In the last few years, the identification and valuation of intangible assets, specifically intellectual property related intangible assets, has garnered increased attention worldwide for a variety of reasons that include increased compliance requirements for financial reporting but certainly also in the leveraged finance arena as lending institutions continue to look beyond traditional collateral sources such as accounts receivable, inventory and equipment.
In defining intellectual property, which is the type of intangible asset that has not been historically considered in leveraged finance deals, it must be seen as the group of innovative technologies and/or processes which create a legally protected and marketable product or service that establishes the foundation for sustained profits and brand development. In other words, the appraiser seeks to analyze how the “product line technology” within a company has formed the basis for creating a marketable branded product. Common types of intellectual property include copyrights, trademarks, trade/brand names, mastheads, customer relationships, patents, engineering drawings, proprietary unpatented technology, software and trade secrets.
During a merger/acquisition transaction, deciding which technique is best used to determine Intellectual property’s fair value depends on many factors, but two of the most important questions are: who is asking? and why? Is the person requesting the valuation on the “buy side” or “sell side”? Why do they need it? The request may be in advance of negotiation, mid-transaction or post-sale. What do they plan to do with the Intellectual property? Block it or use it.
Motivation impacts the intellectual property valuation methodologies that would be used. Different strategies require different techniques, models, value drivers and data. Motivations can be classified as Enabling – intent to utilize or commercialize the Intellectual property, or Blocking – an effort to manage the competitive landscape. An Enabling view requires a measurement of internal benefits whereas Blocking measures the benefits that could be garnered by a competitor.
Once the matters of perspective and motivation have been resolved, the business valuations and valuation of intangible assets can begin. The starting point is to look at the three commonly accepted approaches to value – income approach, market approach or cost approach.
The Income Approach estimates value based on the amount of cash flow an asset is expected to generate over its useful life. There are many variations of the income approach; however, those most frequently used in the valuation of Intellectual property are relief from royalty, excess earnings and cost savings.
Relief from Royalty
As the most widely used business valuation methodology for determining the value of Intellectual property, it measures the value based on the premise that, since the buyer would own the assets, royalties would not have to be paid in order to use it. This approach captures the value of the Intellectual property that was recognized by the current holder as if they had to license it. This raises an important question though – does it represent the value of the asset to other market participants or the value to a specific acquirer? This is a complicated issue, and each case must be evaluated on its own merits and the potential usage of the Intellectual property. The underlying licensing assumptions require a thorough analysis and verifiable documentation. Key assumptions include the selection of the appropriate comparable royalty rate to be applied to the subject, the revenue streams to which the royalty rate will be applied, and the cost of capital or riskiness of the investment. Excess Earnings
Certain intangible assets, such as customer relationships and contracts, can be valued using an Excess Earnings approach. This concept is based upon the theory that the gross revenue of a company is generated by utilizing a combination of the company’s assets, including net working capital, real estate, personal property and intangible assets. By identifying the value of all other “contributory” assets first, a residual income stream is then left available to the subject intangible asset. This left over or excess income stream is then utilized to perform a discounted cash flow analysis to estimate the value of the asset.
This method of business valuation looks at the cost to produce an item with and without the Intellectual property or the profit margin for a branded product versus the profit margin for a similar unbranded product. The estimated operating profit differential between the two costs/profits is applied against projected product sales over the estimated period in which the competitive advantages would exist.
Fair value can also be estimated from the prices paid in actual market transaction or from the asking price for similar assets available for purchase, also called the Market Approach. This approach is more difficult to apply in the valuation of Intellectual property because comparable transaction data is usually not publicly available for business transactions specifically involving Intellectual property; however, this approach should always be considered along with the appropriate research completed to determine whether the approach can be applied.
The third intangible asset valuation approach is the Cost Approach. This approach is generally used in the valuation of non-income producing intangible assets as it considers the current cost of reproducing the asset in order to determine its value. This approach usually provides a minimum value for Intellectual property as no buyer would spend the money to recreate an asset unless it provided a utility which was as great as the monies or effort expended.
After the appropriate value approach has been determined, relevant criteria must be converted into an intangible valuation model. This is where the motivation – enabling or blocking – determines the framework necessary. The challenge arises when the motivation is blocking in nature, as a Market Participant Framework would be utilized. Converting Market Participant criteria into a valuation model is a relatively new exercise for the accounting community. There are few established Intellectual property or intangible asset valuation models that would fall within a category of “generally accepted.” However, there is a standing body of knowledge associated with Intellectual property valuations in the litigation community, which is used to assess damages. The premise is, if you can measure the Intellectual property damages in a courtroom, you can also measure the Intellectual property benefits in a boardroom by using similar modeling.
One such approach is known as a “Technology Applied to Problem Solved” or TAPS analysis. This analysis uses data found in the documentation presented by the inventor to the company’s patent committee as well as in technical journals or through interviews with the inventor to present an analysis of the problems solved using the Intellectual property. A well-constructed TAPS analysis generally yields data that supports an estimate of Market Participant Revenues (income) from use of the Intellectual property. Applying royalty terms found in comparable Intellectual property agreements, an estimated stream of royalty revenue arising from the market participant revenue (stated as a net present value) can be determined. These royalties reflect the fair value.
A business valuation firm can help you to turn intangible assets into tangible value, as they often recognize value that is invisible to others. By recognizing the real value of your company’s Intellectual property, a business valuation firm can provide you with the information and perspective needed to make the best business decisions during a merger/acquisition transaction.