Valuation of IP

IP valuation methods

There are a number of different ways in which IP assets can be valued. The method you choose depends on the type of IP you have and your purpose for giving it a value. The most commonly used methodologies are outlined in the sections below. The examples provided for each methodology reflect the following key financial assumptions:

The sales amount is the total revenue which is generated from the IP. The NPAT reflects an ordinary profit earned by the business which is maintainable in future years. The P/E represents an appropriate rate to times the NPAT by to get an equity value for the whole business. It is generally assessed with regards to the price earnings multiples of comparable companies after adjusting for the individual characteristics of that particular business. The NTA is the sum of the total tangible assets less the total liabilities as disclosed on the company accounts. The royalty rate is chosen having regard to available market information that discloses royalty rates. The royalty maintenance costs reflect the amount needed to be spent to maintain the IP.

Relief from royalty

Relief from royalty assumes that if a business loses ownership of a particular IP, it has to pay a royalty to the owners of the IP asset for the right to use it. This royalty rate can be based on a number of variables, but is most often based on revenues. The size of the royalty rate will differ depending on the characteristics of the asset considered and the industry in which that asset is employed.

The value of the IP under this method is the capitalised value of the after-tax royalties that the company is relieved from paying as a result of owning the asset.

Determining a notional royalty rate is the key consideration here and ideally it is calculated by referencing standard industry values. A simplified example of the methodology is set out below.

In the above example, an implied royalty rate of 5 percent is selected. The incremental cash flow resulting from the ownership of the IP is $2.7 million. This is capitalised at a price earnings ratio of 8.0 to obtain a value for the IP of $21.6 million.

Excess profits or notional maximum royalty payable

This method is used primarily to determine the value of a brand to a business and involves determining a fair market value of the net tangible assets used in producing the branded product.

A rate of return is then used to estimate the profits required to promote investment in those assets. Any return in excess of this required return (which represents the maximum royalty payable) is then capitalised, representing the value of total intangible assets.

This 'excess profits' approach is a variation on the method of valuing the business as a whole then subtracting the current market value of NTA from that value. It assumes that the entire excess return can be attributed to the presence of the brand name alone. It ignores the possibility that other intangible factors, such as an established distribution network or statutory protection from competition, may influence the return earned.

Using the assumptions presented earlier, a simplified approach to valuing the IP using this methodology is set out below.

The required return on NTA is assessed after consideration of the nature and risk of each of the tangible assets. This results in an incremental cash flow of $2.6 million, which is capitalised to obtain a value for the IP of $20.8 million

Capitalisation of Earnings

This method involves applying an appropriate multiple to a business' assessed earnings to derive a capitalised value, then deducting the current value of financial and physical assets needed to generate the earnings, thus resulting in a total value for all of the intangible assets.

The capitalisation of earnings methods requires the valuer to consider what proportion of the indicated value relates to the identifiable intangible asset being valued, as distinct from goodwill.

Often the implied value of the IP can be estimated by taking a proportion of the total assessed intangible asset value.

The proportion can be estimated after having regard to particular industry norms.

Net present value of incremental cash flows

Under this methodology the value of the IP comprises the present value of cash flows generated by the asset over its useful life.

The useful life of an asset depends on its economic life. Critical factors include life cycle, rate of technological change, and barriers to entry.

This method has the strongest theoretical basis because it is based on cash flow, the true economic measure of value that is not subject to vagaries of different accounting treatments. It also focuses the valuer on the future risks associated with the assets, and the duration of the economic life of the asset.

In certain instances it is possible to readily identify the net cash flows that are directly associated with the IP. These include cash flows attributable to a library of film, music or program copyrights or royalty income from licensing a brand name.

The example below shows the net present value of the incremental cash flows approach to the valuation of IP with a useful life of three years. The future cash flows have been discounted back to present value at a required rate of return of 12.5 percent. This is assessed with regards to the perceived risk of the cash flows.

Gross profit differential

This approach determines and capitalises the IP based on the difference between the gross profit contribution after maintenance costs (including marketing) of branded and unbranded or generic products.

The major difficulty with this approach is that it assumes that the difference in gross profits, achieved by branded over unbranded products, is wholly attributable to the brand name.

To use this method effectively, you will need an unbranded equivalent product or a close surrogate to make the comparison and be able to access reliable financial information with respect to the unbranded product. However, even in the case where an equivalent product is found, this method fails to take into account differences in the other assets employed by each of the businesses and the other costs not already included in the cost of goods sold.

Premium sales price

This is a variation on the gross profit differential approach, where the sale price premium of a branded product over its non-branded competitor is assessed. In addition to the shortcomings of the gross profit approach, the premium sales price methodology neglects to consider differences in operating costs and its affect on sales volumes. Under this approach, a high-volumed branded product that, because of economies of scale, provides major benefits would appear to have little value.

In practice, many of the benefits to manufacturers of branded products relate to security of demand, volume, market share and the effective use of assets rather than through premium pricing. Coca-Cola, for instance, is not sold at a premium to its competitors.

Comparable market transactions

Under this methodology, the value of the IP is determined by referring to prices obtained for comparable assets in recent transactions and similar licencing arrangements. The method is credible, objective and relevant in the context of market-based valuation exercises.

Major requirements are an active market, an exchange of comparable assets, access to price information at which assets are exchanged, and transactions that reflect market values. The residential real estate market is a good example of where these conditions are usually present.

However, even when information is available there may be difficulties in valuing IP using this methodology because particular transactions may be affected by non-value related factors. This will include factors such as the parties to the transaction not being fully informed, having had different negotiating skills, or fundamental differences between the assets being considered. This may have the affect of over-pricing or under-pricing the value of the IP.

Cost based

The cost-based approach seeks to measure future benefits of owning IP by quantifying the amount spent on developing an IP asset to its present form or the amount required to replace the future service capability of that asset.

Generally, using historical cost as a basis for this calculation is inappropriate for IP.

The fundamental issue is that this methodology incorrectly assumes that the value of the IP's development costs reflects its ability to derive future economic benefit.

An additional difficulty is that most IP is developed over a lengthy period of time. To effectively utilise the historical cost method, the relevant development costs incurred over the years must be identified and allocated. This requires judgement on the level to which expenditure relates to the development or investment in the asset in comparison to the cost of maintaining the value of the IP. Even if this is practical, capitalising costs incurred many years ago ignores inflation and other changes in the value of money over that period of time. In addition, it may be distorted by differing accounting policies that could place an excessive valuation on less successful assets at which high levels of expenditure have been directed (and vice versa).

While the current replacement cost method does not suffer from the same time value of money difficulties, on a practical basis, the estimation of these costs is a difficult process which is open to a high level of subjectivity

Brand strength

Valuers concerned primarily with the marketing strength of brand names support this approach. It applies a brand multiple (determined by reference to brand strength) to a brand's profitability.

Brand strength is measured by scoring the brand against key performance metrics such as market share, leadership/influence, stability, globalisation, support/marketing spend and protection. These factors will be compared to other industry participants within the current competitive landscape. This process will involve a subjective assessment of each of the particular attributes and an ultimate assessment of a relative score.

Once these metrics are assessed, they can be cumulated to create an overall brand strength indicator relative to other brands in the industry. This can be used to form an opinion as to the appropriate adjustment to be made to the brand multiple.

Real options

The real option valuation approach is an extension of financial option pricing theory to options on real assets that have relatively illiquid secondary markets. This valuation methodology is most often used in relation to start-up companies, technology ventures and other highly risky assets.

A situation where real option valuation is useful is where there is large uncertainty about the future and management's ability to respond to changes that occur in the future.

By building exit strategies and decision capabilities into the model, real options can capture the value of managerial flexibility in a way that traditional valuation analysis does not. Real options not only captures the value of management's ability to chose between options, but also indicates how long a company should stay in business before exiting and when to re-enter.