Maryland Bar Bulletin
Publications : Bar Bulletin : March 2007

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 Bar Bulletin Focus

Intellectual Property     

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 intellectual property.

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.

Conclusion

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 Services Group.

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Publications : Bar Bulletin: March 2007