Intellectual Property; what is it and what is it worth?
The valuation of a business, or specific assets that make up a business operation, is a subjective practice and requires in-depth analysis and application of valuation principles and concepts to reach a reasonable conclusion. At its core, business valuation is prospective and is based on the present value of the future cash flows accruing to the owner of the asset.
While that concept is simple enough to understand, determining the future cash flows and the risks associated with them are where opinions can diverge.
The value of a business is the sum of three asset categories:
- Tangible assets (physical assets, like real estate and machinery),
- Intangible assets (non-physical assets, including intellectual property (“IP”) like patents, trademarks, copyrights, business methodologies), and
- Net working capital (the cash and other current assets needed to sustain day-to-day operations).
This discussion will focus on intangible assets; specifically IP.
What is IP and how does one put a value on it? Think of branded products like Advil, Coca-Cola, and Q-tips against their generic competition. Are 24 capsules of Advil worth twice as much as the bottle of “Ibuprofen” beside it? Why does someone spend more on two litres of Coca-Cola than on “Mr. Soda”? Because the owner of the Q-tip trademark can sell a box of cotton swabs for a dollar more than the generic box beside it, a corporate acquirer would inherently pay more just to put Q-tip on the box since it is more profitable than selling an unbranded product.
There are three main approaches to the valuation of IP:
- Income method
- Market method
- Cost method
The income method is based on the discounting of future cash flows or capitalizing the current cash flows that will accrue to the owner of the IP. The owner of IP could see cash flows generated from royalties or from cash flows that are in excess of what would reasonably be expected from an asset in the absence of the IP.
- Valuing royalties is often done using the relief from royalty method, which is based on subjective estimates of the royalties that would be paid for use of the intangible asset. The royalty paid on gross sales, based on comparable royalty rates, is discounted or capitalized to conclude on a value. For example, if the royalty rate to print Mickey Mouse on a t-shirt is 10% of gross sales, and t-shirt maker sells one hundred of those t-shirts for $20 each, Walt Disney Co. is owed $200 (100 t-shirts x $20 per shirt x 10% gross royalty). If it is determined that similar royalties trade at 10x, the value of the Mickey Mouse image is $2,000 ($200 annual royalty x 10x multiple). It can be difficult, however, to find comparable royalty rates.
- The with and without method considers the incremental cash flows of a business resulting from ownership of the intangible asset. This requires analysis of industry and economic conditions, understanding the duration of those incremental cash flows, and any additional operating expenditures or capital expenditures required to generate the incremental revenues. The resulting difference between the cash flows generated by the business with the intangible asset and without the intangible asset provides the cash flows associated with the intangible asset. A present value of those cash flows can then be determined to conclude on value.
The market method compares the asset in question to similar intangible assets that have recently traded hands. Due to the unique nature of intangible assets and IP, the main drawback to this approach is the lack of comparable intangible assets. Not only can comparable transactions limited in nature, but it can also be challenging to find information on the prices paid for such assets, and even that information can be cloudy at best, as each transaction is unique.
The cost method determines the capital outlay that would be required to replace or replicate a specific intangible asset. The drawback of the cost approach is that it can be difficult to reasonably estimate the total cost to replicate such an asset. One could estimate the man-hours required to produce a specific software application, for example, however, it would be much more difficult to determine how much money Coca-Cola has spent since inception building the value of their brand. Although it cannot be seen or touched, like a factory or a gold mine, IP can add significant value to a firm. The company that possesses key IP assets can benefit as a result of greater market share, increased profitability, higher barriers to entry, and legal protection, thus making a firm owning the IP more valuable than a competitor who does not. Simply stated, the increased benefit of owning the IP over not owning the IP is the key driver of its value.
Learn more about Benson Badger’s Business Valuation practice. If you have any questions about how our team of CBV’s can help you in the valuation of intellectual property or require assistance in an upcoming business valuation, contact us today.
This article was written by Benson Badger Principal Matt Badger, CBV.
© Copyright 2020 Benson Badger Advisory Group Inc. All rights reserved. No part of this publication may be transmitted or reproduced without the written permission of the copyright holder.