for Managing Intellectual Property
OF INTELLECTUAL PROPERTY ASSETS:
THE FOUNDATION FOR RISK MANAGEMENT AND FINANCING"
by Richard M. Wise,
is a specialized classification of intangible assets. Because of their
special status, intellectual properties enjoy special legal recognition
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:
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
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.
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 arms 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-arms length transaction ("transfer
- Determining whether
the licensing or royalty terms of an agreement properly reflect fair
market price, for income tax, corporate law and/or securities regulation
- Corporate reorganizations.
- Family-law settlements,
infringement litigation support and dispute resolution.
of business ownership interests, shareholder buy-sell agreements,
- Allocation of
the total transaction price of a business among its various tangible
and intangible assets.
- Management information
- 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.
The value standard
most frequently applied in notional-market valuations is "fair
market value", which is generally defined as:
price available in an open and unrestricted market between informed and
prudent parties acting at arms 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,
arms 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
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.
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.
Elements of Intellectual
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).
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
- 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
OF INTELLECTUAL PROPERTY AND OTHER ASSETS OF THE BUSINESS ENTERPRISE
As property is worth
what it can earn, what would someone be prepared to pay today, in terms
of money (or moneys worth), for expected future economic benefits
derived from the commercial exploitation of the intellectual property?
The following comprise
the key components of an intellectual propertys underlying value:
- Legal enforceability?The
intellectual property must be capable of legal enforcement.
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 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 enterprises "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.
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).
OF BUSINESS ENTERPRISE VALUE
- Working Capital
is the excess of an enterprises 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,
- Other Tangible
Assets comprise plant, machinery and equipment, land and buildings,
office furniture and equipment, computers, vehicles, etc.
include goodwill such as customer loyalty, organized work force, employee
and bank relationships, favourable contracts, etc.
Property includes patents, copyrights, trade marks, trade secrets,
proprietary technology, etc.
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.
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.
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.)
OF INTELLECTUAL PROPERTY
SELECTED U.S. BRANDS
Value of "Other Assets"
* SOURCE: Financial
World (New York: 1995). Amounts converted to Canadian dollars
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.
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.
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
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
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 marks 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 assets 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 propertys
cost of reproduction new.
Therefore, once the
cost of reproduction new is established, the three types of depreciation/
In summary, adopting
the Cost Approach, the value of the intellectual property would be calculated
New or Replacement Cost*
Depreciated Replacement Cost
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
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
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.
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. Arms 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
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.
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
The most commonly
used methods or techniques under the Income Approach are:
- Super Profits
(Premiums Profits) Method
- Discounted Cash
- Direct Capitalization
- Profit Split
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,
- 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;
- 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
- 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
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 enterprises
"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
Discounted Cash Flow Method
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
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 enterprises
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.
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
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
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.
Profit Split 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.
assumes that the intellectual property is licensed to an arms
length licensee who, in turn, would sublicense it to another arms
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
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;
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.
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
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,
- investment requirements
in complementary assets;
- protection strength
of the asset;
- risk of technological
- government regulations;
- prevailing economic
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".
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.
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
- 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 enterprises 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-arms
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 enterprises 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-categorys
risk. For example, the rate of return allocated to monetary assets would
be lower than the weighted average cost of capital because of the formers
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.
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
© copyright Wise, Blackman 1999-2003