Introduction

Intellectual Property is recognised as the most important asset of many of the world’s largest and most powerful companies. It is the foundation for market dominance and continuing profitability of leading corporations. It is often the key objective in mergers and acquisitions and knowledgeable companies are increasingly using licensing routes to transfer these assets to low tax jurisdictions.

Despite this the role of intellectual property “IPR” in a business is not always properly and sufficiently understood. Accounting Standards are in the main not very helpful in representing the value of IPR’s in the financial statements of an organisation, the consequence of this is that the IPR’s may be seriously undervalued, if valued at all, to the perceived detriment of the business concerned

It is therefore very evident that one of the key factors affecting a business’s success or failure is the degree to which it effectively exploits intellectual capital and values risk. Management obviously need to know the value of the IPR and those risks for the same reason that they need to know the underlying value of their tangible assets; because business managers should know the value of all assets and liabilities under their stewardship and control, to make sure that values are maintained. Exploitation of the IPRs can take many forms, ranging from outright sale of an asset, a joint venture or a licensing agreement. Inevitably, exploitation increases the risk assessment.

The Need to Value Intellectual Property

Valuation is, essentially, a bringing together of the economic concept of value and the concept of property. The presence of an asset is a function of its ability to generate a return and the discount rate applied to that return. The cardinal rule of the commercial valuation is: the value if something cannot be stated in the abstract; all that can be stated is the value of a thing in a particular place, at a particular time, in particular circumstances. I adhere to this and the questions ‘to whom?’ and ‘for what purpose?’ must always be asked before a valuation is carried out.

This rule is a particularly significant as far as the valuation of intellectual property rights is concerned. More often than not, there will only be one or two interested parties, and the value to each of them will depend upon their circumstances. Failure to take account of these circumstances and those of the owner, into account will result in a meaningless valuation.

The Role of the Forensic Accountant

The forensic accountant should act as the independent expert to determine a market value based on one or more of a combination of the methods set out below.

Methods of Valuation

There are a number of different and to some extent relevant widely used methods of valuing intellectual property. However there is a lack of consensus as to what to use, and as such a degree of scepticism has arisen that the value can be reliably measured.

The accounting/financial methods that are in our view the correct ones to use are as follows.

1. Income Based
2. Cost based
3. Discounted Cash Flow

Income Based Methods

1. The capitalisation of historic profits arrives at the value of IPR’s by multiplying the maintainable historic profitability of the asset by a multiple that has been assessed after scoring the relevant strength of the IPR. For example, a multiple is arrived at after assessing a brand in the light of factors such as leadership, stability, market share, internationally, trend of profitability, marketing and advertising support and protection. While this capitalisation process recognised some of the factors which should be considered, it has major short comings, mostly associated with historic earnings capability. The method pays little regard to the future.

2. Gross profit differential methods are often associated with trade mark and brand valuation. These methods look at the differences in sales prices, adjusted for differences in marketing costs. That is the differences between the margin of the branded and/or patented product and an unbranded or generic product. This formula is used to drive out cashflows and calculate value finding generic equivalents for a patent and identifiable price differences is far more difficult than for a retail brand.

3. The excess profits method looks at the current value of the net tangible assets employed as the benchmark for an estimated rate of return. This is used to calculate the profits that are required in order to induce investors to invest into those net tangible assets. Any return over and above those profits required in order to induce investment is considered to be the excess return attributable to the IPRs. While theoretically relying upon future economic benefits from the use of the asset, the method has difficulty in adjusting to alternative uses of the asset.

4. Relief from royalty considers what the purchaser could afford, or would be willing to pay, for a licence of a similar IPR. The royalty stream is then capitalised reflecting the risk and return relationship of investing in the asset.

Cost Based

1. Cost to replace values an intangible asset by aggregating the cost that would be required to replace the asset. The central thesis of this approach is that an investor should not pay any more to buy the asset than would be paid to reproduce the asset. This approach has merit for some assets, in particular those that do not directly generate income however caution should be exercised as cost and success are not entirely synonymous

Discounted Cash Flow

Discounted cash flow (“DCF”) analysis sits across the last two methodologies and is probably the most comprehensive of appraisal techniques. Potential profits and cash flow needs to be assessed carefully and then restated to present value through the use of a discount rate, or rates. DCF mathematical modelling allows for the fact that 1 Euro in your pocket today is worth more than 1 Euro next year or 1 Euro the year after. The time value of money is calculated by adjusting expected future returns to today’s monetary values using a discount rate. The discount rate is used to calculate economic value and it includes compensation for risk and for expected rates of inflation.

With the assets that you are considering, the valuer will need to consider the operating environment of the asset to determine the potential for market revenue growth. The projection of the market revenues will be a critical step in the valuation. The potential will need to be assessed by reference to the enduring nature of the asset, and its marketability and this must subsume consideration of expenses together with an estimate of residual value or terminal value, if any. This method recognises market conditions, likely performance and potential, and the time value of money. It is illustrative, demonstrating the cash flow potential, or not, of the property and is highly regarded and widely used in the financial community.

The discount rate to be applied to the cashflows can be derived from a number of different models, including common sense, build-up method, dividend growth models and Capital Asset Pricing Model Utilising a weighted average cost of capital. The later will probably be the preferred option.

Conclusion

This Bulletin has highlighted some of the accounting methods used by the financial community. What is sometimes not always appreciated is valuation is not entirely a science, but rather an interdisciplinary study drawing upon law, economics, finance, accounting and investment.

It is to this end that a firm such as Bishop Fleming can bring together the right multidisciplinary team to help calculate that realistic valuation.