“IP Valuation- is it an option or a duty?” ‘Intellectual capital is recognized as the most important asset of many of the world’s largest and most powerful companies………’
In recent years, companies have been highly competitive and seem to have a short product cycle. One of the major reasons is the technology driven market and the rush of mergers and acquisitions in the industries. Due to the information age, valuation of certain intangible assets at initial stage of a product life cycle becomes crucial for the welfare of the company. One such asset is Intellectual property (IP). Not only are there accountants, IP valuators, IP management companies but even to lawyers IP valuation is becoming a field of interest since they seek revenues from methods of valuating patents. Some seek proprietary gains from patenting their own valuation method.Slowly, this is becoming an area of interest to lawyers and legal advisors since it is one of the focus areas when there is a merger deal and patents are either sold, licensed or securitized’. This paper identifies and analyses the existing literature relating to the valuation of intellectual property rights and why is it necessary in the ever changing economy. There are number of methods that have been analysed so as to reach to the optimal method for Intellectual Property (IP) valuation. Even though there are around 100 methods so as to value Intellectual Property but we focus on a few important principle techniques relating to intellectual property valuation.
Recent reporting standards have made it an obligation to identify value and put on the balance sheet all the intangible assets in case a merger deal takes place. This helps shareholders in knowing what has been paid off and how much has the value changed over a period of time. This regulatory change has made intangible asset valuation an important and crucial issue. ‘According to a recent PricewaterhouseCoopers analysis of the US market, intangible assets and goodwill constituted around three-quarters of the average purchase price of acquired companies. These findings are certainly in tune with the increasing attention now being paid to the management of intangible assets by companies in the US and worldwide – and the growing demand from investors, analysts and standard setters for the provision of accurate, properly communicated information on the value of companies ‘ intangible assets’.‘Intangible asset valuation has presented itself as a live strategic business issue in the wake of the introduction of the International Financial Reporting Standard for Business Combinations (IFRS 3) and the introduction in the US of similar standards FAS 141 (Business Combinations) and FAS 142 (Goodwill and Other Intangible Assets). These standards effectively require all companies listed on exchanges in the EU and US, among several other countries including Australia, to identify and value acquired intangible assets.’
Valuation of IP has always been a topic of much debate and many different compelling arguments. IP Valuation is a must so as to have a potential impact on business value. Intangible assets like patents, marks, know-how and licenses play increasingly a key factor for firms’ economic performance. IP is regarded as a primary contributor to the earning power of a firm and hence its value becomes of much importance. However, along with being crucial, IP valuation also becomes a major problem in an economy which is run on knowledge or intellectual assets. Intellectual assets are Intellectual Property, explicit knowledge and human capital .This is essential for Mergers and Acquisitions, Investment licensing, infringement damages etc. Intellectual property is an intangible asset and calculating the value of intangible assets is not a problem when they have been formally protected through trademarks, patents or copyright. This is not the case with intangibles like know how, (which can include the talents, skill and knowledge of the workforce), training systems and methods, technical processes, customer lists, distribution networks, etc. since they are more difficult to identify in terms of the earnings and profits they generate. With many intangibles, a very careful initial due diligence analysis needs to be undertaken together with IP lawyers and in-house accountants. Hence, the importance of IP valuation increases even more. ‘Value is the representation of all future benefits of ownership, compressed into a single payment. Therefore, value is continually changing as the future benefits increase or decrease, either with the passage of time or with changing perceptions of what the future will bring. Value does not exist in the abstract and must be addressed within the context of time, place, potential owners and potential uses.’
Valuation is, essentially, a bringing together of the economic concept of value and the legal concept of property. Intellectual Property is an identifiable intangible asset since it can be given a fair value and a reasonable return in the future can be expected. However, some companies look at IP as a profitable tool and do not classify them in any group. Hence, for such companies it also becomes a strategic asset. Valuable know-how is generally treated as trade secrets and not disclosed to public but are rather held as trade secrets within the organization. They are only disclosed to licensees and partners in confident. For valuing a company it is important that the asset is readily identifiable, documented and is separable from other assets of the company. The first section of this paper has already dealt with the introduction of IP Valuation. The second part deals with the valuation pyramid and basics underlying it. The third section deals with the different methods for valuation of IP .The fourth section points out the problems faced while valuing IP and suggestive measures that can be taken while dealing with the problems.
2. Valuation of Pyramid
2.1 Purpose – Why is the asset valued?
2.2 Description – What is the asset?
2.3 Premise – What will be the use of the asset in the future?
2.4 Standard – Who is the assumed buyer of the asset?
Different level Name of Levels Significance of levels First Level Foundation Level Underlying rationale and key assumptions of IP valuation Second Level IP Profile Business Legal and Economic Attributes are defined. Third Level Methodology Level Financial Analysis is performed to generate results. Fourth Level Solution Level This addresses the issue as to how valuation analysis solves a business problem.
2.1 Purpose of IP Valuation: Since valuation of any asset requires time and involves expenses, it becomes important to know as to why IP needs to be valued.
- Transparency of Balance sheet: Shareholders of a company require that any “hidden” assets are reflected in the balance sheet. Since IP is intangible in nature, its valuation can give shareholders a better understanding as to the value of the company that can be reflected in the price of the company’s shares.
- Tool for improving management performance: IP is a key value driver and its valuation can cause changes in the financial analysis in the company. It will then give a realistic view on the companies return on asset and other key important ratios.
- Back up Security: Recently IP is being considered by banks as a valid asset against which loans can be granted. However, this can only be done when IP appears on the balance sheet. Amortization leading to tax benefits: IP can lead to tax benefits due to amortization since there will be a reduction in tax liability due to amortization of identifiable tangible asset and IP capitalization.
- Litigation: ‘A high-profile purpose of intellectual property valuation is to compute damage awards in an infringement lawsuit. The court history for determining IP valuation for infringement is rather lengthy, and a separate court system, the Court of Appeals for the Federal Circuit, is dedicated to resolving IP disputes.’
2.2 Valuation Description : Intellectual Property refers to patents, trade secrets, copyrights and trademarks. This states the general attributes of an intangible asset. ‘Intangible assets refer to the broader class of intangibles that are specified in a contract between the contracting parties. It gives the IP owner rights Intellectual property in contrast gives the IP owner rights against anyone, regardless of the presence of a contract, as in the case of patent infringement where a non-contracting party has made a patented product’. There are different characteristics if IP regimes for example, trademarks offer leverage by way of brand extension etc. In the same way patents can provide a competitive edge especially when the markets are technology based. Copyrights can help generate additional revenues through additional exclusive rights.
2.3 Valuation Premise: This refers to the use of asset in the future. Usually, the highest value is taken but this may not be valid in exceptional circumstances like incase of bankruptcy.
2.4 Valuation Standard: The most common valuation standard is the ‘fair market value’ standard. This is the transaction price between a willing buyer and a willing seller. This gives access to all the important and required information to both the parties. It should be noted that neither parties are under any compulsion to transact. ‘Fair Value’ is one of the alternative standards that is used in court cases ‘to compensate a party for the involuntary use of an asset, such as eminent domain, where there is no reasonable assumption of a fair market value transaction’.
3. Valuation Methods
Before valuing intellectual property, the purpose for which valuation is being done should be taken in account since various methodologies are used in different circumstances. In this paper, we will be looking at three methodologies:
3.1 Cost Based Approach
- Historical Method: This method measures the ‘actual cost’ incurred while creating the IP .The expenditure aspect is not taken into account which serves as a big drawback. This means that this method will fail in cases where a patent was developed but never reached market or a trademark involved huge costs but never satisfied its potential customers.
- Replacement Method This is also known as ‘Replacement Cost’.It means the cost it would take to replace a certain asset or develop an alternative. Adjustments for elements of obsolescence may be considered. Depreciation is taken into account so as to show that the correct value after the asset wears and tears in the future. The third component while calculating by this method is the reflection of economic obsolescence.This method is usually used while negotiating where the seller states the value of the alternative in case the original is not sold.
Drawbacks of Cost Approach
It does not tell us as to the amount of economic benefit since these are generated by the demand for that specific product and profits associated thereafter. Social attitudes, demographics and competitive forces affect the trend of economic benefit but this method fails to capture the effect it has on the IP Value. Time is ignored in this method which is a vital factor. The cost approach is based on several economic principles such as the ‘principle of Substitution (a prudent buyer would pay no more for an intellectual property than the cost to construct or develop an asset of equal desirability and utility), the principle of Externality (external conditions may cause a newly constructed intellectual property to be worth more or less than its original cost), the principles of Functional, Technological and Economical obsolescence (the value of the asset may be reduced by its inability to perform a function for which it was designed, or by competing technology which makes the asset less than the ideal replacement for itself, or by external considerations such as economic cycles), and finally the principle of shifts in supply and demand’.
This is the sales value of a comparable intellectual property where a similar deal could be used for a purpose of comparison. It is usually considered when transactions occur in the open market. The price at which similar intellectual property has exchanged can serve as a proxy for subject intellectual property. The major limitation of this approach is it is extremely difficult to ascertain the parameters of comparability. Moreover the price at which such transactions take place is seldom disclosed by the transacting parties. The Methods for valuation under this approach:
- Comparable Valuation Method Or Market Transaction Method :This method provides an indication by comparing the price at which similar property is exchanged between buyers and sellers. But for intellectual property it is often difficult to implement this approach because information about third party transaction involving similar property is scarce. The following are the requirements for valuation of intellectual property under this method: Active market involving comparable property · Past transactions of comparable property · Access to transaction price information · Arm’s-length transactions between unconnected parties In practice it is difficult to find sufficiently comparable transactions since number of transactions are limited and the prices of comparable assets may vary from time to time.
- Royalty Rates Method: It considers what the purchaser could afford, or would be willing to pay, for a license of similar Intellectual Property Right. The royalty stream is then capitalized reflecting the risk and return relationship of investing in the asset. The primary forces for driving the value of intellectual property and royalty rates are listed below: · Profit margins · Market penetration potential · Capital investment requirements · Commercialization costs · Economic Based3.3 Income Based The Income Approach seeks to measure the value of intellectual property on the basis of the present value of the future stream of economic benefits that can be derived from its ownership. It considers the time factor while valuing and is considered a credible technique. It considers the following · Revenue or income associated with the use of IP · Expected growth characteristics of the identified revenue or income · Expected duration of the revenue or income ; risk associated with generating the estimates of revenue or income · The proportion of the revenue or income that is attributable to the subject of IP. Discounted cash flow (“DCF”) is the method under income based technique and out of the three methodologies; it is probably the most comprehensive of appraisal techniques.
Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one. It is calculated as:
DCF= CF1/(1+r1) + CF2/(1+r2)………..CFn(1+rn) Where WACC is the weighted Average cost of capital and is calculated as WACC=(E/V)* Re + (D/V)*Rd*(1-Tc)
Where Re = cost of equity Rd = cost of debt E = market value of the firm’s equity D = market value of the firm’s debt V = Equity (E) + Debt (D) Equity/Value = percentage of financing that is equity Debt/Value = percentage of financing that is debt Tc = corporate tax rate
Here the discount rate (r) is applied to cash flows that can be calculated under different models like, dividend growth models and the Capital Asset Pricing Model (CAPM) utilizing a weighted average cost of capital. The latter will probably be the preferred option when there is a mix of equity and debt in the capital structure of the firm.
CAPM is a method to calculate cost of equity and is considered to be the discount rate only when there is no debt or leverage in the company. The method to calculate it is: Ra=Rf + B(Rm-Rf)where Ra= Discount Rate on securityRf= Risk Free RateRm= Return on Market PortfolioB= Beta of the security The CAPM says that the expected return of a security equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken.
Beta is measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. This is the sort of risk that cannot be diversified since it is the market risk. A beta of less than 1 means that the security will be less volatile than the market. The duration or number of years is important when considering the legal life of intellectual property. It is incorrect to drive out cash flows for the entire legal length of copyright protection, which may be 70 plus years, when a valuation concerns computer software with only a short economic life span of 1 to 2 years.However, the legal life of a patent i.e. 20 years may be very important for valuation purposes, as in case of the pharmaceutical sector with generic competitors entering the marketplace at speed to dilute a monopoly position when protection ceases. Hence, a project life longer than the realistic picture should not be considered since it is not a proper method of valuation. We should keep in mind that we are concerned with ‘the economic life of Intellectual Property, or the period during which the intellectual property can be expected to afford its owner an economic benefit’.
The advantages of using this method over others are many: · It takes the time effect into account and gives a true picture about the expected returns without any market transactions. · It shows the relationship on investment on a security and the returns on overall market portfolio. However, it may be noted that risk free rate might be difficult to obtain indifferent changing environment. Also, CAPM fails to provide optimal results in case the number of years is more than one year since it is a single period model.
Even with as many as 100 methodologies, the role of valuation of intellectual property rights (IPRs) and intangible assets in business is insufficiently understood. Usually during the valuation of Intellectual Property very little co-ordination is noticed between different professionals. Accounting standards are generally not helpful in representing the worth of IPRs in company accounts and IPRs are therefore often under-valued. However , while valuing one must keep in mind the level of risk associated with the intellectual property ,ownership of IP and how could it be exploited in a manner that can raise its value. It should be noted that exploitation can increase risk assessment and hence affect the value of the IP. Recently many developments have been noticed in the field of IP Valuation . The German Institute for Industry Standards is working on a standard for patent valuation together with Steinbeis in Hamburg, whereas banks are working on a standard to valuate IP for financing purposes. But, none of these initiatives have led to a worldwide standard yet. IP Valuation is a big challenge and yields big rewards. In this innovative environment, one needs to be updated so as to know which method of valuation to use under what circumstances.
According to Tony Hadjiloucas(Author of ‘Your Intellectual Property. What’s it worth?…IP valuation has come of age’, WIPO property review,2007) , “companies are finding new and innovative uses for the value of IP, from gaining competitive advantage in negotiations to enabling better communication with the market and this trend is expected to continue as IP valuation becomes even more main stream”. Hence, IP Valuation becomes more of a duty and less of an option in case the firm wants to add value and remain competitive.