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INFONEX
Business Strategies for Managing Intellectual Property

"VALUATION OF INTELLECTUAL PROPERTY ASSETS:
THE FOUNDATION FOR RISK MANAGEMENT AND FINANCING"


by Richard M. Wise, FCA

GENERAL


Intellectual property is a specialized classification of intangible assets. Because of their special status, intellectual properties enjoy special legal recognition and protection.

Intellectual property has made a major contribution in establishing and building competitive advantage of businesses, as industries in the western world have shifted to technology-intensive industries and towards the creation of added value through product differentiation. In the words of Russell Parr, an experienced American valuator:

"Intellectual properties are the spark plug assets that bring the sleepy monetary, fixed, and intangible asset investment engine to thunderous and profitable life. Intellectual properties are the most powerful assets a company can possess. They can command premium selling prices, dominate market share, capture customer loyalty, and represent formidable barriers to competitors."

Not only has the market recognized the importance of intellectual property such as trademarks, patents and proprietary technology as determinants of corporate worth, but lenders are increasingly accepting intellectual property as collateral to secured financing. My co-panellist, Zareer Pavri, will be commenting on what the bank and insurance companies look for in an intellectual-property valuation.

This paper is intended to provide an overview of (a) business valuation principles and approaches in determining the fair market value of intellectual property, (b) "royalty economics" and (c) the interrelationship of intellectual property and the assets of a business. Zareer will provide a hands-on illustrative case study, using data for a world-class U.S. firm.

UNDERSTANDING IP VALUATION METHODOLOGIES

Valuations are technically referred to by business valuators as notional-market valuations because they are generally performed in the absence of open-market negotiations. For example, the appraisal of a home provides fair market value in the notional market (hypothetical market); but the actual price at which that home transacts, following arm’s length negotiations, is the market value of the home in the open market. "Fair market value" is determined in the context of the notional market.

There are many reasons why intellectual property may have to be valued. Valuations are generally commissioned for the following purposes:


  • When property is transferred in a non-arm’s length transaction ("transfer pricing").
  • Determining whether the licensing or royalty terms of an agreement properly reflect fair market price, for income tax, corporate law and/or securities regulation purposes.
  • Corporate reorganizations.
  • Family-law settlements, infringement litigation support and dispute resolution.
  • Transactions of business ownership interests, shareholder buy-sell agreements, etc.
  • Allocation of the total transaction price of a business among its various tangible and intangible assets.
  • Management information and planning.
  • Licensing.
  • Independent fairness and/or valuation opinions pursuant to provincial Securities Acts and/or Securities Commission Policies.
  • Financing securitization and collateralization with banks and other lenders.
  • Insolvency.
Fair Market Value

The value standard most frequently applied in notional-market valuations is "fair market value", which is generally defined as:

"The highest price available in an open and unrestricted market between informed and prudent parties acting at arm’s length and under no compulsion to act, expressed in terms of cash."

In summary, fair market value is the so-called "willing buyer/willing seller" price in the notional market, assumed to be transacted between informed, arm’s length parties.

However, it may well be that if the property were actually exposed for sale over a reasonable time in the open market, there may be buyers who may be able to benefit from synergies, economies of scale, increased market share, assured source of customers, or other strategic advantages from the ownership of a business or interest therein, and would therefore be willing to pay a higher price than the stand-alone "fair market value" of the property to obtain possession thereof. For example, a controlling interest in a public company may fetch a significant control premium over the prevailing stock market price. Premiums of 30% and more, over the unaffected, pre-announcement takeover price, are common.
As a general background, there are essentially three alternative premises of intellectual-property value:

  • Value in exchange. This assumes that the intellectual property is sold separately, on a stand-alone basis, at the highest price obtainable from a willing purchaser, i.e., at fair market value. Such sale can be on an orderly liquidation basis or a forced liquidation basis.
  • Value in continued use . This reflects the value of the asset on the basis that it will continue to generate income in such a manner that the owner employs only those same prospective financial and operational activities which maximize the value of the intellectual property.
  • Acquisition value. This recognizes all of the synergies and strategic advantages following business combination. That is, rather than viewing the specific intellectual property on a stand-alone basis (value in exchange), it is viewed in the hands of an enterprise which would maximize the value through the commercial exploitation thereof.

Basic Principles of Valuation

The following fundamental valuation principles apply to notional-market valuations of property:

  • Value is determined as of a specific point in time.

As value determined as of a specific point in time, hindsight ?or the use of retrospective evidence ?is inadmissible. Value is typically prospective or forward-looking, with the past possibly serving as a guide to the future.

  • Value is forward-looking: it is a function of the future benefits anticipated to accrue from ownership.

In an open-market context, a hypothetical purchaser wishes to exploit the intellectual property because of the prospective earning capabilities measured by way of super profits, cost savings, exclusivity of a market or product, royalty and licensing potential, etc., as opposed to historical earnings. (Historical results are basically limited to providing a benchmark for establishing trends as to the future manner in which the property can be exploited, but may have no relationship to future potential.)

  • Value can have two distinct components: commercial (or transferable) value and non-commercial value (or value-to-owner).

Before intellectual property can be valued on a stand-alone basis, it must be established whether it is separately identifiable vis-à-vis other assets with which it has been commercially exploited. To be separately identifiable, the intellectual property must be:

     
  • capable of being legally enforced and legally transferred;
  • capable of having its income stream separately identifiable and isolated from the contribution of other assets employed in the business (discussed below); and
  • capable of being sold, without selling the other business assets of the enterprise to the same buyer.
  • The market drives the required rate of return.

The required rate of return a notional purchaser requires on his or her investment in intellectual property is market-driven and affected by general economic conditions and other relevant factors impacting risk and the yield on alternative investments.

  • The value of intellectual property is based on what it can bring to the enterprise, unless liquidation results in a higher value.

If the business holding the intellectual property is not earning an adequate return on its capital employed or is not viable as a going concern, the underlying business assets (including intellectual property) may be worth no more than the price they could fetch in the open market if the business were to be liquidated. For example, intellectual property which is transferable and is versatile to numerous applications can have a greater liquidation value than the value-in-use to a business which has suffered a market or financial downturn, i.e., the purchaser might use the property in a more profitable manner.

Elements of Intellectual Property Valuation

As property is worth what it can earn, what would someone be prepared to pay today, in terms of money (or money’s worth), for expected future economic benefits derived from the commercial exploitation of the intellectual property?

The following comprise the key components of an intellectual property’s underlying value:

  • Legal enforceability?The intellectual property must be capable of legal enforcement.
  • Transferability?The asset must be capable of being transferred to purchasers other than those who will buy the other business assets. For example, if a licence is not transferable and does not carry the right to sub-license, it will not have a transferable or commercial value, but value only to the owner.
  • Separability?As the asset must be capable of legal enforcement and legal transfer of ownership, discussed below, it must be possible to isolate the benefits it generates from those derived from other intangible business assets such as reputation, workforce and distribution networks, i.e., the enterprise’s "goodwill".
  • Economic Life?The economic life of the asset may be totally different from its legal or contractual life because of a host of outside forces such as legislation, end-product industry, economy, government regulations, etc.
  • Extent of Novelty?The less the intellectual property has a proven, established track record, the more difficult the valuation will be because of lack of historical track record, demonstrated market acceptance and information on industry required rates of return.
INTERRELATIONSHIP OF INTELLECTUAL PROPERTY AND OTHER ASSETS OF THE BUSINESS ENTERPRISE
There is a direct correlation between the value of a business and its underlying intellectual property and other intangible assets. The assets of a business enterprise typically include (a) working capital, (b) other tangible operating assets and, often, (c) intangible assets including intellectual property. Each asset may contribute to the earnings and operating cash flows of the business in its own specific way.

Figure 1 summarizes the components of the business enterprise as a going-concern. In most cases, intangible assets and intellectual property are not reflected on the balance sheet (and, if they are reflected, the carrying value is seldom representative of their contributory value to the business).
Figure 1

ELEMENTS OF BUSINESS ENTERPRISE VALUE
BUSINESS
ENTERPRISE
GOING-CONCERN
VALUE
= Working Capital
Other Tangible Assets
Intangible Assets
Intellectual Property
Where:
  • Working Capital is the excess of an enterprise’s current assets (cash, short-term investments, accounts receivable, inventories, prepaid expenses, etc.) over its current liabilities (trade accounts payable, current portion of long-term debt, income taxes, withholding taxes, accrued liabilities, etc.).
  • Other Tangible Assets comprise plant, machinery and equipment, land and buildings, office furniture and equipment, computers, vehicles, etc.
  • Intangible Assets include goodwill such as customer loyalty, organized work force, employee and bank relationships, favourable contracts, etc.
  • Intellectual Property includes patents, copyrights, trade marks, trade secrets, proprietary technology, etc.

Intangible assets and intellectual property have their highest and best use within the business enterprise. Intangible assets other than intellectual property are directly employed by the business because they are generally an integral part thereof and inseparable from it (e.g., an assembled and trained work force, customer relationships, employee relationships, banking and supplier relations, etc.) ?often referred to as "goodwill", being a catch-all term to describe these advantages. Intellectual property owned by a business may be separately identified and the benefits from its commercial exploitation can be measured.

Judicial decisions have referred to various sources of goodwill which include location and potential; the benefit and advantage of good name, reputation, and connection of a business; the ability of employees, good relations with clients or customers, competent and experienced management team, current contracts; as well as management goodwill and goodwill of product or service. As noted earlier, intellectual property derives its particular characteristics from the legal system.

Financial statements typically record assets on the balance sheet at their actual, original, historical costs. Accordingly, to the extent that the real value, or fair market value, of these assets exceeds their recorded book values, the enterprise has a higher value than that indicated by its balance sheet. The following table may illustrate this point. (The 1995 estimated values in the table have not been determined by applying generally-accepted valuation approaches and were subjectively estimated in 1995 by the editorial staff of Financial World magazine.)

VALUATION OF INTELLECTUAL PROPERTY
SELECTED U.S. BRANDS
Brand Name Estimated Brand Value* Book Value of "Other Assets"

$ Billions
Coca Cola 52.8 1.7
Marlboro 52.2 1.8
IBM 23.1 5.3
Microsoft 15.8 2.2
Kodak 15.7 0.9
Budweiser 15.4 1.3
Kellogg's 14.9 0.3
Gillette 13.1 0.5
Nike  7.4 0.1
                             
* SOURCE: Financial World (New York: 1995). Amounts converted to Canadian dollars at 1.35.
Under recently proposed new accounting rules in the United Kingdom, trademark and brand assets must be valued and reflected on the balance sheet. In fact, they must be re-valued annually.
VALUATION METHODOLOGIES

Intellectual property is valued by applying the same basic valuation concepts used to value businesses or indeed any other assets: (a) Cost Approach, (b) Income Approach or (c) Market Approach. In some circumstances a combination of these approaches is used.

Cost Approach


The Cost Approach is a general way of measuring the future benefits of ownership by quantifying the amount of money that would be required to replace the future service capability of the subject property. This approach contemplates that the cost to purchase or develop a similar new property is commensurate with the economic value of the service that the property can provide during its life. It assumes that economic benefits exist and are of sufficient amount and duration to justify the expenditures. Under this approach, the current costs of obtaining an unused replica of the subject property or the costs of obtaining a property of equivalent utility are determined. Physical depreciation is deducted from the costs to reflect elements of functional obsolescence.

This is a useful approach for certain intellectual property when (a) the income stream or other economic benefits associated with the asset being valued cannot be reasonably and/or accurately quantified, (b) the intellectual property forms part of a larger group of assets and (c) when other valuation approaches are not appropriate. However, because this approach relies heavily on historical cost data (if available), problems often arise.

Although not intended to reflect fair market value, the Cost Approach is often the only appropriate valuation method for newly-developed intellectual property, as the future end-product market share which the intellectual property may allow the user to capture, may be entirely speculative. In such cases, the asset might be labelled "valueless". The key elements to consider in applying this approach are transferability, reasonableness and commercial potential.

In adopting the Cost Approach, there are various methods or techniques, including the Reproduction Cost Method and the Replacement Cost Method. The Reproduction Cost Method estimates the cost to replicate the subject property; the Replacement Cost Method establishes the cost to replace the subject with another of similar function and utility. Hence, the latter method considers the development of a new asset which would achieve the same functions as, but not necessarily be identical to, the subject property. Both methods, nonetheless, consider the cost of equipment and supplies together with the cost of labour necessary to fully develop the property.

Typically, the cost to recreate intellectual property would include labour and other direct expenditures such as consulting fees, research and development expenditures, prototype costs and other direct out-of-pocket expenses. For example, applying the Cost Approach to value trade marks would entail aggregating historical advertising and promotional expenditures used to develop the trade mark’s recognition, whereas legal costs incurred would be particularly relevant to valuing a patent application.

Once the cost to reproduce the subject asset is determined, the economic depreciation is estimated in light of the asset’s useful-life cycle. The depreciation adjustment amortizes the cost of the property over its useful economic life, which is a function of physical deterioration, functional obsolescence and economic obsolescence, which must be measured against the property’s cost of reproduction new.

Therefore, once the cost of reproduction new is established, the three types of depreciation/

obsolescence must be deducted.

In summary, adopting the Cost Approach, the value of the intellectual property would be calculated as follows:

Reproduction Cost New or Replacement Cost*
minus
Physical Depreciation
and minus
Functional Obsolescence
equals
Depreciated Replacement Cost
minus
Economic Obsolescence
equals
Fair Market Value

* If a less costly substitute for Reproduction Cost New.

There is a concept in the U.S. called the "Iowa-Type Survivor Curve". Empirical data were collected in the 1930s for purposes of statistically forecasting remaining service expectancy of physical properties (very similar to the use of mortality tables when a life insurance company determines premiums). Iowa-Type Survivor Curves have often been applied by public utilities in estimating their useful service lives. It is beyond the scope of this paper to describe its use in estimating useful service life under the Cost Approach; even if the Iowa-Type Survivor Curve were to be applied, a detailed study of the subject property must nonetheless be performed.
In the event there is strong evidence of technological and commercial potential, the Cost Approach may not provide an indication of the "highest price obtainable" in the open market, in the context of the "fair market value" standard. This is because potential purchasers, may be willing to pay a premium over the cost they would incur in attempting to replicate the property, to become the proprietor of a novel product on a timely basis. This premium may be measured by profits or royalties foregone throughout the development process, or for an indefinite time for novel property which would assure absolute exclusivity through potential infringement protection.
The Cost Approach therefore has its weaknesses in intellectual-property valuation: costs are not necessarily commensurate with the future economic benefits a notional purchaser would anticipate in pricing the intellectual property. In many Cif not most Ccases the value of trade marks or patents bears little relationship to historical costs incurred in their development. However, where the value of intellectual property is significantly higher than the aggregate historical costs incurred to develop it (such as in the pharmaceutical industry where successful patented drugs have captured such a significant portion of the market share which their value, measured in terms of future earnings or benefits, is significantly higher than the historical costs incurred to develop them).
Hence, the Cost Approach in valuing intellectual property is often limited to notional valuations prepared for purposes of apportioning the price of a business among its underlying assets in an income-tax or a financial-reporting context. Even then, it fails to consider risks associated with the intellectual property being valued or for the actual ideas which give rise to the intellectual property being developed.

Market Approach


The Market Approach is a general way of determining a value indication of an asset using one or more methods which compare the subject to similar assets which have been sold. Arm’s length, open-market transactions can provide objective, empirical data for developing value measures.

The Market Approach is based on the principle of substitution: a notional purchaser would not pay more for a business asset than for equally desirable opportunities with similar characteristics. To the extent that empirical data on similar assets are available, this method can provide an indication of value, as it is based on the behaviour of knowledgeable and uncompelled buyers and sellers in the marketplace, each of these parties attempting to maximize the respective benefits.

This approach develops a value indication based on comparable market transactions or on market license/royalty agreements for comparable intellectual property. The principal weakness of this approach is that it is often difficult, if not impossible, to obtain information on actual transactions or sales offers which can reasonably compare to the intellectual property being valued. As most intellectual property is highly specialized, finding appropriate market-comparable assets is, at best, difficult, particularly because details relating to licensing transactions (such as the level of risk assumed by each party) are rarely disclosed and the only comparable is often found within the company itself.

The Market Approach is mainly used in conjunction with the Income Approach (outlined below), when comparable royalty rates are used in valuing intellectual property.

Income Approach


The Income Approach is a general way of determining a value indication of an asset using one or more methods wherein a value is determined by converting future anticipated benefits, expressed in monetary terms. This approach is likely the most frequently adopted methodology in valuing intellectual property.

The most commonly used methods or techniques under the Income Approach are:

  • Super Profits (Premiums Profits) Method
  • Discounted Cash Flow Method
  • Direct Capitalization Method
  • Relief-From-Royalty Method
  • Profit Split Method.

Depending on the nature of the intellectual property, anticipated benefits may be reasonably represented by such items as direct cash flows, super profits, cost savings, royalties, licensing fees and various forms of earnings. Often intellectual property can derive benefits from licensing in addition to direct sales. The anticipated benefits are estimated, considering items such as:

  • The nature of the intellectual property and the manner in which it is exploited (i.e., trade marks, trade secrets, franchise, know-how, copyrights, patents, etc.);
  • The economic and legal life of the intellectual property;
  • Historical financial benefits derived from the exploitation of the intellectual property;
  • Anticipated benefits which can be derived by alternative uses, such as potential to sub-license;
  • Industry trends impacting on the exploitation of intellectual property and/or the commercial potential of end-products;
  • Economic factors; and
  • Level of protection and confidentially which acts as a barrier to competitive entry (i.e., exclusivity vs. non-exclusivity).

Adopting the Income Approach, benefits anticipated from the commercial exploitation of the intellectual property are converted to value by separately identifying the income associated by virtue of such exploitation. (If the particular income yielded by the asset cannot be separated from the earnings generated by the other business assets, this valuation method may not be appropriate.)
Whichever method is used, its appropriateness depends largely on the quality of the information available as to the earning capacity of the intellectual property. Moreover, the Income Approach typically has three key variables:

  • The level of the prospective income stream generated;
  • The longevity of the income stream; and
  • The risk of achieving the level of prospective income.

Super Profits (Premium Profits) Method


A valuation technique applied in valuing intellectual property is the Super Profits Method, or Premium Profits Method, which involves estimating the level of future cash flows anticipated from the product in excess of the cash flow that might otherwise be expected to be generated by the business enterprise if it were not an owner of the specific intellectual property, i.e., "super profits" or "premium profits". Care is exercised in distinguishing between (a) profits attributable to the individual product itself (absent the trade mark or brand) and (b) profits identified with the trade mark or brand. Moreover, it is also important to distinguish between brand-related premium profits and super profits earned by the business as compared with its competitors generally (say, because the former has a strong marketing and distribution network). In capitalizing these super profits or discounting them back to the effective quantification date, the rate of return (or discount rate) considers the enterprise’s "weighted cost of capital" (discussed below) and the various risk factors and earnings growth relating to the business environment in which the intellectual property is being valued. Again, it is always essential to distinguish between (a) profits generated in the normal course of business by the enterprise and (b) profits which can be identified from the commercial exploitation of the trade mark which yield the super profits.
Often, the difficulty in applying this method is isolating the income and super profits directly associated with the intellectual property. In such cases, direct analytical approaches, such as the Super Profits Method or the Reasonable Royalties Method (discussed below), may be appropriate.
Applying the Super Profits, or Premium Profits, Method, the first step is to project the total cash flows of the business enterprise which owns the intellectual property. An appropriate return on the net tangible assets is subtracted therefrom, yielding the "excess earnings" or "super profits" attributable to all of the business’ intangible assets. More specifically, as the risk attached to the tangible assets of a business is typically lower than that with respect to the intangible assets, the required rate of return on the former is lower. The after-tax return on the net tangible capital employed in the business is deducted from the enterprise’s total cash flow after tax, yielding the "excess earnings" or "super profits" as noted above. The income generated by each intangible asset (or asset category) must be separately identified. Other (unrelated) intangibles are then valued and an appropriate return on these is deducted from the super profits in order to value the intellectual property which is the subject of the valuation.
This method may not be appropriate, or may be difficult, if the business benefits from more than one intangible asset contributing to excess earnings of the enterprise.
Discounted Cash Flow Method

In situations where future capital investments in complementary assets are required, the specific timing of the cash in-flows and cash out-flows can be reasonably identified (e.g., newly-developed intellectual property, initial market penetration with a new product, implementation of a new manufacturing process, etc.) and future expected results are either known or reasonably predictable, the Discounted Cash Flow ("DCF") Method is generally appropriate.

Applying such method, cash flows projected for a selected period ?say five years ?are discounted to the present by a rate of return which considers the time-value of money and the investment risks relating to the commercial exploitation of the subject intellectual property, as well as the opportunity costs of acquiring the assets.

In addition, the present value of the residual, or "terminal", value of the assets at the end of the cash flow period is included in the calculation, because there is an assumption that assets purchased will ultimately be disposed of (converted to cash). To the extent that sales proceeds for such assets would form all or part of the return of the initial purchase price, such proceeds would be considered in the same manner as other cash in-flows received during the period and would be discounted to also reflect the limited legal and economic life of the intellectual property.

Direct Capitalization Method

If the income stream attributable to the intellectual property can be clearly segregated, it can be capitalized at a rate of return which would consider, among other things, the life expectancy of the asset as well as its growth rate. The cash flow to be capitalized must take into account any additional capital investments necessary to generate the cash flow. It should be noted that the indicated value arrived at is considered on a debt-free basis; therefore if a capital injection is required, or if there are borrowings, these will be deducted at arriving at the "equity value" of the property.

Relief-From-Royalty Method

This method is applied mainly when economic benefits are a function of royalties. It is premised on the fact that if the intellectual property being valued, e.g., a brand, were not owned by its user, the user would normally have to pay the owner a royalty for the right to use it. My co-panellist, Zareer Pavri, will be reviewing this method.

Profit Split Method

This methodology assumes that the intellectual property is licensed to an arm’s length licensee who, in turn, would sublicense it to another arm’s length party. This methodology is often appropriate when two or more parties along with their respective assets can perform different functions or provide different services. The negotiated split among the parties may be arrived at by way of either an analysis of the respective revenues and costs or on the fair market value of the respective parties’ asset contributions. The valuation would involve estimating the indicated income stream associated with the asset, which could then be notionally split among the parties.

The key elements inherent in the Profit Split Method are:

  • Estimation of income;
  • Hypothetical split of income to notional licensor and licensee;
  • Application of the split to estimated income generated by the intellectual property;
  • Appropriate discount rate or capitalization rate;
  • Capitalizing or discounting the estimated profit split.

As with any of the other methodologies under the Income Approach, a thorough analysis must be performed as to the estimated income generated.

ROYALTY ECONOMICS

Royalty payments are normally expressed in a manner so as to provide a fair rate of return on the investment made by the owner in the intellectual property being transferred.
As intellectual property will normally generate future economic benefits when combined with a portfolio of other business assets, a royalty rate is normally established by isolating the required rate of return directly attributable to the intellectual property component of the business. This royalty, or rate of return, is selected after consideration of the particular risks each licensing party must bear; the party bearing the higher risk should receive the higher rate of return. Factors affecting the royalty rate, all of which are determinants of future profitability, include:

  • investment requirements in complementary assets;
  • competition;
  • protection strength of the asset;
  • risk of technological obsolescence;
  • government regulations; and
  • prevailing economic conditions.

Where public information is not available for comparative purposes, a notional royalty rate is calculated in such a manner as to permit both the licensor and the licensee to earning a reasonable return on their respective "investments".

Reasonable Royalties Method

This approach is based on the estimated future royalty stream, generally expressed as a percentage of revenue, which could be generated by licensing the right to use the trade mark or brand name. Alternatively, this may be construed in terms of the royalties one would be required to pay if he or she did not own the trade mark or brand, but merely manufactured under licence from the plaintiff.

More specifically, royalty and licensing terms entered into in exchange for the ability of another party (licensee) to exploit the intellectual property are established to provide the owner of the asset with a fair rate of return on investment. The rate of return must also be acceptable to the potential licensee and should consider the rates of return available on alternative forms of investment which compare, in terms of risk, (a) the value of the intellectual property, (b) required complementary assets used to commercialize such property and (c) the relative investment risk, such as potential obsolescence, competing technology, industry changes, government regulations and other factors.

Royalties must relate directly to profits. As noted above, a reasonable royalty may be established applying one of the following three methods:

  • An established royalty.
  • A notionally (hypothetically) negotiated royalty.
  • Adopting an analytical approach (which determines the reasonable royalty as the excess of the anticipated profits from infringing sales over a normalized level of industry profit margin).

In the United States a method (essentially a rule-of-thumb) which is sometimes used in determining a royalty is "The 25 Percent Rule". This "method" calculates a royalty as 25% of the pre-tax gross profit of the business owning the intellectual property.

It is the gross profit, defined earlier, to which the 25% rate is applied. Overhead expenses (selling, administrative, general and financial) are excluded from this "rule" and therefore the real, "bottom-line" profitability resulting from the contribution of the intellectual property is ignored. Therefore, to the extent that substantial advertising and marketing efforts are required to support the commercial exploitation of the property, as well as the complementary assets, the 25 Percent Rule fails. As noted earlier, the owners of a business must earn a reasonable rate of return on the different categories of business assets which make up the total enterprise.

There are host of other crude rules-of-thumb such as "The Five Percent of Sales Method", which establishes a royalty payment equal to 5% of sales. However, this, too, ignores both the above-the-line costs (cost of sales) and below-the-line costs (operating overhead) which components factor into the enterprise’s profitability.

When valuing intellectual property based on (a) the amount of royalties foregone, or (b) cash flows anticipated from royalties, and when the intellectual property is not already licensed, a notional royalty rate (expressed as a percentage of revenue) might be estimated by researching licensing agreements covering similar intangibles. However, publicly-available information as to royalty rates is often limited and, even if available, underlying factors affecting the level of royalties must be isolated to allow a meaningful comparison.

When a non-arm’s length transaction is contemplated, income tax and/or corporate law may require a determination as to whether the royalty rate charged in exchange for the use of the intellectual property is fair, i.e., whether it compares to commercial market rates. Absent publicly-available information on royalty rates for similar intellectual property, the valuator will estimate an appropriate rate of return on the investment for the owner of the property.

As intellectual property rarely generates economic benefits on a stand-alone basis, but together with complementary assets (such as working capital, tangible operating assets and other intangible assets), the first step is to determine the overall economic return on the global assets of the business which owns the intellectual property. Once the aggregate return is determined (at least for purposes of estimating the enterprise’s overall "weighted average cost of capital"), it is allocated among the assets based on (a) the relative importance of each asset in a particular business and (b) an appropriate rate of return associated with each asset-category’s risk. For example, the rate of return allocated to monetary assets would be lower than the weighted average cost of capital because of the former’s underlying liquidity.

Intellectual property is considered to be the riskiest asset component of a business enterprise; it is generally not as liquid or as versatile for redeployment elsewhere. Consequently, it would dictate a higher rate of return.

Once the overall return on the business is established and reasonable returns for the net working capital and other tangible operating assets have been estimated, the business valuator is in a position to derive an appropriate rate of return to be earned on the intangible assets and intellectual property. The rate on the intellectual property and complementary assets is then converted into a royalty rate.

CONCLUSION

By far, the most significant and valuable business assets possessed by successful enterprises are intangible, represented mainly by intellectual property. Combined with labour and capital, intellectual property can build markets, dominate industries, preserve customer loyalty and generate super profits for the owner.

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