Before we can properly discuss what methods are used to value a business’ or individual’s intellectual property and intangible assets, we should first discuss what actually has value.
What Has Value?
CONSOR specializes in the valuation of intellectual property and intangible assets. However, many times companies are unsure about what intangible assets in their portfolio have “value”? A starting point is defining what are intangible assets and what are intellectual properties.
One key difference is that an intellectual property has been granted specific legal protection and recognition under the intellectual property laws of the United States. While many other intangible assets are recognized under contract law and general commercial law, only a small group of intangible assets are granted legal protection as intellectual property: trademarks and service marks, patents, trade secrets, copyrights, and other rights such as domain names.
Intellectual properties such as patents, trademarks, or copyrights typically are tied to other intangible assets. When CONSOR values these assets for clients, they regularly assemble and bundle groups of intangible assets around their core intellectual property.
CONSOR believes that intellectual property travels with intangible assets. For instance, a trademark will travel in tandem with associated assets such as logo designs, corporate colors, sub-brands, etc. Because we tend to bundle them together, the terms “intangible assets” and “intellectual property” often are used interchangeably. However, the term “intangible assets” should be universally understood to include all traditional types of intellectual property. Below is a partial listing of some of the intangible asset and intellectual property bundles that we often value. The following is a partial list of intangible assets and intellectual property bundles and is not intended to be all encompassing; the world of intellectual property is constantly evolving and expanding as is the range of intangible asset/intellectual property bundles.
- Trademarks and service marks
- Trade names
- Brand names
- Design patents
- Process patents
- Patent applications
- Business method patents
- Technical documentation ( e.g. , laboratory notebooks, technical know-how)
- Literary works and copyrights
- Musical compositions
- Platform software
- Software copyrights
- Automated databases
- Integrated circuit masks and masters
- Industrial designs
- Trade secrets
- Engineering drawings and schematics
- Technical know-how
- Customer databases
- Customer contracts
- Customer relationships
- Open purchase orders
- License agreements
- Franchise agreements
- Operating licenses
- Subscription rights
- Futures contracts
- Trained and embedded workforce
- Union contracts
- Employment contracts
- Mineral exploitation rights
- Air rights
- Water rights
- Domain names
- Web site design
Once the intellectual property and intangible asset portfolios have been established, then the valuation expert can determine the methodologies to be used.
What Methods Are Used to Value Intellectual Property and Intangible Assets?
Once portfolios of intellectual properties and intangible assets have been determined, then the process of placing value on those assets can begin.
When valuing intellectual properties, we consider each of the different valuation methodologies, in light of the information available and the specific circumstances, in order to determine the best method for ascertaining value. The methodologies commonly used to determine the value of intellectual properties are: the Cost Approach, the Market Approach, the Income Approach, and a hybrid methodology known as the Relief from Royalty Approach.
The Cost Approach
Whether using historical or current costs, the basic underlying principle is that of substitution. This principle states that the value of an object or piece of intellectual property is no greater than the cost to acquire that asset elsewhere, whether the cost of obtaining the asset is measured by purchasing it today or replacing it with a substitute asset of equal strength and utility.
There are several different variations to the cost approach method, and each one uses a slightly different definition of cost. For example, the difference between reproduction cost and replacement cost may seem a question of semantics, but in fact, those two terms can be very different things. Reproduction cost establishes what it would take to construct an exact replica of the intellectual property. Replacement cost establishes what it would take to create or purchase a piece of intellectual property of equal functionality or utility.
Alternative approaches to the cost methodology, historical and prospective, assess the value of the intellectual property or bundle of assets by measuring the expenditures that would be necessary to replace the assets being valued. Whether historical or future cost is being established, three general areas of cost must be examined:
- hard costs, such as materials and acquisition of assets
- soft costs, including engineering time, design time, and overhead
- market costs, including costs of advertising or other costs to build a market for the intellectual property
Unless a premium is added to these costs, however, this method does not give an indication of economic benefits derived from the development, ownership, and utilization of the intellectual property. Instead, it provides a minimum value for the assets. Because the cost approach is based on the economic principle of substitution, the essential premise is that a damage calculation or valuation should be no greater than the amount a potential buyer would pay for an asset, or no greater than the cost to develop or obtain another asset of similar utility and quality.
Not all costs incurred may always be used as part of the calculation, because the obsolescence factor applies. For example, cost items relative to the development of the intellectual property may once have been proprietary but are now in the public domain.
Finally, two important thoughts: First, the costs included when calculating damages with this valuation methodology must be considered within the current economic and legal environment. Second, it is important to account for opportunity costs that arises either from delayed market entry or denied market entry.
Because the cost approach does not reflect the earning potential of the assets, it often is used most effectively for embryonic technology or other assets where no specific market application or specific stream of benefits or income has yet been identified. In any event, the cost approach often can be seen as providing a floor or minimum value for the intellectual property in question, against which a second methodology may be measured.
In this particular case, the client had a group of technology assets that were rendered obsolete because of infringement.
The Market Approach
The market approach to valuation of intangible assets is used just as it would be for a tangible asset valuation. In other words, the intellectual property or intangible assets are valued by comparing them to recent sales, transfers, and transactions that involve similar assets in similar markets (the greater the similarity, of course, the more suitable the transaction is for comparison purposes). As the name implies, the market approach to the valuation of any asset, tangible or intangible, is most applicable when a truly active marketplace exists and actual transactions can be found.
Even when an active marketplace can provide market comparables, the similar transactions used also must be adjusted to reflect the differences among the transactions, and the differences in the intellectual property or intangible assets being valued.
The market approach to valuation traditionally has been used with tangible assets where active markets have existed for decades, in areas such as real estate, equipment, and raw materials. However, most intangible assets, at least until recently, have not been bought and sold frequently enough to be able to establish a value based solely on direct market-based comparables; therefore, analysis and adjustment almost always are necessary. In addition, intangible asset transactions often are cloaked in several layers of confidentiality.
Therefore, it typically is difficult to get enough detail on each of the similar or comparable transactions to be certain that all of the elements of value that make for a comparable to be used in the market approach have been considered appropriately. On the other hand, because the market approach uses actual transaction data to the maximum extent possible, and values are derived from the sale, transfer, license, or other activity of similar assets, it is increasingly the preferred approach—if the necessary data can be found.
Using the market approach depends on finding one or more comparable transactions and then extrapolating those comparable transactions to the value of the intellectual property under review.
The Income Approach
The income approach methodology is based on determining the future income streams that can be, or will be, generated from the intellectual property or intangible assets being valued. The income approach is a widely-used intellectual property valuation methodology; however, it can be complex, and one must decide how to measure the “income” attributable to the asset.
A brief example illustrates this: An unsophisticated analyst might see that a branded product earns a profit margin 30 percent higher than its unbranded counterparts, and the expert is tempted to attribute the entire 30 percent to the trademark or brand. In fact, only some portion of that 30 percent may be attributable to the actual intellectual property, as the balance of the increased profit may be due to cheaper ingredients or more efficient manufacturing of the branded product. With these caveats in mind, the three basic parameters of the income approach are:
- Future income stream
- Duration of income stream
- Risk or discount rate associated with the income stream generation
The subtleties come in identifying the alternative measures of economic income that can be used in this sort of analysis. These can include net revenues, gross income, gross profit, operating income, income before tax, operating cash flow, EBITDA (earnings before interest, taxes, depreciation, and amortization), net cash flow, expected incremental income, etc.
The most common error in applying this approach is the expert’s lack of differentiation between the income generated by the total business enterprise, or the business enterprise value, and the value of the income generated by the intellectual property within that business. When valuing intellectual property, in order to use the income approach, it is critical to be able to separate the stream of income that the intellectual property is generating (and therefore its value,) from the value of the business as a whole, and then apply an appropriate discount rate and life span.
In summary, when using the income approach, the intellectual property or intangible asset values calculated represent the worth or present value of the future economic benefit/income that will (or should have) accrued to its owner. This requires projection of future income, an estimate of the duration of the income stream and/or useful life, and an estimate of the risk associated with generating the income stream, also known as the discount rate. Although at first glance it may seem less precise than the cost approach, due to the inclusion of multiple inputs of assumptions, often the information needed to make these assumptions can be developed accurately and verified based on market conditions and market data.
A key benefit of the income approach is that it provides the expert analyst the ability to perform sensitivity analyses by adjusting the various parameters, such as income levels or discount rate. This allows the expert to better understand the performance of the various factors driving value, and enables estimates of upper and lower limits to a range of value.
The Relief from Royalty Approach
The relief from royalty approach is another method for establishing intellectual property values; however, it can be a very dangerous methodology in that it tends to be oversimplified and inappropriately applied in many situations. Properly applied, it is an excellent methodology, provided that the expert truly understands appropriate royalty rates: where to find them, how to modify them, and then how to apply them. This is a skill that takes years of development, as opposed to the overused rule of thumb that says a 5 percent royalty rate is appropriate in most situations.
This method is a combination of the income approach and the market approach, where comparable market royalty rates can be found.
Briefly, the relief from royalty method of value for intellectual property is the calculation of the present value of a stream of royalties that the intellectual property owner would have received (or that the infringer has been relieved from paying). This approach provides a measure of value by determining the avoided cost of an infringer not having to pay the appropriate royalties. It is calculated by assuming that the infringer does not own the patent, trademark, or copyright and thus has avoided a royalty that the infringer should be paying for its use. This relief from royalty method uses royalty rates that are based on marketplace transactions or interpolations of royalty data, and it uses a forecast of the infringer’s actual or projected revenue as the income stream to which the royalties apply.
Specifically when using the relief from royalty approach, the present value of the future or past royalty streams is the measure of damages. The assumption, of course, is that the assets would have to be licensed in order to use them. This method determines what the cost would be of that hypothetical license, measured by royalty streams. Therefore, it incorporates either a projection of future revenue or past infringer revenue and relies on comparable royalty rate data.
Usually, data from marketplace comparable license agreements is used as the source for the royalty rate in the calculation. It must be noted, however, that there is no such thing as an exact market comparable royalty rate. Each one is different and reflective of the unique intellectual property for which the rate is being charged. However, the inclusion of this market-based information adds credibility to the damages analysis. With both the income approach and the relief from royalty approach, the results can be revisited periodically for updates as needed.
A note of caution : Although the relief from royalty method has been used for many years, in the last decade it has become, in our view, misused and abused to some extent. Far too many valuations are performed using royalty rates that do not accurately reflect the marketplace.
Other Valuation Approaches
This section addresses some of the alternative methods of valuation. Some of these alternative methods are permutations of traditional methods while, on the other hand, others of these are completely new approaches to the questions and issues of valuing very complex assets. Each is treated very briefly and is intended as a summary for the reader.
Some of the alternatives listed below are specific to a particular type of intellectual property or intangible asset. A good example of this is the technology factor approach. This approach is used primarily to analyze the strengths of early stage technology or patents, and occasionally trade secrets. Its methodology to some extent mirrors the relative strength analysis that goes into establishing royalties in a relief from royalty approach.
Because the analysis and valuation of intellectual property is an evolving process and a relatively new field of discipline—not much more than two decades old— methodologies continue to be refined and expanded. Therefore, one can expect to see ongoing changes, modifications, refinements, and evolution of intellectual property and intangible asset valuation techniques.
The Brand Value Equation Methodology
The brand value equation methodology (BVEQ™) is based on the premise that when valuing intellectual property more than one asset may be involved. In this methodology, a core value for the trademark is calculated, and then each of the individual other assets attached to the core asset have their values calculated. Therefore, the sum of the core brand value plus the incremental assets becomes a total brand value. Expressed in an equation it is as follows:
BVE Q 5 CBV 1 IVE 1 1 IVE 2 … IVE n
The Competitive Advantage Technique
The competitive advantage technique is best used when the subject company has a complex portfolio of intellectual property. The competitive advantage can sometimes be quantified based on share of market, market growth, higher competitive pricing, or other benchmarks. While individual pieces of intellectual property within the overall portfolio of a company may be difficult to measure, this approach allows one to estimate the value of the entire portfolio as used in one or more business units of a corporation.
The Concept of Relative Incremental Value
The concept of relative incremental value works when one is trying to represent some percentage of value of an individual asset that is associated with a larger trademark or patent portfolio. For example, if an underlying trademark or brand has a value of $100 million, and the domain name associated with it is generating 10 percent of revenues, then one can allocate a relative value of 10 percent of the total or, $10 million dollars for the domain name.
Decremental Cost Savings Valuation
Decremental cost savings valuation quantifies a decrease in the level of costs being experienced by the intellectual property owner/operator. If, in fact, the intellectual property owner can quantify lower levels of capital or operating costs connected directly with the ownership of the intellectual property; then those lower costs can be a direct measurement of the value of the specific intellectual property.
Enterprise Value Enhancement
Enterprise value enhancement is related to the traditional income method approach to valuing intellectual property. The valuation analyst establishes the value of the intellectual property owner’s overall business enterprise value as a result of owning the intellectual property and then compares that to the business enterprise value if the owner did not, in fact, have or control the intellectual property or was not able to use it in its business enterprise. The value of the intellectual property then would be the difference between the total business enterprise value and the business enterprise as calculated without the intellectual property.