Intellectual Property is considered an alternative asset class on a balance sheet and is often overlooked by businesses. However, listing Intellectual Property assets can potentially create substantial value for the business if the proper steps are taken in their valuation. The intent of this article is to give an overview of intellectual property, how it is valued, and its relevance to a business’ balance sheet. Specific topics covered include:
- an introduction on the various forms of intellectual property,
- an introduction on patent valuation and topics surrounding it, including specific approaches to valuing intangible aspects
- an explanation of how listing intellectual property value on a balance sheet can be beneficial for a company.
What is Intellectual Property?
Intellectual property (IP) is a form of intangible asset created by human intellect (e.g., works of art, designs, symbols, names, and physical inventions). A company’s well-developed IP portfolio could be a large contributor to realizing growth opportunities. An IP portfolio strengthens the company’s foothold in the market space by preventing competitors from fulfilling the niche that is covered by the patent-protected technology. Furthermore, by introducing a novel idea in a patent, a company can attract investors and create opportunities to generate more revenue by leveraging the exclusivity granted by the patent protection.
The most common forms of IP include copyrights, trademarks, trade secrets, and patents.
Copyrights
Copyrights grant protection over expression of original ideas. Some forms of copyright include literary works, visual arts, songs, software, etc., which are often denoted by a copyright symbol (©). For a work to be eligible for protection, a creator must “fix” their work in a tangible medium of expression (e.g., by recording or writing it such that it can be perceived, reproduced, shared, or somehow communicated). Once fixed, copyright protection is automatically granted to the original work and lasts at least as long as the life of the creator plus an additional 70 years. Even though copyrights are automatically protected upon fixation, registering a copyright is recommended as it established a public record, and therefore, evidence that the protected work is original. Copyright protection is typically only granted on the national level in territories they were created in; however, on the international level, they can receive the same national-level protection in territories of the Berne Convention¹ member parties.
Trademarks
Trademarks, similar to copyrights, are words, phrases, or symbols that serve to distinguish specific brands or companies. Examples of trademarks include the Nike swoosh logo, the word “Nike”, and the “Just Do It” slogan. Trademarks are identified by a trailing trademark symbol (™, ℠, ®), with the main differences being that the ™ and ℠ markings provide notice for common law rights in the mark are claimed for unregistered trademarks while the ® marking indicates an officially registered trademark and provides national legal protection in the country the trademark was registered in. For international protection, owners can file trademark applications to the countries they would like protection in or use the World Intellectual Property Organization’s (WIPO) Madrid System² to file one single application and then pay one set of fees to apply for protection in up to 129 countries that make up the Madrid Union. Unlike copyrights and other forms of intellectual property, a trademark does not expire after a set period of time and can last indefinitely.
Trade Secrets
Trade secrets are information—usually a formula, pattern, method, or process—that are developed internally and hold economic value because they are known only to a limited group of people. An example of a trade secret would be the Coca-Cola formula. Given that trade secrets are internally held, they are not officially registered with a government agency for protection. As a result, holders of the information about the trade secret take reasonable steps to ensure it stays a protected secret, including use of confidentiality agreements.
Patents
Patents grant their owners the legal right to exclude others from making, using, or selling their invention for a limited period of years in exchange for publishing a public disclosure of the invention. Traditionally, patents have been used to protect tangible inventions, but have seen utility for the sake of protecting specific industry methods as well. Usually, the lifetime of a patent is at least 20 years after the initial filing of the patent application, not accounting for the maintenance periods.
There are three types of patents: design, plant, and utility patents. Design patents protect new, original, and strictly ornamental (i.e., having no utility or function) designs in an article of manufacture (e.g., iPhone design, emojis, curvy Coca Cola bottle). Similarly, plant patents protect any new and distinct variety of a plant.
Utility patents encompass the majority of patents and are granted to inventions that are both novel and useful. In order to qualify for utility patent protection, inventions must fall into one of the following categories:
- Machines, which are objects composed of moving parts (e.g. computers, engines)
- Articles of manufacture, which are usually static, but useful items (e.g. hammers, gloves, screws, bolts)
- Processes, or methods (e.g., business processes, software)
- Compositions of matter (e.g., pharmaceuticals)
How are Patents Valued?
Because patents are, by nature, intangible assets, it is essential to obtain an accurate valuation for them to reflect their worth, not just in terms of monetary value in a balance sheet but also in applications like internal strategy development or monetizing transactions with third-party entities. The process of valuing a patent is involved and can be approached with three main approaches outlined below:
Cost Approach
The Cost Approach of patent valuation equates the patent’s value to the cost of developing an equivalent or comparable patent considering elements such as R&D costs and general patent drafting, filing, and maintenance fees. The Cost Approach is generally more applicable when the intellectual property is relatively new and/or can be exchanged or substituted for a similar asset.
There are four cost components that are generally considered when utilizing the Cost Approach:
- Direct Costs: Costs relating to material, labor, and overhead costs incurred directly by the inventor.
- Indirect Costs: Costs relating to material, labor, and overhead costs specific to expenditures involving third-party contractors, consultants, and independent professionals outside of the inventor’s organization.
- Developer’s Profit: The inventor’s expected return attributable to reproducing the asset, additionally considering expenses financed internally or by third-party sources.
- Entrepreneurial Incentive: The economic benefit required to motivate the inventor to proceed into the development process, often perceived as an opportunity cost.
The largest challenge to utilizing the Cost Approach is the fact that patents are, by nature, unique, so identifying proper replacement costs for a particular patent is difficult. Furthermore, the value determined using the Cost Approach can be unreliable in the context of the potential value that can be gained from monetizing the asset.
Market Approach
The Market Approach derives the patent value based on the value of previous arms-length transactions of comparable patents.
The Market Approach is generally applicable when details of prior arms-length transactions involving related intellectual property can be publicly accessed, and usually involves three different methods:
- Sales Comparison Method, which relies on Comparable Uncontrolled Transaction (CUT) sales of assets similar to the subject asset to obtain a number amount to be applied to the subject asset;
- Licensing Rate Comparison Method, which relies on CUT licenses of similar assets to the subject asset to obtain a relevant royalty rate to be applied in licensing agreements to use the subject asset.
- Comparable Profit Margin Method, which relies on obtaining profit margins of comparable companies with a similar intangible asset as a way of measuring the subject asset’s potential value.
One major challenge to this approach is that the necessary details about transactions may be difficult to search for given that many IP deals are confidential. In addition, evaluating comparable patent transactions to assign a value to a pertinent patent is difficult because patents are unique and like-for-like analysis is impossible such that various adjustments and assumptions would likely be required to derive a proper valuation.
Income Approach
The Income Approach values patents based on projections of future income flows generated by the asset presented as a nominal value and then discounting to derive a net present value (NPV), the difference between the present value of cash inflows and present value of cash outflows over a period of time, adjusted for inflation. A drawback to the Income Approach is that its reliance on assumptions to make derive values necessitates obtaining appropriate royalty rates and discount rates to generate an accurate valuation.
However, this approach is the one of most utilized approaches in patent valuation because it is comprehensive in accounting for multiple factors to estimating a value based on how the patent is monetized (e.g., acquisition or licensing). For instance, the Relief-From-Royalty (RFR) method measures the patent’s value by quantifying the potential income generation from licensing the asset. This method considers how much a licensor would charge a licensee in royalties for the rights to use the patented technology. Furthermore, this method requires the determination of projected royalty payments, which are derived by multiplying a royalty base times a royalty rate. Royalty rates are often derived from the market and are based on arms-length third-party licenses or CUTs. The lump-sum value of the patents may then be quantified by applying a discount rate that reflects the risk of realizing the calculated income (or royalty) stream.
Another common method of the Income Approach to value a patent is the Incremental Earnings method which measured a patent’s value by the incremental earnings achieved by a product that incorporates the technology detailed in the patent relative to a comparable product that does not incorporate the patented technology. The incremental earnings can be attributed to generating a greater amount of revenue (e.g., charging a higher price premium or achieving larger sales quantities) or lower costs (e.g., reducing production costs or decreasing capital expenses) by owning the patented technology.
The RFR and Incremental Earnings methods are just two of many methods of the Income Approach, exemplifying the effectiveness of the Income Approach in IP valuations. The Income Approach is usually the preferred approach of the three main approaches because of its comprehensive analysis of an asset backed with real market data and analysis.
Common Terms in Valuation
IP valuation is an involved process and as such, it is crucial to become familiar with the terms that it encompasses. Some fundamental terms commonly referenced in valuation reports include:
- Total Available Market (TAM): The overall market relevant to the intellectual property. TAM analysis is required to find market size, growth, and opportunities for monetization.
- Nominal Value: The current value without accounting for inflation or current factors.
- Net Present Value (NPV): The difference between the present discounted value of cash inflows and present value of cash outflows over a period of time.
- Royalty Rate: A rate paid to the owner of the intellectual property for rights to use the intellectual property.
- Discount Rate: A rate determined by evaluating the risk of realizing the projected cash flow, typically used in NPV calculations.
- Market Comparables: Similar assets to a particular intellectual property that have previously encountered third-party transactions. These assets are typically used to estimate the value of intellectual property in the Market Approach.
- Royalty Rate Comparables: Royalty rates obtained by previous third-party licensing agreements for intellectual property similar to the subject asset.
- Replacement Cost: The present value that would be paid to replace the patent. This number is used in the Cost Approach as the primary means to estimate the value of the IP.
Intellectual Property on a Balance Sheet
Copyrights, trademarks, and patents are considered intangible assets that can be recorded on a company’s balance sheet. Because development of copyrights, trademarks, and patents have associated costs, they should be amortized in a balance sheet over their expected life term to reflect their value as assets. Accordingly, if intellectual property is acquired from another party, it should be reflected on the balance sheet as an intangible asset and amortized. However, for the sake of maintaining balance sheets, trade secrets are not listed as an asset because they have no clear or direct value by nature of being internally developed.³
IP valuation is a challenging but important process that helps ensure that a company is properly valued, especially if most of its assets are derived from the ownership of several IPs. Evidently, knowing the value of intellectual property is important for projecting sales or for monetization use cases such as licensing or asset transferring.
Although patents are not conventional liquid assets that appear on a balance sheet, their uses as an alternative asset class directly increase the value of the business that holds them by providing opportunities to expand their foothold in their respective industries. Considering the factors previously mentioned, it is important for companies to obtain accurate IP valuation which provides leverage in third-party negotiation cases like mergers and acquisitions (M&A), investment-backed loans, etc.
Notes:
- Berne Convention for the Protection of Literary and Artistic Works, https://www.wipo.int/treaties/en/ip/berne/
- The Madrid System – The International Trademark System, https://www.wipo.int/madrid/en/
- GHB Intellect is not an accounting, investment or law firm. We do not offer accounting, tax, investment or legal advice or representation. No part of this article or this website is to be considered as offering accounting, tax, investment, or legal advice.