Intellectual Property

Importance of Proper Valuation of Intellectual Property

Your Intellectual Property (IP) assets stand a greater chance of being accepted as having significant value and even collateral for loans if you are able to prove their liquidity and that they can be valued separately from your business.

It is critical to identify all of the IP assets of your business and to obtain an objective valuation of the identified assets from a competent valuation firm. The value of IP management processes which identify, log, track and quantify your IP assets becomes increasingly important in the Internet economy. This is one more reason for you to increase in-house awareness of the extent and value of IP asset holdings, including trade secrets, which might be used to collateralize a loan.

It is true that until now the valuation of intellectual property is considered to be highly subjective by both lenders and borrowers. While well-founded valuation methodologies exist, they are either considered to be too subjective or are not generally understood by most people. However, the increasing use of royalty streams arising from licensing to determine the value of intellectual property is a welcome development in enhancing the acceptability of intellectual property assets as valuable assets providing security for debt financing and equity participation.

Methodologies for valuing intellectual property

The following methodologies are widely used in valuing intellectual property. While some are more suited to specific circumstances, all can have a role to play in finalizing a view on valuation.

Relief from royalty

Relief from royalty is usually considered by both practitioners and theorists as the most reliable intellectual property valuation method. It is based on deprival value theory and looks at the amount that a company would be deprived of, if it did not own the intellectual property in question, but rather was required to rent it from a third-party. The royalty represents the rental charge which would be paid to the licensor if this hypothetical
arrangement were in place. The ability to determine an appropriate royalty rate depends upon the specific circumstances and requires the identification of suitable comparable transactions and prices involving third parties.

Obtaining a royalty rate is only a first step, however, as a reliable sales forecast is also required in order to determine the income which flows directly from the intellectual property. An appropriate cost of capital has also to be determined by comparison with other companies which operate in similar fields.

Premium profits

The premium profits method is often used for valuing brands or individual products where a price premium can be achieved. The basic assumption of this method is that, the value of the intellectual property is equal to the capitalized amount of the profit premium which can be derived from that particular brand or intellectual property. The premium profits achieved from existing products / services sold under a brand name can sometimes be deduced by comparing margins and volumes with those obtained from selling similar own-label products / services.

Within the context of certain guidelines for transfer pricing, this approach falls within the "profit split" method, as the value of the overall intellectual property must be split by reference between some functional and some value-based judgments in assessing the overall contribution made by the various components.

Cost-based

Historic cost: This valuation methodology measures the amount of money spent in the development of the intellectual property at the time it was developed. Unless the intellectual property was developed in the recent past, an historic cost measure tends to be unreliable due to the impact of inflation. In addition, it is not always possible to provide accurate information for such quantification.

Replication cost: This measures the amount of money that would need to be spent in current cost terms in order to develop the intellectual property in exactly the same way and to the same final state as it currently exists. This includes costs incurred on any unsuccessful or inefficient prototypes.

Replacement cost: This measures the amount of money which would need to be spent in current cost terms in order to develop the intellectual property as it currently exists, but excludes the costs relating to unsuccessful or inefficient prototypes. For taxation purposes and within the context of the OECD guidelines for transfer pricing, this approach is regarded as one of the least reliable single means of identifying an arm's-length transfer price.

Elimination method

The elimination method is based on the principle that the value of the intellectual property is equal to the value of the business, less the tangible net assets used within the business and the goodwill that is not specifically attributable to the intellectual property. Normal business valuation techniques, such as benchmarking and discounted cash flows, which are typically used in relation to quoted companies, are used to determine the value of the business.

The method is relatively straightforward until the value of the goodwill has to be distinguished from the overall intellectual property. In our opinion, the elimination method is best viewed as a technique to determine the maximum value of the intellectual property.