Overcoming the hurdles of intellectual property

Intellectual property (IP), such as brand names, patents, copyrights or trade secrets, can significantly contribute to companies’ values. So it’s important to understand the nuances of valuing these assets.

Companies may need to know IP’s value in many different situations. For instance, a valuation professional can help a business considering buying another company with significant intangible assets or one that needs to estimate appropriate royalty rates or licensing fees to pay an inventor. And recent accounting standards — including Statements of Financial Accounting Standards 141 and 142 — necessitate IP valuations.

Ins and outs - Several litigation situations require IP values. Whether faced with bankruptcy, divorce, a breach of contract, a dissenting shareholder suit or an infringed patent, one can benefit from hiring an experienced IP valuator. But before contacting an expert, you should understand how IP valuations differ from traditional business valuation assignments.

IP is hard to get a handle on - IP is a type of intangible asset that derives its value from creative ingenuity or innovative technology. Unlike hard assets, intangible assets can’t be visited or touched.

When valuing IP, a valuator needs to consider its nature, its competitive advantages to end-users and its costs to implement. He or she should also understand the company’s legal rights to the IP as well as the marketplace in which the company operates.

IP is also subject to a wide variety of payment methods, ranging from one-time flat fees and annual/monthly payments to payments that vary depending on sales or gross margins. To complicate matters, some IP payment terms call for a combination of fixed and variable fees or may be subject to minimum or maximum fees over the asset’s life.

IP’s complex nature requires the cooperation of valuation professionals and technical experts. Although it can be time consuming, such collaboration ensures the valuator truly understands the IP, so he or she can identify meaningful comparables and estimate viable cash flow projections. Although it’s easy to get caught up in an inventor’s zeal for his or her discovery, it’s important that your expert remain grounded in economic reality, especially if the IP is not fully developed.

Attorneys should also educate valuators about the laws governing their clients’ IP. These complex regulations determine the scope of the IP’s legal protections and can help identify potential and existing non-infringing competition. Such legal knowledge is imperative in developing royalty rates and cash flows. But keep in mind that it is typically outside a valuator’s area of expertise.

Empirical data on IP is scarce - Real-life market evidence is usually the best way to value IP but, because IP is so innovative, valuators often have trouble identifying truly comparable transactions. Because of IP’s proprietary nature, the intimate details of many IP transactions are also kept secret.

Nonetheless, experienced valuators have access to commercial IP databases, and many have developed their own proprietary resources from previous consulting experience. From these databases, your client’s expert will typically develop a range of reasonable royalty rates.

But the multitude of payment options can make comparing the terms of comparable transactions and developing a reasonable range of royalty rates difficult. After a valuator has identified a reasonable range, he or she is likely to employ a scorecard approach to evaluate the distinctive characteristics of the IP, rather than simply applying the average or median from their ranges.

Even though finding comparables may be difficult, value conclusions must be supported with empirical evidence. Beware of valuators who rely on anecdotal rules of thumb — such as an undocumented royalty rate of 25% of gross margin — except as sanity checks. These simplistic measures fail to consider the IP’s relative technical strengths, market competition, useful life, or differences in expense classifications between companies and industries.

IP and IP valuations can quickly become obsolete - Remember, time can quickly render IP less valuable or even valueless. Protective legal rights can expire. New technology or competition can enter the marketplace. Economic conditions and consumer demands can quickly evolve.

Because IP is so sensitive to these dynamic variables, another difficulty valuators face when valuing IP is estimating the asset’s remaining useful life. As conditions change, this estimate can quickly become outdated. Therefore, market comparables must be proximate to the valuation date. Further, IP valuations should be used only for their original purpose and “as of” date.

IP is tricky - For many reasons, IP is different from other assets. Its nuances underscore the importance of timeliness and teamwork among the valuator, client and attorney. It’s also imperative that you choose a business valuator who understands the specific valuation situation — whether you’re interested in strategic decision making, merger and acquisition considerations, litigation or income tax/GAAP financial reporting. We would be happy to answer your questions about IP and its implications.

Sidebar: A calculated risk

Intellectual property’s (IP) higher costs of implementation, complexity and vulnerability make it riskier than hard assets such as receivables, inventory or equipment. IP’s greater risk often translates into a higher weighted average cost of capital or “investment hurdle” rate. Depending on the IP’s attributes, applying a company’s overall cost of capital to its IP may not make sense.

This is especially true for IP that is not yet fully developed. While early-stage IP may have considerable upside potential, it is untested and faces many obstacles. For instance, finalizing the idea will require additional time and expense. During the remaining development time, market conditions or competitors’ technology may render the prospective IP obsolete — before it even has a chance to hit the market.