Valuation of IP

What this module is about

What is valuation and why should it be applied to your IP?
What IP can be assigned value?
Accounting issues relating to IP.
The criteria for recognising IP.
What methods you can use to value your IP.

Valuation of IP

What is valuation and why should it be applied to your IP

Valuation is the process of allocating a dollar value to all the resources (assets) your business owns and that you expect will benefit you in the future. IP is one such asset. There are no hard and fast rules about how to value your IP assets and it is not a quick or easy task. A good place to start however is to look at how you currently manage your IP and what plans you have in place to exploit it.

Valuation of IP

What type of resource or asset is IP

Businesses generally have two types of assets. Current assets, which are those that can be converted to cash within one year or less, and non current assets, which are those that provide benefit for longer than a year. Assets are divided into tangible and intangible assets.
Most non-current assets are tangible in that their physical form provides their usefulness, eg. land, buildings and equipment. Intangible assets on the other hand do not physically exist, but are useful because of the special rights they carry. IP is a specialised classification of intangible assets that are created by human intellectual and/or inspirational activity and enjoys special legal recognition and protection. Patents, trade marks, designs and copyright are examples of IP.
Patents, trade marks, designs and copyrights are also examples of identifiable assets as are cash, inventory, land, property and equipment. This means they can be identified individually and are recorded separately on a company's books. These assets are generally measured on the basis of fair value. The accounting standards define fair value as the amount for which the asset could be exchanged between a knowledgeable and willing buyer with a knowledgeable and willing seller.

Valuation of IP

Why value your IP

Putting in the time and in some cases, expense to identify and value your IP will:

Provide a better reflection of the business value
Record and disclose to shareholders previously 'hidden' balance-sheet assets at realistic amounts to give shareholders a better understanding of the value of the company. This should ultimately be reflected in the company share price or value.
Provide a tool to measure and manage your assets
IP is often an important input to production and therefore, a key value driver. Monitoring the value of IP can help provide a realistic view of the business' return on total assets and, as a result, enable management performance to be better gauged.
Provide security and backing for lenders
Identifying IP separately on the balance sheet may improve the strength of your balance sheet presentation. This can be useful if funding is sought and a bank requires a certain level of assets to lend against. Intangible assets are increasingly being considered by financiers as valid assets to lend against.
Provide taxation benefits
The amortisation of certain identifiable intangible assets and capitalising the value of IP can lead to a reduction in tax liability and aid management in business structuring decisions in the future. Amortisation is the expense that applies to intangible assets, in the same way depreciation applies to non current assets.
Reduce goodwill on acquisition
This is also important when a business is being put up for sale because it reduces the proportion of the business' net worth attributed to goodwill. Goodwill is the value to a prospective purchaser in excess of the sum of its identifiable net assets and is a difficult and often subjective asset to value. It includes factors such as a favourable record of management performance or an assembled workforce. If IP is identified and separated from unidentifiable intangibles such as goodwill, in some circumstances it may not have to be amortised.

IP valuation is still under-utilised.

A recent survey by national accounting firm Ernst & Young showed that 69 percent of Australia's top 100 companies by market capitalisation have included some amount for IP assets in their balance sheets.

Top 100 Industrial Companies
Companies which have intangible assets	77%
Companies which separately record identifiable intangibles	69%
Total amount of separately identifiable intangibles recorded billion	$56.7
Amount of identifiable intangibles recorded as brand names	69%
Amount of identifiable intangibles recorded as licences	14%

Of the 77 percent of the top industrial companies that recorded intangible assets on their financial statements, the majority separately recognised and valued at least a part of their total intangible assets. As the above table shows, around 69 percent of the total value of identifiable intangible assets were separately identified as brand names.

Valuation of IP

What IP can be assigned value

Currently, many Australian companies do not recognise their acquired IP as separately identifiable intangible assets and instead they are included on their financial statements as goodwill.

This is increasingly being regarded as inadequate for accounting purposes. If goodwill is separated into identifiable and unidentifiable intangible assets, the IP owner can more easily ascribe value and achieve particular financial benefits.

For instance, if IP is classified as identifiable it does not have to be amortised according to the same rules that apply to goodwill. This may have an immediate effect on both your profit and loss statement and your balance sheet.

Valuation of IP

Identifying intangible assets

The table below contains examples of some identifiable and unidentifiable intangibles that may be found within a typical business. If you have not already compiled an IP register, use the table below as a guide to reviewing the intangibles your business already has. Alternatively, revisit the list you made in our section on IP auditing which may help your adviser meet your objectives. For a detailed description of an IP Audit see Conducting an IP audit.

Identifiable intangible assets	Unidentifiable intangible assets
Patents, trade marks and brand names Copyrights and industrial designs Franchises and licences Distribution agreements Newspaper mastheads/publishing rights Government quotas Covenants not to compete Secret processes and formulas Information databases Computer systems software Core technology	Quality of the management team Know-how Marketing expertise/market profile Management expertise Distribution network Economies of scale Technical skills Program rights

The value of IP, particularly brand names and trade marks, is now widely recognised. The number of high profile acquisitions and divestments of well-known brand names are increasing this awareness. Historical transactions in Australia involving the sale of businesses with well-known brand names include:

Brand	Acquirer	Vendor
Edgell - Birds Eye, Herbert Adams	J R Simplot Company	Pacific Dunlop
Peters Ice Cream	Nestle	Pacific Dunlop
Smiths, Planters, Samboy, Cheezels, Twisties	United Biscuits	Coca Cola Amatil
Hoover	Southcorp	Maytag
Arnotts	Campbell Soup Co	Arnotts Ltd
Pauls	Parmalat Finanziaria SP	Pauls Ltd
James Boags	San Miguel Corp	Boag & Sons Limited
Spring Valley and Wave brands	Cadbury Schweppes Plc	Bonlac Food
Steggles	Bartter Pty Ltd	Goodman Fielder
Rosemount	Southcorp	Rosemount Estates Pty Ltd

Similar trends were witnessed overseas, where the value of IP rose to prominence with the increase of leveraged and management buy-outs during the 1980s.

In the United States, for instance, the business community witnessed several large takeovers of brand-owning companies such as RJR Nabisco by Kohlberg Kravis Robert. RJR Nabisco’s major asset - its brand names including Camel, Ritz, Oreo and Nabisco - did not appear on its balance sheet because those names had been developed internally or acquired over time and were not differentiated from goodwill.

Valuation of IP

Accounting issues relating to IP

Australian Accounting Standards

There is currently no Australian Accounting Standard that comprehensively addresses the accounting treatment of IP in Australia. The most relevant accounting standards include:

AASB 1010: Recoverable Amount of Non-Current Assets;
AASB 1011: Accounting for Research and Development Costs;
AASB 1013: Accounting for Goodwill;
AASB 1015: Accounting for the Acquisition of Assets;
AASB 1021: Depreciation of Non-Current Assets;
AASB 1041: Revaluation of Non-Current Assets; and
Accounting Interpretation AI1: Amortisation of Identifiable Intangible Assets.

Being a non current asset, IP may be measured, subsequent to initial recognition, on either the cost basis (where AASB1010 applies), or the fair value basis (in which case AASB1041 applies).

AASB 1010 requires that company directors determine whether non-current assets (shown in the accounts at the balance date) exceed the net amount that is expected to be recovered through the cash inflows and outflows arising from its continued use and subsequent disposal (recoverable amount test).

AASB 1011 provides for the accounting of identifiable intangible assets that arise from research and development activities. With the exception of AASB 1011, there is no explicit recognition criterion for internally generated identifiable intangibles.

AASB 1013 specifically prohibits internally generated goodwill from being recognised. Purchased goodwill should be recognised on the acquirer's balance sheet as the excess of the cost of acquisition incurred by the entity over the fair value of the identifiable net assets acquired. AASB 1013 also requires that any recognised goodwill should be amortised on a straight-line basis over its expected useful life, which cannot exceed 20 years.

Where an entity or operation is acquired, the cost of the underlying identifiable intangible assets are measured at the acquisition date at their fair values according to AASB 1015. Judgment is required to determine what identifiable intangible assets exist and whether they can be measured with sufficient reliability.

Not all intangible assets must be amortised. Under AASB1021 and Accounting Interpretation 1, only those non current assets that have a 'depreciable amount' are subject to depreciation over their useful lives. The depreciable amount is the difference between an asset's cost or revalued amount and its residual value. Consequently, if an intangible asset has no depreciable amount then no depreciation or amortisation is required.

Where a useful life is determined, the depreciation method must be over this life and reflect the pattern over which the asset's future economic benefits are consumed.

Under AASB 1041, IP may be measured, subsequent to initial recognition, on a fair value basis. Fair value is the amount for which the asset could be exchanged between knowledgeable willing parties in an arms length transaction.

Once the revaluation method is chosen for IP, the entity can only revert to cost in extremely limited circumstances, and the revaluations must be undertaken with sufficient regularity to ensure the carrying amount does not differ materially from the fair value at each reporting period.

Assets must still be depreciated even where they have been revalued. In cases where asset values are increased, this will result in a higher deprecation expense.

Valuation of IP

International accounting treatment of intangible assets

In 1998 the International Accounting Standards Committee (IASC) issued IAS 38: Intangible Assets and revised IAS 22: Business Combinations. These statements were effective for the financial years beginning on or after 1 July 1999. These International Standards require that intangible assets purchased as part of a business combination be based on their fair values at the date of acquisition. If an intangible asset cannot be reliably measured then it will be accounted for as part of goodwill.

According to IAS 38 the benchmark treatment for measurement, subsequent to initial acquisition, is the cost less accumulated amortisation and any accumulated impairment loss.

Under IAS 36: Impairment of Assets, intangible assets must be reviewed for impairment according to the Standard. Only identifiable intangible assets can be revalued. This must be done according to an 'active market' and once done, the company is required to make regular revaluations.

Both IAS 22 and 38 require that the intangible assets be amortised on a systematic basis over the best estimate of their useful life. There is a rebuttable presumption that this useful life will not exceed 20 years. Intangible assets can have greater useful lives, however, the IAS does not permit an enterprise to subscribe an indefinite useful life.

On 29 June 2001, the United States Financial Accounting Standards Board, (FASB) unanimously approved the issuance of Statements of Financial Accounting Standards No. 141 Business Combinations and No. 142 Goodwill and Other Intangible Assets. These statements drastically change the accounting for business combinations, goodwill and intangible assets.

FASB 141 includes new criteria to recognise intangible assets separately from goodwill in a business combination. If the intangible asset acquired arises from contractual or other legal rights or the intangible asset acquired is separable, that is, it is capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented, or exchanged whether in combination with a related asset or on its own.

Under FASB 142, goodwill and intangible assets with indefinite lives are no longer amortised but are reviewed annually, or more frequently if impairment indicators arise, for impairment.

The issues discussed in relation to the accounting treatment of intangibles are currently being considered by the AASB through its intangible assets project. This project aims to address the definition, recognition, measurement and disclosure of intangible assets. It is possible that the Australian Accounting Standards Board (AASB) and the International Accounting Standards Board (IASB) will move to follow the US Standards. The AASB is considering papers on key issues and forming views, but it has not specified a time at which an intangible asset accounting standard might be issued.

Valuation of IP

The criteria for recognising IP

In accordance with current Australian practices, to be able to separately recognise, value and record your IP you must be able to:

Identify your IP as a separate, stand-alone asset.
It is necessary to distinguish IP from other assets in the event of an acquisition, or to record IP in its own right as an internally developed asset. In order to separately recognise IP, the future economic benefits derived from the asset must be capable of reasonable estimation and separation from the value of the other assets that comprise the business. IP can be regarded as a stand-alone asset if it can be identified and sold separately from the business as a whole or licensed for use to others. Intangible assets classified under 'goodwill' cannot be separated from the whole business in this manner.
Sell or transfer your IP.
Many kinds of IP, such as brands and patents, can be sold separately or licensed. Franchising, for instance, is essentially the licencing of a brand. Good examples of brand licencing are Fosters Lager and Pierre Cardin, where third parties have been licensed to use these brand names.
There are other circumstances where IP may be separated from a business and sold separately. For example, in January 2001 Cadbury Schweppes Plc paid $30 million to Bonlac Foods Ltd to acquire their Spring Valley drink brands, to increase its share of the Australian fruit juice market.
Alternatively, the brand name may be sold to a third party with the company continuing to manufacture the product on a contract basis, as well as continuing to produce unbranded products. The brand name purchaser is responsible for marketing and distributing the branded product. The original company (the licensor) would then earn a royalty on the licence of the branded products as well as standard manufacturing profit.
Protect your IP.
The value of an identifiable asset will generally be higher if it is protected. The legal status of IP can underpin the asset's value by providing greater certainty for the owners to legally transfer their interest in that particular asset. The strength, duration and extent of protection are important determinants of whether IP can be given a fair market value and what amount of value that might be.
Recognise your IP as enduring in nature.
The IP in question should be regarded as a capital asset rather than the residual of some recent expenditure. The life of IP needs to be assessed, taking into consideration any technological developments that may reduce the value of the asset. When assessing a value for IP, that value should be assessed devoid of any supporting expenditure.

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:

Assumptions
Sales	$100m
Net Profit After Tax (NPAT)	$9m
Price Earnings Ratio (P/E)	8.0x
Equity Value	$72m
Net Tangible Assets (NTA)	$40m
Royalty Rate	5.0%
Maintenance Costs (branded products)	$1.2m
Maintenance Costs (non branded products)	$0.4m

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.

$m
Sales		100
Implied Royalty	(at 5%)	5.0
Less maintenance		(1.2)
		3.8
Less Income Tax	(30%)	(1.1)
Incremental Cash Flow After Tax		2.7
Capitalised Value P/E	8.0x	21.6
NTA		40.0
Identifiable Intangible Asset		21.6
Implied Goodwill		10.4
Value of whole business		72.0

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.

$m
NPAT (before tax adjusted maintenance costs)		10.2
Less Req'd Return on NTA	16%	6.4
Excess Profits		3.8
Less maintenance costs		(1.2)
Incremental cashflow		2.6
Capitalised Value P/E	8.0x	20.8
NTA		40.0
Identifiable Intangible Asset		20.8
Implied Goodwill		11.2
Value of whole business		72.0

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.

$m
NPAT	9.0
Capitalisation Rate	8.0x
Capitalised Value of Business	72.0
Less NTA	40.0
Total intangibles	32.0

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.

	Year 1 $m	Year 2 $m	Year 3 $m
Cash flow with intangible	100.0	120.0	130.0
Cash flow without intangible	90.0	110.0	110.0
Net cash flow before tax	10.0	10.0	20.0
Less income tax (30%)	(3.0)	(3.0)	(6.0)
Net cash flow after tax	7.0	7.0	14.0
Present Value	6.2	5.5	9.8
(Required Rate of Return = 12.5%)
Total present value of marginal cash flows			$21.5

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.

	Branded $m	Non-Branded $m
Sales	100	80
Gross Profit margin (before maintenance costs)	15%	13%
Gross Profit	15.0	10.4
less maintenance cost	(1.2)	(0.4)
	13.8	10.0
less income tax (30%)	4.1	3.0
Incremental Cash Flow After Tax		2.7
Capitalised Value of IP P/E	8.0x	21.6
Net Tangible Asset		40.0
Identifiable Intangible Asset		21.6
Implied Goodwill		10.4
Value of whole business		72.0

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.

Valuation of IP

Summary of key concepts

IP is a specialised type of intangible asset that enjoys special legal recognition and protection. As such, similar valuation methods and economic analysis procedures apply to IP, as do intangible assets.
To be able to separately recognise, value and record your IP, you must be able to:
- Identify your IP as a separate, stand-alone asset;
- Sell or transfer your IP;
- Protect your IP; and
- Recognise your IP is enduring in nature.
IP is recorded on the basis of fair value, although the process of valuing IP is not a quick or easy task.
There are a number of advantages in separately identifying your IP. These include providing a true reflection of business value, providing a tool to measure and manage key assets, providing security for lenders, gaining tax benefits, and reducing goodwill in acquisitions. Despite this, many Australian companies neglect to value their IP.
The valuation of IP is gaining increasing recognition. There are a number of examples of transactions both in Australia and overseas where the value of IP, particularly brand names and trademarks, has been a major factor in the determination of purchase consideration.
According to Australian Accounting Standards, most intangible assets may only be recognised on acquisition. Identifiable intangible assets will be recorded at their fair values on the acquisition date. Goodwill is the residual of the cost of acquisition incurred by the entity over the fair value of the identifiable net assets acquired.
If it can be established that the IP or other identifiable intangible asset does not have a depreciable amount, that asset need not be amortised.
The AASB is currently considering revising the current Australian Accounting Standards so that they are more in line with international standards.
There are numerous methods appropriate for the appraisal of value for IP. The following are the most commonly used approaches:
- Relief from royalty;
- Excess profits or notional maximum royalty payable;
- Capitalisation of earnings;
- Net present value of incremental cash flows;
- Gross profit differential;
- Premium sales price;
- Market based;
- Comparable market transactions;
- Cost based;
- Brand Strength; and
- Real Options.