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Intellectual Property Valuation Or Intangible Asset Valuation in a Merger-Acquisition Transaction
In recent years, the identification and valuation of intangible assets, especially intangible assets related to intellectual property, has attracted increasing attention worldwide for a number of reasons that include increased compliance requirements for financial reporting, but certainly also in the arena of leveraged finance as credit institutions . continue to look beyond traditional sources of collateral such as accounts receivable, inventory and equipment.
In defining intellectual property, which is a type of intangible asset historically not considered in leveraged financial transactions, it must be viewed as a group of innovative technologies and/or processes that create a legally protected and marketable product or service that establishes a foundation for sustainable profit and brand development. In other words, the appraiser seeks to analyze how the “production line technology” within the company created the basis for the creation of the brand’s marketable product. Common types of intellectual property include copyrights, trademarks, brand names, front pages, customer relations, patents, engineering drawings, proprietary unpatented technology, software, and trade secrets.
During an M&A transaction, deciding which technique is best used to determine the fair value of intellectual property depends on many factors, but the two most important questions are: who is asking? and why? Is the person asking for a valuation on the “buy side” or the “sell side”? Why do they need it? The request can be before the negotiation, in the middle of the transaction or after the sale. What do they plan to do with the intellectual property? Block or use.
Motivation influences the intellectual property valuation methodologies to be used. Different strategies require different techniques, models, value drivers and data. Motivations can be classified as Enabling – the intention to use or commercialize intellectual property or Blocking – the effort to manage the competitive environment. An enabling view requires measuring internal benefits, while a blocking one measures the benefits that could be realized by a competitor.
Once the issues of perspective and motivation have been resolved, it is possible to assess the value of the business and intangible assets. The starting point is to look at the three generally accepted approaches to value – the income approach, the market approach or the cost approach.
The income approach estimates value based on the amount of cash flow the asset is expected to generate over its lifetime. There are many variations of the income approach; however, those most commonly used in the valuation of intellectual property are royalty exemptions, excess earnings, and cost savings.
Exemption from royalties
As the most commonly used business valuation methodology for determining the value of intellectual property, it measures value based on the premise that since the buyer would own the asset, no royalties should be paid for its use. This approach captures the value of the intellectual property that the current holder has recognized as having to license it. This raises an important question though – does this represent the value of the asset to other market participants or the value to a particular acquirer? This is a complicated issue and each case must be evaluated on its own merits and the potential use of the intellectual property. The underlying licensing assumptions require thorough analysis and verifiable documentation. Key assumptions include the selection of an appropriate comparable royalty rate to apply to the entity, the revenue streams to which the royalty rate will be applied, and the cost of capital or riskiness of the investment. Surplus earnings
Certain intangible assets, such as customer relationships and contracts, can be valued using the excess earnings approach. This concept is based on the theory that a company’s gross income is generated using 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 “contributing” assets first, a residual income stream remains available to the intangible asset in question. This residual or excess income is then used to perform a discounted cash flow analysis to estimate the value of the property.
This method of business valuation looks at the cost of manufacturing an item with and without intellectual property or the profit margin for a branded product versus the profit margin for a similar non-branded product. The estimated operating profit difference between the two costs/profits is applied to the projected sales of the product during the estimated period in which competitive advantages would exist.
Fair value can also be estimated from prices paid in an 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 not usually publicly available for business transactions specifically involving intellectual property; however, this approach should always be considered in conjunction with appropriate research that has been completed to determine whether the approach can be applied.
The third approach to the valuation of intangible assets is the cost approach. This approach is generally used in valuing non-revenue intangible assets because it takes into account the current cost of reproducing the asset to determine its value. This approach usually provides minimal value for intellectual property since no buyer would spend money to recreate the property unless it provides a utility that is as great as the money or effort involved.
Once the appropriate value approach is determined, the relevant criteria must be translated into an intangible valuation model. Here the motivation – enabling or blocking – determines the required framework. The challenge arises when the motivation is of a blocking nature, as the framework of market participants would be used. Converting market participant criteria into a valuation model is a relatively new exercise for the accounting community. There are few established models for the valuation of intellectual property or intangible assets that would fall into the “generally accepted” category. However, there is an ongoing body of knowledge related to the valuation of intellectual property in the litigation community, which is used to assess damages. The assumption is that if you can measure the harms of intellectual property in the courtroom, you can also measure the benefits of intellectual property in the courtroom using similar modeling.
One such approach is known as “Technology Applied to Problem Solving” or TAPS analysis. This analysis uses data found in documentation submitted by the inventor to the company’s patent board, as well as in technical journals or through interviews with the inventor to present an analysis of the problems solved using intellectual property. A well-constructed TAPS analysis generally provides data to support an estimate of market participants’ income (income) from the use of intellectual property. By applying the royalty terms found in comparable intellectual property agreements, an estimated stream of royalty income derived from market participants’ income (stated as net present value) can be determined. These royalties reflect fair value.
A business valuation firm can help you turn intangible assets into tangible value, as they often recognize value that is invisible to others. By identifying the true 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 an M&A transaction.
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