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Intellectual Property Valuation Or Intangible Asset Valuation in a Merger-Acquisition Transaction
Over the past few years, the identification and valuation of intangible assets, particularly intangible assets related to intellectual property, have attracted increased attention worldwide for a variety of reasons, including increased compliance requirements for financial reporting, and certainly in the area of leveraged finance as lending institutions. continue to look beyond traditional sources of collateral such as accounts receivable, inventory and equipment.
When defining intellectual property, which is a type of intangible asset that has historically not been considered in leveraged financial transactions, it should be considered as a group of innovative technologies and/or processes that create a legally protected and marketable product or service that establishes the foundation for sustainable profits and brand development. In other words, the evaluator wants to analyze how the “production line technology” within the company formed the basis for the creation of the brand’s marketable product. Common types of intellectual property include copyrights, trademarks, trade names/trademarks, rosin, 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 requesting the valuation on the “buy side” or the “sell side”? Why do they need it? The request can be pre-negotiation, during the transaction or after the sale. What do they plan to do with the intellectual property? Block or use.
Motivation affects the applied methodologies of intellectual property valuation. 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. The enablement view requires measuring internal benefits, while the blocking view measures the benefits that could be gained by a competitor.
Once perspective and motivational matters are resolved, business valuations and intangible asset valuations can begin. The starting point is a look at three commonly 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, royalty exemptions, excess earnings, and cost savings are most commonly used in the valuation of intellectual property.
Exemption from license fee
As the most commonly used business valuation methodology for determining the value of intellectual property, it measures value based on the assumption that since the buyer would own the asset, there would be no royalty payment for its use. This approach captures the value of the intellectual property recognized by the current owner as if it had to license it. This raises an important question – does it represent the asset’s value to other market participants or value to a specific acquirer? This is a complex issue and each case must be evaluated on its merits and the potential use of the intellectual property. Basic 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 investment risk. Excess 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 revenue is generated using a combination of the company’s assets, including net working capital, real estate, personal property, and intangible assets. By first identifying the value of all other “contributing” assets, a residual income stream remains available to the intangible asset in question. This residual or excess income stream is then used to perform a discounted cash flow analysis to estimate the value of the asset.
This method of business valuation looks at the cost of producing an item with or without intellectual property, or the profit margin for a branded product versus the profit margin for a similar non-branded product. The estimated difference in operating profit between the two costs/profits is applied based on the estimated product sales 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, which is also called the market approach. This approach is more difficult to apply to the valuation of intellectual property because comparable transaction data is usually not publicly available for business transactions specifically involving intellectual property; however, this approach should always be considered in conjunction with properly completed research to determine whether the approach can be used.
The third approach of valuing intangible assets is the cost approach. This approach is commonly used when valuing non-performing intangible assets as it considers the current cost of reproducing the asset to determine its value. This approach usually provides minimal value for the intellectual property, as no buyer would spend money to recreate the asset unless it provided a benefit as great as the money or effort invested.
After determining the appropriate value approach, the relevant criteria must be converted into an intangible valuation model. Here, the motivation—enabling or blocking—determines the necessary framework. The challenge arises when the motivation is of a hindering nature, as the market participant framework would apply. Translating market participant criteria into a valuation model is a relatively new task for the accounting community. There are few established models for the valuation of intellectual property or intangible assets that fall into the “generally accepted” category. However, there is an existence of knowledge related to the valuation of intellectual property in the judicial community that is used to assess damages. The premise is that if you can measure IP damage in the courtroom, you can measure IP benefits in the boardroom using similar modeling.
One such approach is known as “technology applied to a problem” 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 interviews with the inventor, to present an analysis of the problems solved by the use of intellectual property. A well-constructed TAPS analysis generally provides data to support an estimate of market participants’ revenue (income) from the use of intellectual property. Using royalty terms from comparable intellectual property agreements, it is possible to determine an estimated royalty revenue stream derived from market participants’ revenue (expressed as net present value). These royalties reflect fair value.
A business valuation firm can help you turn intangible assets into tangible value by often identifying 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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