Intellectual Property and Intangible Assets
Written for Valorem Principia
Intangible assets are non-physical assets (such as franchises, trademarks, patents, copyrights, and goodwill) that grant the potential for certain rights and privileges as well as the possibility for economic benefits to the owner. The benefits may be fruitful or fleeting, depending on the nature of the intangible asset and the company exploiting it. Unlike tangible assets, which you can see and touch, intangible assets cannot be physically distinguished. Nonetheless, in the appropriate circumstances an intangible asset can be exchanged, purchased, or licensed. For some companies intangible assets may have such a bearing on the business' value that shareholders are willing to go great lengths and expend funds to define their intangible assets, monitor and manage them, and protect them from infringement and damage. An intangible asset's influence on business value, however, may be ephemeral, subject to the gyrations of the stock market, consumer sentiment, and competition.
Intellectual property is simply a subset of intangible assets. Many modern companies that are largely defined by the nature of their intellectual property are competing based on unique knowledge, branding, or know-how. While “old economy” companies competed under the armor of their bricks and mortar, modern companies that are dependent on their intangible assets contend for market share with adaptation and innovation. This article provides a general overview of the various types of intangible assets and intellectual property, the general approaches and methods to valuing them, and what situations may require the need for a valuation.
Identifying Intangible Assets and Intellectual Property
To qualify as an intangible asset, the owner should be able to specifically identify and describe the asset, it should be subject to legal protection, and one should be able to privately own the asset and legally transfer or sell it to another party. The asset also should also have come into existence at an identifiable time or as the result of an identifiable event, and should be subject to destruction or termination at a particular time or event.
For an intangible asset to have quantifiable value from an appraisal perspective, it should possess certain economic attributes or characteristics in addition to those that indicate legal existence. In particular, the asset should generate some measurable amount of economic benefit to its owner and it should potentially enhance the value of the other assets with which it is associated. The following lists examples of intangible assets:
· Trademarks, trade names, brand names, logos
· Process patents, product patents, technical know-how
· Copyrights, blueprints, trade secrets
· Computer software and automated databases
· Customer lists, customer contracts, open purchase orders
· License and franchise agreements
· Trained and assembled workforce, employment agreements
· Leasehold interests, mineral rights, air and water rights
· Going concern goodwill, professional practice goodwill
Amongst the above examples of intangible assets, there are five general classifications of intellectual property, including:
· Trademarks · Copyrights · Patents · Know-How · Trade secrets
Intellectual property differs from other intangible assets in that it is the result of conscious creative activity, and the deliberate inventive activities can be attributed to the efforts of specific people.
Valuing Intellectual Property
Valuation of intellectual property (“IP”) falls into three general approaches to value: Income Approach, Market Approach, and Cost Approach.
The Income Approach focuses on the future benefits that can be realized from a particular IP asset as well as the inherent risks of realizing the benefits. Methods that value intellectual property under the income approach may by focus on:
· The greater level of income realized by the owner of the intellectual property compared to not owning the property (leading to higher profitability).
· The lower levels of costs realized by the owner of the intellectual property compared to not owning the property (also leading to higher profitability).
· “Relief From Royalty” methods, which are based on a hypothetical royalty payment that the owner of the IP asset would be willing to pay or otherwise would have to pay to a third party to exploit the IP asset. The royalty represents the “rental charge” that would be paid to the licensor if this hypothetical arrangement were in place.
In any of the above circumstances the value of the business is incrementally greater as a result of the business’ ability to successfully exploit the intellectual property and realize higher profits.
The market approach focuses on actual arm's length transactions of similar IP assets between unrelated parties. The market approach process includes researching the appropriate market for information on transactions and/or license arrangements of comparable intellectual properties, and analyzing the facts and circumstances of the comparable transactions relative to the subject asset.
The two common types of cost include “reproduction cost” and “replacement cost”. Reproduction cost is the total cost, at current prices, to develop an exact duplicate or replica of the IP asset. This measures the amount of money that would need to be spent to develop the IP asset in exactly the same way and to achieve the same final state as it currently exists.
Replacement cost, on the other hand, contemplates the cost to recreate the utility of the subject IP assets, but in a form or appearance that may be different. This concerns the ability of the replacement property to perform its designed task, while, from an economic standpoint, having the ability to provide an equivalent amount of contribution. The replacement cost of an IP asset is the total cost to create, at current prices, an asset having equal utility to the subject IP asset. However, the replacement intellectual property would be created with modern methods and developed according to current standards.
Simplified Example Using Three Approaches
Income Approach: The subject patented technology allows the business to generate $1 million in greater profits every year compared to not owning the patent. The incremental profitability adds $4.2 million in value to the Business.
Market Approach: Comparable patent sales were found related to the industry in which the subject business operates. The comparable transactions yielded value indications ranging from $3.5 to $6.2 million, after making adjustments for specific differences between the actual patents sold and the subject patent. All sales were arms-length between unrelated parties.
Cost Approach: The cost of developing the patent (including employee labor hours, testing costs, design costs, etc.) would range from between $2.1 and $2.8 million.
A reconciliation of value from the three approaches shows that the benefits of owning and exploiting the patented technology were feasible and realizable. Therefore, more weight may be placed on the Income and Market Approaches, resulting in a value of approximately $4.5 million.
Uses of Intellectual Property Valuations
For companies that are increasingly dependent on their IP assets for a competitive edge, valuations of IP assets have been and will be needed for a variety of purposes, including:
· Identifying assets that enhance value or need protection
· Evaluating assets of a potential merger or acquisition candidate
· Purchase price allocation after an acquisition and fair value reporting
· Making informed financial decisions for protection, maintenance, and commercialization
· Evaluating potential for research and development projects
· Supporting loan collateral analysis
· Litigation disputes and damage/infringement claims
The resulting IP valuation may be the determining factor in whether an acquisition goes forward or a potential research and development project continues to receive funding. Moreover, as certain businesses experience intellectual property gaining a greater proportion of their value, valuations will be of increasing importance to shareholders and business owners.