Estimating remaining useful economic life

Many theories and techniques that appraisers apply in valuing privately held businesses also apply to intangible asset appraisals. But a clear exception is the concept of remaining useful economic life. While most viable business entities are assumed to have perpetual lives, intellectual property usually generates income (or cost savings) over a finite period.

Remaining useful economic life captures this limited longevity. When applying the income approach, remaining life becomes the period over which cash flows are discounted. Valuators also incorporate remaining life into the cost approach when assessing obsolescence as well as into the market approach when selecting comparable transactions or adjusting pricing multiples.

Remaining life framework - Quantifying remaining useful economic life is no easy task. It’s a function of several interrelated factors, including, but not limited to:

1. Expected use of the subject asset,
2. Required maintenance expenditures to prolong economic life,
3. Legal life and renewal provisions (if applicable),
4. Contractual issues, such as licensing and transfer price,
5. Competing and emerging technology,
6. Market demand,
7. Other factors, such as industry volatility, unexpected changes in distribution channels or legislative actions, and
8. The appraiser’s professional judgment.

Before calculating an asset’s remaining life, appraisers usually evaluate average life, which is the average expected life for a new member of the asset group. Average life is the lesser of two aspects of an intangible asset’s life: its legal life and its economic life. An asset’s legal life typically imposes a ceiling on its life expectancy. For example, most patents are protected for 20 years from their application filing dates.

Extenuating factors and circumstances may shorten an asset’s economic life, which is the period during which the asset is likely to generate income or cost savings. For instance, a patented asset’s 20-year life may be cut short by cost-prohibitive raw materials or a competitor’s launch of a superior substitute product.

Average life is a building block for estimating remaining useful economic life, which is the amount of time the asset is expected to survive, based on its current age. Calculating the remaining life takes more than merely subtracting the asset’s current age from its average life.

To estimate average and remaining lives, appraisers frequently study the lives of similar intangible assets. In essence, they select a population of comparable assets and analyze the turnover or decay of these assets over time. For patents, the analysis might entail studying the historical decay in terms of dollar volume or units of production. For copyrighted songs, the appraiser may look at the pattern of royalty income over time.

Sophisticated analytical tools - Valuators also use statistics and actuarial science to derive mortality/survival curves of intangible asset populations. To illustrate, they may graph the historic survival rate of a comparable population and then use software to determine an appropriate formula for analyzing the data.

After the valuator has identified the appropriate formula, he or she can apply it to the subject intellectual property and predict its average life, remaining life and expected future retirements.

Prerequisites to reliable estimates - Perhaps more than any other type of valuation assignment, intellectual property appraisals call for experience and specialization. Remaining life estimates require an in-depth understanding of intangible assets, many of which are technical or scientific in nature, and of an asset’s specific legal rights and contract terms.

In addition, the valuator must know how to extrapolate historic and projected cash flows attributable to the subject intellectual property from financial statements, using data and financial forecasts. These cash flows are the fundamental building blocks for analyzing comparable transactions, quantifying remaining life and, ultimately, valuing the intangible asset. The valuator also needs to step back and consider whether that asset value makes sense in light of the surrounding facts and circumstances.