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| Valuing Intellectual Property |
| C. G. Srividya / New Delhi Oct 20, 2009, 18:16 IST |
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 A leading global IT solutions company needs to value software applications acquired as a part of a business combination for financial reporting purposes. A fully integrated healthcare company intended to transfer rights and ownership of certain intellectual property related to bio-generics to a group company at fair valuation. A large spirits company requires to value its product related intangibles / brand for the purpose of debt financing.
How do these companies recognize, value and leverage the intangible assets / intellectual property? What could be the end use of such valuation? What methods and approaches may be used in estimating the fair value of the intellectual property for the transactions? What are the key considerations and concerns in selecting an appropriate method for valuing the intellectual property?
The use and applicability of Intellectual Property (IP) has evolved significantly over the years from a primary focus on defensive competitive behavior (e.g. prevent competitors from entering markets, enforcing patents against infringers) to being core to business strategy (e.g. licensing, building a patent portfolio) and an important financial asset (i.e. to attract external sources of finance). Today, IPs are used for a range of business requirements making the valuation of IP an important aspect of strategic decision making.
Why value IP?
As organizations identify more open models of innovation based on collaborations and external sourcing of knowledge, they utilize their IPs in a wider variety of ways.
Although public perceptions of IP valuation are often focused on capitalization of development costs, the real significance has increased for a variety of purposes including purchase price allocations, acquisitions, investor relations, licensing and franchising; securitized borrowing; equity fund raising, legal arguments, tax planning and for internal management evaluation of performance.
How to Value?
 With respect to estimating the value of IPs, several methodologies are currently in vogue. These may be broadly classified as under:
Cost Approaches
The cost approach is based on the cost of obtaining a patented invention by either internal development or external acquisition. Replacement cost represents what it would cost today to acquire a substitute asset of comparable utility if the same is available in the market. The replacement cost method is especially useful for purchased intangibles such as off the-shelf software and similar licenses. The reproduction cost method requires an estimate of the cost incurred to reproduce the IP in the as is condition as on the date of acquisition. It can be useful as an estimate of fair value for an intangible asset that has been developed by the acquired entity for its own use (for example in-house developed technology).
Market Approaches
The market approach determines the value of an IP by using one or more methods that compare the prices paid by other market participants for reasonably similar assets. However, IPs are rarely sold in piecemeal transactions. Furthermore, since intangible assets are unique to a particular business entity, comparison between entities would be difficult and hence this method is rarely used in practice. Market approaches include:
Market Transactions Method
The market transactions method determines the fair value of an asset by reference to the transaction prices or valuation multiples implicit in the transaction prices of identical or similar assets in the market.
.jpg) Income Approaches
The income approach attempts to calculate the present value of the projected future cash flow arising from the subject IP during its economic life.
A. Relief-from-royalty method: The relief-from-royalty method values the IP by reference to the amount of royalty one would have had to pay in an arms length licensing arrangement to secure access to the same rights. The key input into this method is the "royalty rate", which is then applied to the "royalty base" to estimate the amount of theoretical royalty payments. This royalty stream, which the owner does not have to pay since the intangible asset is already owned is then taxed and discounted back to present value.
B. Multi-period excess earnings method (MEEM): The MEEM is applied to a wide variety of intellectual assets, especially those that are close to the 'core' of the business model (sometimes referred to as 'primary' or 'leading' assets). In practice, IP is frequently valued using the MEEM.
Since the IP being valued generates after-tax operating income by using contributory assets, in order to estimate the earnings that are solely attributable to the asset being valued, an economic rent for the use of other contributory assets is deducted from the operating income. These cash flows are then discounted after adjustment for required rate of return.
 Selecting the right method
Selecting an appropriate methodology is an important aspect of the valuation process, the relative emphasis of each method often varying with the factors such as:
• Whether current and future goods or services depend on the developed IP either directly or indirectly;
• How the IP enables cost savings or additional income streams compared to a situation without the IP;
• Whether the IP is fully developed or it is an in-process research and development project (IPR&D);
• How the entity restricts third-party use of the IP (e.g. by patent applications or copyrights);
• How long the entity will benefit from the IP and the period after which the IP becomes obsolete;
• Whether the IP could be licensed to or from a third party;
Next Steps…
The utility of these approaches and the frequency of their use vary according to the purpose of the valuation and the inherent nature of the IP to generate revenues and cash flows. In addition, one must be cautious in associating value with an IP without considering specific risks associated with the asset, its marketability and its synergy with various other business functions. It would be prudent to entrust valuation of such intellectual property and other intellectual assets to valuation experts who would be better equipped in appropriately identifying and quantifying such risks.
The author is Partner – Valuation Services at Grant Thornton, India. She can be reached at CG.Srividya@wcgt.in. The article has been written with support from Kapil Bellubi and Karthik Balisagar, Senior Consultants at Grant Thornton.
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