Got IP? Value it with the relief from royalties method
From the November/December 2017 issue of BCC Advisers Litigation & Valuation Report
ome of a business’s most valuable assets may not show up on its balance sheet. Intellectual property (IP) is an intangible asset. When IP is developed internally, it’s usually not recorded on a company’s financial statements — only IP that’s acquired from another party is reported as an asset under U.S. Generally Accepted Accounting Principles (GAAP).
The value of IP typically comes into play when IP rights are infringed or when selling the asset or the entire business. Here’s an overview of how IP is valued under the relief from royalty (RFR) method.
What is IP?
Businesses may not recognize all of their intangible assets, so the first step is to identify specific types of IP. Most IP generally falls into one of four broad categories:
- Trademarks, and
- Trade secrets.
IP also may refer to trade names, trade dress, brands, computer software and other intangible assets that fall within, or are closely related to, the four categories listed above.
Why is IP valued?
Almost as numerous as the types of IP are the reasons for valuing it. They include financial reporting (fair value measurements, annual impairment tests); tax compliance (gift and estate taxes, charitable contributions); litigation (damages calculations, shareholder disputes, divorce, bankruptcy); and sale or licensing transactions (mergers and acquisitions, IP sales/licenses).
Under GAAP, companies are required to allocate the purchase price of an acquired company among the tangible and intangible assets being acquired. They also must test acquired goodwill and other indefinite-lived intangibles annually for impairment and write them down if their fair values drop below their carrying amounts.
Testing goodwill for impairment is a complex process. But, in general, the value of goodwill depends on the value of a company’s tangible and identifiable intangible assets, including IP. Goodwill is a residual intangible asset; that is, its value is assigned after value has been assigned to all other assets.
To help reduce costs and complexity, private companies may elect a simplified alternative, however. Under this alternative, private companies have the option to amortize goodwill over a period not to exceed 10 years, rather than test it annually for impairment. For companies that elect this option, it’s critical to value IP assets accurately from the acquisition date.
How is IP valued?
IP assets can be valued using the cost, market and income approaches. When applied to IP assets, however, the cost approach may not be effective because valuation experts can’t identify and quantify all of the costs involved in creating an IP asset. Moreover, the cost of creation may have nothing to do with the IP’s value.
The market approach also may not work because comparable transactional data for IP and other intangible assets is difficult to obtain. Some assets — such as trademarks, trade names or brands — are rarely bought and sold in the marketplace. And even for assets that are sold, such as copyrights and patents, transactional data may not be published.
How does the RFR method work?
The RFR method is categorized as an income-based method (somewhat similar to the discounted cash flow approach). But it also shares some attributes of the cost and market approaches.
Under the RFR method, an IP asset’s value is equal to the value of the royalty payments from which the company is relieved by virtue of owning the asset. A valuation expert applies the RFR method by selecting a royalty rate based on available market data for licenses involving similar assets, industries, territories and other characteristics. Then he or she selects an appropriate, risk-adjusted discount rate to determine the present value of the royalty payments.
Typically, this hypothetical license is treated as a perpetual license. To estimate value, the expert calculates the present value of projected royalty payments over a certain period (for example, 10 or 15 years) and then calculates the present value of the residual at the end of that period.
Ready, set, value
Today, many companies rely heavily on their IP assets. So, it’s important to value these assets correctly. One tried-and-true technique is the RFR method. We can help you get it right.