Methodologies for Valuing IP
Intellectual property is a subset of intangible assets that comes in four
generally accepted forms: (i) patents, (ii) trademarks, (iii) copyrights, and
(iv) trade secrets and know-how. Intangible assets are created through the
normal course of business, while intellectual property is created through and
is generally subject to formal legal recognition and protection. As a result,
most forms of intellectual property have a finite legal life.
While all intellectual property can be classified as intangible assets, not
all intangible assets are intellectual property. However, similar valuation
methodologies may be utilized in the valuation of both intangible assets and
Why Value Intellectual Property
There are many reasons to place a value on intellectual property. These reasons
can be purely transactional in nature, such as in the purchase or sale of intellectual
property or the establishment of a fair royalty rate for licensing purposes;
notational in nature, such as for accounting or recording purposes; or as a
result of controversy (i.e., litigation), such as in the case of patent
infringement and economic damages. In each case, the same rigorous valuation
methodologies are applied with the results used for different purposes.
Methods for Valuing Intellectual Property
There are three generally accepted approaches for valuing intellectual property.
These approaches are commonly referred to as the Cost, Income and Market Approaches.
» Cost Approach – The most common definitions of cost
are reproduction cost and replacement cost.
Reproduction cost considers the construction of an exact replica of the subject
intellectual property, at current prices as of the date of the analysis, using
the same or similar development methods and materials as were used in the original
effort. Reproduction cost does not account for changes in technology and higher
utility. The resultant intellectual property will include the same inadequacies
and obsolescence as the subject intellectual property.
Replacement cost considers the construction of intellectual property, at
current prices as of the date of the analysis, with equivalent utility to the
subject intellectual property, using modern development methods and materials.
The resultant intellectual property from this effort will exclude all curable
inadequacies and obsolescence present in the subject intellectual property.
Whether determining reproduction cost or replacement cost, there are five
components of cost that are generally considered. These components of cost
are (1) materials, (2) labor, (3) overhead, (4) developer's profit and (5)
entrepreneurial incentive. Once all the components of cost have been determined,
the valuation analysis should consider any loss in economic value due to the
presence of functional, technological and economic obsolescence.
» Income Approach – There are several difference measures
of economic income that may be utilized in the income approach to valuation.
Some of these measures include gross or net revenues; net operating income;
net cash flow and cost-savings.
There are many income approach methods suitable for the valuation of intellectual
property. These methods can generally be grouped as follows:
1. Methods that quantify the greater levels of economic income that the intellectual
property owner will enjoy as a result of owning the asset as compared with
not owning the asset.
2. Methods that quantify the lower level of economic cost enjoyed by the
asset owner as compared with not owning the asset.
3. Methods that estimate a relief from a royalty or rent payment that the
owner of the asset would be willing to pay a third party in order to obtain
the use of/rights to the same asset.
4. Methods that quantify the difference in overall business enterprise value
as a result of owning the intellectual property asset as compared with not
owning the asset.
All of the income approach valuation methods listed above can be categorized
as either direct capitalization or discounted future economic benefits analysis.
The term of the economic income generated depends upon the expectation of the
duration of the economic income stream which can be determined through an analysis
to determine the remaining useful life (RUL) of the subject intellectual property.
» Market Approach – The market approach consists of an
attempt to utilize data obtained from comparable transactions that have recently
occurred in the open market.
In order to be useful for comparative purposes, the identified transactions
should be similar to the subject intellectual property in qualities such as
type of intellectual property, intellectual property use, the industry in which
the asset functions, the specific legal rights conveyed in the transaction,
the physical, functional and technological attributes of the guideline asset
compared to the subject intellectual property and many others.
To the extent comparable arms length transactions can be found in the market,
a value indication can be derived for the subject intellectual property.
The final step in a valuation analysis is to reconcile the indications of
value derived from application of the cost, income and market approaches to
arrive at a final indication of value for the subject intellectual property.
As we move forward in the information age, companies are becoming increasingly
dependent on the development and use of intellectual properties. Therefore,
understanding the economics driving the value of these assets will become more
critical in the strategic planning process. Those professionals with the best
understanding of these economic value drivers will be in the best position
to influence the strategic planning process.
R. Christopher Rosenthal is a Director and David R. Bogus is a Manager
in Ellin & Tucker Chartered's Business Valuation/Forensic and Litigation