Identifying and Valuating Intangible Assets and Intellectual Property : Discussed

Craig A Jacobson for the NY Law Journal writes:    All businesses are comprised of a variety of assets, including both tangible assets and intangible assets. Tangible assets include items such as cash, inventory, accounts receivable, and fixed assets. Intangible assets include both "traditional" intangible assets and intellectual property (IP). "Traditional" intangible assets can include the company's customer lists, vendor relationships, license agreements, and noncompete agreements. Some intangible assets (such as customer lists) exist in the normal course of business. Other intangible assets, such as noncompete agreements, typically originate during the course of an unusual event such as an acquisition.¹ Balance sheets of American companies are increasingly comprised of intangible assets such as those discussed in this article.

IP, on the other hand, is a special category of intangible asset. IP is created by human intellectual or inspirational activity, and includes patents, trademarks, trade names, copyrights, trade secrets, technological know-how, and software. IP may enjoy special legal recognition, which provides motivation for intellectual property innovators and protection for intellectual property creators.This article discusses the identification and valuation of intangible assets and intellectual property, including situations in which the valuation of such assets often arise.

Recorded vs. Non-Recorded Intangibles

The tangible assets of a company are recorded on the company's balance sheet at the time of their acquisition or creation. Although intangible assets are developed in the normal course of operating a business, unlike tangible assets, they are only recorded on the company's balance sheet when the subject company is acquired. Just because intangible assets don't show up on the balance sheet does not mean that they don't exist.

Reasons to Value Intangible Assets

In many valuation assignments, it is not necessary to separately value intangible assets (which are already baked into the conclusion of enterprise value). However, certain situations require the separate valuation of intangible assets. The purpose of these valuation assignments may include: Financial reporting purposes. As discussed above, intangible assets are not recorded in the normal course of business. However, when a company is acquired, the purchase price is allocated among the company's assets, which requires the intangible assets to be valued and recorded on the balance sheet of the buyer. Intangible assets also may need to be valued after the acquisition, when a company tests its goodwill or intangible assets for impairment. Tax purposes. Intangible assets are sometimes transferred to a separate company, and need to be valued for tax purposes. For example, a company may separate the income from its centrally developed IP by retaining it at the corporate level and licensing it out to its foreign operating subsidiaries. Litigation purposes. Intangible assets are sometimes separately valued for litigation purposes in situations including (but not limited to) infringement, breach of contract, fraud, and expropriation.

Standard of Value

An important determination in any business valuation analysis is the applicable standard of value. The standard of value is the definition of the type of value being sought, indicating "value to whom" and "under what circumstances."² An entity can be worth different amounts depending upon the standard of value that is selected. Two common standards of value used in valuation are fair market value and fair value. Fair market value. Fair market value (FMV) is defined by the American Society of Appraisers as "the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm's length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts."³The FMV standard of value often applies for valuations prepared for tax or matrimonial dissolution purposes. Fair value. As employed under Generally Accepted Accounting Principles (GAAP), the Financial Accounting Standards Board defines fair value (FV) as "the price that would be received to sell the unit as a whole in an orderly transaction between market participants at the measurement date."⁴The FV standard of value applies for valuations prepared for financial reporting purposes.⁵A key difference between FMV and FV is that FMV assumes a hypothetical buyer or seller, while FV is considered from the perspective of a market participant that already holds the subject asset. A fair value analysis estimates the exit price, or what the holder would receive upon a sale of the asset.

Overview of Intangible Asset Valuation

Valuation Approaches. At the outset, it is important to understand what value is and isn't. While these precepts apply to business valuation in general, they are particularly important to understand for intangible asset valuation.Irrespective of the selected standard of value (see above), value is generally considered to be a market-based concept. In other words, a valuation is an estimate of the price at which an asset would sell in an open marketplace. The cost to produce an asset may or may not provide any meaningful information on the value of the asset. For example, one can envision a software program that cost several thousands of dollars to create, yet does not have any current economic value that would result in a meaningful sales value in an open market. Likewise, the fact that an asset sold for a particular price might not indicate the value of the asset. If a transaction price was influenced by factors that were particular to one of the participants, and not to the market in general, the price might not provide meaningful information about the value of the asset. There are three valuation approaches commonly used to value intangible assets: the cost approach, the income approach, and the market approach. These valuation approaches are conceptually similar to the approaches used to value companies themselves. However, it is important to note that the nature of specific intangible assets indicates which valuation approaches are appropriate as discussed below. The cost approach generally estimates value based on the replacement cost of the subject asset. This valuation approach assumes that the value of an intangible asset will be no more than the cost of an intangible asset with similar utility. When applied to intangible asset valuation, the cost approach does not assume that the cost estimate will result in an intangible asset that is identical to the subject intangible asset. Rather, the utility of the intangible asset to its owner is the basis of its value.It is important to note that replacement cost differs from reproduction cost. Reproduction cost involves creating a replica of the subject intangible asset. However, reproduction cost does not consider whether the market would even want an exact replication.

A cost approach analysis necessarily involves consideration of the inputs to the production of the asset. These inputs can include labor, materials, and overhead. The valuation analyst should utilize inputs that reflect the costs to a market participant. For example, if a company is paying a certain type of programmer $200 per hour, but a market participant could obtain similar services for $100 per hour, the lower amount is the proper input into a cost approach analysis. The cost approach is often used to value intangible assets such as software that do not directly generate economic benefits for the owner. If the valuation analyst establishes that the software is important to the operations of the subject company or reporting unit, this indicates that the software does in fact have value, which can be estimated using the cost approach. The cost approach should also consider the obsolescence of the subject intangible asset. There are three common types of obsolescence for intangible assets: functional, technological, and economic. Functional obsolescence represents a decline in the utility of the asset due to its function having become dated. Technological obsolescence (a related concept) is when the intangible asset is less needed (although the asset still works as designed) due to newer, more useful intangible assets. Economic obsolescence represents the loss in value due to factors external to the intangible asset. The various forms of obsolescence must be considered under the cost approach, and generally represent a reduction in the value of the intangible asset from its replacement cost. The income approach estimates value based on the economic benefit, often expressed as cash flow, expected from the ownership of the subject intangible asset. The economic benefit can take the form of increased revenue and/or decreased expenses. The application of the income approach involves (1) projecting the expected economic income attributable to the ownership of the subject intangible asset, and (2) discounting the economic income to present value at a discount rate that reflects the risk in achieving the projected income stream. The discount rate for the subject intangible asset is related to the discount rates for the other assets (tangible and intangible) owned by the company (the weighted average of which should represent the discount rate for the company as a whole). Each asset of a company contributes to the earnings of the company. The most risky assets of a company are usually its intangible assets and IP, and therefore these assets warrant the highest rates of return. Within this realm, intangible assets are usually considered the less risky assets, with IP representing greater risk and requiring higher rates of return.The measure of economic income should include only the portion of economic income attributable to the subject intangible asset. As discussed above, every asset of the company may contribute to the earnings (and therefore to the value) of the company. For example, when estimating the value of a customer list, the valuation analyst should consider that other assets may contribute to the earnings: current assets (e.g., cash, inventory), fixed assets (e.g., buildings and equipment), and intellectual property (e.g., patents and trade names). An adjustment, often called a "capital charge," can adjust for the portion of income attributable to other assets of the business. The market approach estimates the value of an intangible asset based on the price of arm's length transactions in similar intangible assets. The market approach begins with analyzing empirical data on transactions in both the subject intangible asset and comparative intangible assets. Transactions can include either or both of (1) the sale of the asset itself, or (2) a license agreement to utilize the subject asset. In terms of comparable sales, the usefulness of transactional information can be limited by differences between the transactional asset and the subject asset. The market approach requires consideration of changes in market conditions between the date(s) of the comparative transactions and the valuation date. The valuation analyst may need to adjust market-derived pricing information to account for changes in market conditions.

Intangible Asset Valuation Examples

This section presents some examples of certain types of intangible asset valuation that frequently arise in an intangible asset valuation assignment. This is not a representative list of intangible assets or applicable valuation approaches, and is intended only to serve as examples of the intangible asset valuation process. Customer list. A company often earns profits from its existing list of customers as of the valuation date. The value of the customer list is often estimated using the multiperiod excess earnings method under the income approach. A multiperiod excess earnings method analysis utilizes projections of the economic income expected to be derived from the ownership of the customer list. Such an analysis considers factors such as the expected remaining useful life of the customer list and the expected falloff in the income generated from the customer list. One question to ask at the outset is what constitutes a repeat customer? For some companies, a repeat customer is a customer who purchases the company's products every year. For other companies, such as car manufacturers, a repeat customer might only make a purchase every three to five years. A customer list is a decaying asset (one that has a limited life, and for which the value is expected to decline over time). Historical sales information may indicate not only which customers are repeat customers, but the expected decay (or decline) in business from the customer list over time. The expected economic benefit is projected over the remaining useful life of the asset, and discounted to present value at an appropriate discount rate. Note that the discount rate for a customer list will often be higher than for the company's tangible assets, but lower than for the company's IP. Noncompete agreement. Many purchase and sale agreements include a provision preventing the sellers from competing with the buyer for a specified period of time. This represents a component of value to the buyer, which is often valued using the "with and without" method of the income approach. Here, the difference in economic income both "with and without" the noncompete agreement is analyzed. Such an analysis necessarily will utilize subjective information (often provided by management) as to the decline in sales and profits that the company would experience "without" the noncompete agreement in place. The projections period for such an analysis are determined by the length of the noncompete agreement, and the projected economic benefits are discounted to present value at an appropriate discount rate. Patent. The value of a patent can be estimated based on the royalty payments the company would be willing to pay if it didn't own the subject patent using the "relief from royalty" method. This valuation method is in essence a hybrid valuation method that uses an assumed royalty rate derived from analysis of uncontrolled license agreements for other comparable patents (which is a market approach analysis) and discounting the economic benefits from owning the patent (and therefore being "relieved" from making royalty payments) to present value (which is an income approach analysis). This valuation method involves examining licensing agreements for other patents, and making adjustments to this data based on differences between the benchmark licensed patents and the subject patents. The projected economic benefit is then discounted to present value at an appropriate risk-adjusted discount rate. Software. Software that is directly income-generating can be valued using an income approach that considers the direct economic benefit from the ownership of the software. However, software is most often valued without any measure of economic benefit. For example, software might be acquired without any history of generating sales. Software is thus often valued using a cost approach analysis. As discussed above, such an analysis should estimate replacement cost, and not reproduction cost. This accounts for factors such as the software possibly not having been developed in an optimal manner. Such an analysis should consider the technological obsolescence of the software. Various methodologies have been developed to estimate the value of software using the cost approach. These methodologies consider factors such as the number of lines of code, the number of hours to program each step of the development process, the cost of programmers, obsolescence, etc.

Valuation Reconciliation

In performing valuations of intangible assets and IP, the valuation analyst should make sure that the value conclusions reached are reasonable within the context of (1) the other assets of the company, and (2) the value of the company as a whole. A company is comprised of several tangible and intangible assets, and the value of the company should reflect the value of the combined assets. If the combined value of the assets is greater than the value of the company as a whole, this suggests situations such as (1) the company might be worth more as an assemblage of assets than as a going concern, or (2) there is a problem with one or more of the valuation analyses. In addition, the required rate of return on the company's assets, calculated on a weighted average basis, should reflect the risk of the company as a whole.

Summary and Conclusion

This article has discussed the valuation of intangible assets and IP for different purposes. It is important for business owners to identify and understand the value of the intangible assets owned by the company. Proper management of intangible assets can enhance the operations and value of a company, making knowledge of its value important for both business owners and their professional advisors.