Intellectual properties (IP assets) are often the primary driver of profits for a company. They differentiate a company’s products and services from those of its competitors. In today’s technology-driven environment, IP assets often comprise more than half of a company’s value.
What Are IP Assets?
The World Intellectual Property Organization (WIPO) is a global forum for intellectual property services, policy, information, and cooperation. According to WIPO, intellectual properties fall into the following categories:
- Copyright (or author’s right) – a legal term used to describe the rights that creators have over their literary and artistic works. Works covered by copyright range from books, music, paintings, sculpture, and films to computer programs, databases, advertisements, maps, and technical drawings.
- Patent – an exclusive right granted for an invention, which is a product or a process that provides, in general, a new way of doing something or offers a new technical solution to a problem. To get a patent, you must disclose technical information about the invention to the public in a patent application.
- Trademark – a sign capable of distinguishing the goods or services of one enterprise from those of other enterprises. Trademarks are protected by intellectual property rights.
- Industrial Design –the ornamental aspect of an article. An industrial design may consist of three-dimensional features, such as the shape of an article, or two-dimensional features, such as patterns, lines, or color.
- Geographical Indication (GI) – a sign used on products that have a specific geographical origin and possess qualities or a reputation that are due to that origin. In order to function as a GI, a sign must identify a product as originating in a given place.
- Trade Secret – IP rights on confidential information, which may be sold or licensed. In general, to qualify as a trade secret, the information must be commercially valuable because it is secret; known only to a limited group of people; and subject to reasonable steps taken by the rightful holder of the information to keep it secret, including the use of confidentiality agreements for business partners and employees.
Why Should You Value Your IP Assets?
An IP assets valuation may be required — or preferable — for a variety of reasons. Here are just a few:
- If there is intent to sell or license the IP to a third party.
- For intercompany transfer pricing.
- To calculate damages for litigation purposes.
- To use as collateral for bank financing.
- For reporting purposes in the context of a purchase price allocation as set forth in Accounting Standards Codification (ASC) 805 Business Combinations.
- For fresh-start accounting for bankruptcy purposes as set forth in ASC 852 Reorganizations.
- For gift and estate planning purposes.
How Can You Determine the Value of Your IP Assets?
There are three common approaches to utilize when determining the value of your IP assets.
The first of these, the cost approach, is based on the principle of substitution, which states that no sensible buyer would pay more for an asset than what a similar, equivalent asset would cost. In applying the cost approach to your IP assets, it is necessary first to determine replacement and/or reproduction costs, and then to consider allowances for applicable forms of depreciation and obsolescence.
The cost approach is often used when the IP assets being valued can be reasonably replaced and/or when the economic benefits pertaining to the IP assets are difficult to quantify. Consequently, the cost approach is often used to value IP assets such as office software and technologies that are used to manage and support operations, e.g., bookkeeping, payroll, inventory management, tax returns and preparation, invoicing, cash flow management, and supply-chain management software as well as proprietary support hardware. Non-income-producing IP assets could also include patented technologies that are not yet being exploited, patented technologies held for defensive purposes, and patented technologies held for sale.
A second option is the market approach, sometimes referred to as the “sales comparison approach” because it estimates value based on the cost of similar assets recently sold to other market participants. Using this approach, you will need to adjust your estimate to compensate for the inherent distinctions among similar assets, such as each asset’s age, condition, and capacity and the dates of the comparable transactions.
The market approach could be used to value IP assets if comparable assets have been bought or sold in the marketplace and terms of the transactions are publicly available. However, the sale of IP assets is uncommon except as part of the larger purchase of a going concern. Furthermore, detailed information on the terms of the sale of IP assets often is not made public. Consequently, the market approach is typically not used in the valuation of IP assets.
Finally, the income approach estimates IP assets’ value based on the net economic benefit — operating income or cash flow — over the life of the assets, discounted to the present value using a rate of return that accounts for various factors such as the time value of money and investment risk.
With respect to IP assets, two income approach methods are most common:
- The Multi-Period Excess Earnings Method (“MPEEM”) estimates the value of an intangible asset by quantifying the amount of residual (or excess) cash flows generated by the asset and discounting those cash flows to the present. The MPEEM requires the application of contributory asset charges. These charges represent the return on and of all contributory assets, and are applied in order to estimate the “excess” earnings generated by the intangible asset in question. Contributory asset charges typically include payments for the use of working capital, tangible assets, and other intangible assets.
- The relief from royalty method is based on the assumption that in lieu of ownership of an intangible asset, a company would be willing to pay a royalty in order to enjoy the benefits of the asset. Under this method, value is estimated by discounting the hypothetical royalty payments to their present value over the economic life of the asset.
The MPEEM is sometimes used for purchase price allocation purposes when the IP assets are the primary asset of the company. This method can be quite complex in that it requires all other assets of the company to be valued so that contributory returns can be applied. For this reason, the MPEEM is usually not employed when the valuation assignment calls for simply valuing the IP assets.
The relief from royalty method is probably the most common method used to value IP assets. Relying on the relief from royalty method, you must first determine a reasonable royalty rate to apply in the valuation, using one of two general methods: The first entails searching for and then purchasing suitable public market evidence pertaining to IP assets in your industry. The second, also known as the “pretax profit method,” assumes a portion of the pretax profitability margin (often in the 25%-to-33% range) as a reasonable starting point in a negotiation to license the IP assets. For example, if your company has a pretax margin of 10%, then a reasonable royalty rate for the IP assets arguably would fall in the range of 2.5% to 3.3%.
Why Hire a Valuation Professional for Your IP Assets?
Valuing IP assets is a complex process. As illustrated above, there are a number of potential methods for valuing IP assets. The selection of the method (or methods) to use is based on the specific facts and circumstances associated with the IP assets, as well as the purpose for which the valuation analysis is being conducted. A great deal of research, thought, and experience are required to properly select valuation methodologies and the underlying assumptions. To value IP assets properly, therefore, you should always employ a qualified valuation analyst — the benefits of doing so far outweigh the costs.