar utility) the asset under consideration. The Cost Approach is generally more applicable when the intangible asset is relatively new and/or could be exchanged or substituted for another similar intangible asset. The FASB Statement of Financial Accounting Standards No. 157 describes the Cost Approach as follows:
The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (often referred to as current replacement cost). From the perspective of a market participant (seller), the price that would be received for the asset is determined based on the cost to a market participant (buyer) to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence.[3]
There are four general cost components that should be considered under the Cost Approach:
- Direct Costs – includes costs related to material, labor, and overhead costs incurred directly by the intangible asset creator.
- Indirect Costs – incudes costs related to material, labor, and overhead costs but are specific to expenditures related to contractors, consultants, and independent professionals that are outside the intangible asset creator’s organization.
- Developer’s Profit –includes the intangible asset creator’s expected return associated with reproducing or recreating the intangible asset. This would also include consideration of whether the incurred expenses are financed by external sources or by the intangible asset creator directly. Typically, the higher rate of return is assigned to the cost financed directly by the creator.
- Entrepreneurial Incentive – includes the amount of economic benefit required to motivate the intangible asset creator to proceed into the development process. From the perspective of the creator, entrepreneurial incentive is often perceived as an opportunity cost (i.e., forgone income).
A prudent investor of a technology would generally not pay more than the cost to develop or re-create a non-infringing solution that would accomplish the same ends. Likewise, a prudent seller would generally not sell the asset for less than the incremental cost to create it. Thus, if a proprietary technology is fundamental to a product or enhances the product in a way that cannot be easily duplicated, then the technology will typically be more valuable than one with readily available substitutes.
The Reason To Value Intangible Assets
David Post leads the Sustainable Accounting Standards Board’s of sector analysts, states that : “Intangibles have grown from filling 20% of corporate balance sheets to 80%, due in large part to the expanding nature, and rising importance, of intangibles as represented by intellectual capital vs. bricks-and-mortar, research and development vs. capital spending, services vs. manufacturing, and the list goes on.” (forbes.com)
Intellectual Property (IP) is a crucial portion of a company’s assets. A strong IP portfolio is instrumental for; fundraising, leverage in business transactions, an exit strategy, M&A valuation. Mergers & Acquisitions provides portfolio strength and freedom to operate. There are varying discount rates between 10-30% which can change the value of the company significantly. A strong valuation can have huge success to an initial public offering (IPO), provide leverage in cross licensing, easy liquidation, and strategic partnerships take a close look before investing. The IP transaction market has grown rapidly, due primarily to the boom in new patent claims.
At GHB Intellect, we have high-credentialed and industry-seasoned experts with strong valuation skills. Because we have deep roots in the high-tech industry, we are a trusted source for intellectual property consulting services. Our full-service IP services assign each client with a project manager who will assist the client through the entire process, from initial expert selection, through execution of tasks, to the final reports for the project.
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[1] FASB, “Statement of Financial Accounting Standards No. 157” (Amended), September 2006, p. 11
[2] FASB, “Statement of Financial Accounting Standards No. 157” (Amended), September 2006, pp. 10-11
[3] FASB, “Statement of Financial Accounting Standards No. 157” (Amended), September 2006, p. 11