Only by valuing intangible assets, such as IP, can a company definitively measure its own worth, says Robert Wulff, from Griffith Hack, Australia.
The recent push for companies to value intangible assets, such as IP, has come about for a number of reasons. These include: the increasing importance of intangible assets to the value of companies and to the market, especially hi-tech companies; international legal and governmental developments such as the US Sarbanes-Oxley Act and the 2003 OECD European Intangibles Summit; new international accounting standards from the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB); and the need to disclose all asset values in business dealings such as during fundraising, securitisation, mergers and acquisitions, financial reporting and taxation calculations, bank financing and so on.
When an appropriate and rigorous methodology is applied to the valuation of intangible assets, especially IP, a business has both a better idea of its own worth, and a reportable and more transparent indication to the general market and government of its worth. This can make a business more attractive to investors and can more easily facilitate financing options for the business. It also helps with regulatory compliance. However, in a recent study conducted by the large European general practice firm DlA, it was discovered that only 12% of European businesses had ever commissioned a valuation of their IP assets by an independent third party. The general approach of business in the past has been to lump the valuation of intangible assets in with the business’s goodwill. This has the effect of typically undervaluing or erroneously valuing the intangible assets of a business.
Going forward, global pressures will force businesses in advanced and emerging economies to adopt international standards and approaches to valuing IP assets. Poor or improper valuation methodologies will affect investment through impaired investor confidence and failed regulatory compliance. Hence there is a good reason for SMEs in emerging economies to now start adopting proper valuation methodologies, especially in relation to the intangible and IP assets of their business. But where should you start?
Choosing the right method
There are many models for valuing intangible assets, such as IP, being put forward. However, there are a number of common models which financial and accounting professionals generally agree on. These can be summarised as the cost-based model, the market-based model and the income-based model.
Cost-based: This model (or method) seeks to estimate value by estimating the costs of replacing the intangible asset. Such costs typically include development costs, for example, R&D costs and IP protection costs. In this model past costs are adjusted to present value; however, the model is not very useful for income-generating assets (for example, a patent, design, copyright or trademark currently being exploited, or generating royalties), and the model only takes into account one factor, namely cost.
Market-based: This model attempts to value an intangible asset by comparing it with sales of similar assets (for example, patented technologies of a similar nature and function). It is currently favoured by the international accounting standards boards and can be quite an effective model in that it represents the ‘real’ market value of an asset. However, the model relies on accurate and complete (ie inside) information concerning the details and nature of other similar transactions – data that is often not available. Errors can arise when this data is estimated.
Income-based: In this model the ability of an intangible asset to produce income is valued; for example, by way of royalties (through licensing) or by way of profit (through the sale of the patented article). Income-based methods may also use discounted cash flow (DCF) analysis in order to arrive at a reliable present value. In each case, the model is prospective (ie it assumes that future royalties or future sales can in some way be predicted). However, calculating future returns from an IP asset has associated risks (including inflation, interest rates, market fluctuation, legislation factors and so on).
When an appropriate and rigorous methodology is applied to the valuation of intangible assets, especially IP, a business has both a better idea of its own worth, and a reportable and more transparent indication to the general market and government of its worth
Option-based: This model is a recent development on the income-based model, and takes into account analysis based on financial options. In this case the value of the intangible asset as related to its investment opportunity in the future. As a result, the option-based model treats the R&D process and the IP generated, as an option to be bought or sold at various stages of development, and it allows for the factoring in of the expected costs of developing technology and the expected returns from using it, and takes into account the level of risk associated with a project at various stages.
Flexible approaches
There are also variations and derivations of the above models including the premium profits model, the premium pricing model, the cost savings model and the royalties savings model. These last four approaches are all special situations of the income-based model, and all rely on a calculation of cash flow and risk.
Premium profits: This method/model (also known as the excess operating profits method) is a specific market-based model. In this method the value of intangible assets is determined by capitalising the additional profits generated by the business over and above those generated by similar businesses which do not have access to the IP asset. Excess profits can be calculated by reference to a margin differential, or by comparing the return on capital earned by the business owning the property with that earned by companies without such access to the IP asset. Calculated excess operating profits expected to be earned over the life of the intangible asset are then discounted to the present day to arrive at the value. A problem with this model is that the comparative business will have margins and returns on assets attributable to some of its own intangible assets. Similarly, the calculation of the value can be affected if the other business has more efficient production, better marketing or distribution channels, and so on.
Premium pricing: This model is a variation on the premium profits method and is typically used to value brands (for example, for consumer products). The value of additional revenue generated by the brand is projected over its life, net of marketing and other brand support costs, and then discounted to the present day. However, it is unlikely that the competing products to which the brand is compared will be unbranded and hence the value derived may be erroneous.
Cost savings: This method derives from the income-based model and values the asset by calculating the present value of cost savings the business can expect to make as a result of owning the intangible asset. This method can apply to assets such as trade secrets (processes and procedures). However, although a business can usually calculate the costs it has saved since introducing the new intangible asset, it may be problematic to derive a true value because a third party may not achieve the same cost savings.
Royalty savings: This method is also derived from the income-based model. It is premised on the cost to a business should the business not own the relevant intangible asset. In other words, the business would have to license in that asset, and this would potentially represent an ongoing cost. The value of the intangible asset in question is calculated based on a discounted to the present value of the royalty payment that the business saves by itself owning the asset. However, determining what royalty payment applies can in some cases be problematic (for example, if industry standards are not available).
Influencing factors
Today’s businesses should be rigorously and appropriately valuing intangible assets, such as IP, no matter their size. Companies should be selecting the best valuation methodology for their IP and business, and seeking expert (third party professional) advice. In my experience, businesses which employ appropriate and rigorous valuation methodology derive considerable benefits, including internal awareness of a business’s actual value, and an externally demonstrable valuation for investors, shareholders, market analysts, competitors and governmental authorities (including taxation bodies).
Of course, there are many factors which may influence IP valuation; for example: the size of the business and its capacity to defend and enforce the IP asset in question; the distribution and marketing networks that a business has; the competitive nature of the industry in which the business operates and the business’s competitive ability in that industry; the market share of the business in question; the business’s access to credit; and whether or not it has insurance in place for the intangible asset. As IP valuation models are further developed, they will start to (or will need to) take into account these factors; however, having said this, it is much better to apply an existing model, even if it does not take into account all such factors, than to have no valuation of the intangible asset at all.
This article first appeared in IP Review, issue 15
