Methods of valuing IP and Intangibles
There are three broadly accepted methods of valuation for intellectual assets. Each has a number of different variants, the main ones being those explained below.
The principle behind the cost method is to derive a valuation from determining the cost of reproducing or re-creating a given set of intangibles, usually by reference to the actual cost of creation less deductions for obsolescence (which might be functional, physical or economic). In this regard it is closest to the accounting method used by some companies to capitalise their intangibles.
The main advantage of the cost method is that it only requires historical data. It can be relatively easy to perform, in some cases only requiring the calculation of labour costs (staff and contractors) based on time expended plus a suitable apportionment of overheads.
The main disadvantage is that cost bears very little relation to market value, as intangibles routinely cost far less (or far more) to create than the economic benefit they contribute. In addition, isolating relevant costs is not always straightforward, and a buyer can often argue that its cost of re-creation would not be the same.
The principle behind the market method is to identify similar sales and purchases of comparable assets and set a corresponding value. This is a common method used to establish values for tangible assets offered for sale, such as houses and vehicles.
One way of achieving a market valuation is to conduct an open sale or auction, on the basis that this will ensure that the asset realises the value the market attributes to it at that time. However, it is not necessary to organise an actual transaction and place an asset (or set of assets) on the market to derive the valuation, as the figure can in theory be based purely on research.
The main advantage of the market principle is that the resultant value will be based on prior factual transactions, which ought to provide the most accurate indication of the “arm’s length” value of any asset.
The main disadvantage is that the input data on comparable transactions is generally very difficult to obtain. Many intangibles are not created with the intention of re-selling them; most asset sales happen as part of a business sale; those that do not are either conducted under commercial confidentiality or are by definition not comparable with each other, for instance because the organisation is no longer a going concern, meaning that the assets are “distressed”. Comparisons are also made more difficult because intangible assets are, by definition, unique.
For these reasons, the market method is seldom used at present (however, by conducting a large volume of IP valuations and subsequent transactions, Inngot aims to build a database capable of supporting this type of assessment).
The principle behind the various income-based methods is that the best way to determine the true value of a set of assets is to estimate the cash benefit that they will generate (or, potentially, save) over a relevant period of time and bring this back to a present day amount.
In many situations, the challenge is to isolate the value associated with a particular set of intangibles from the rest of an organisation’s value-producing assets. There are a number of variants on this theme:
- Capitalisation of historic profits – multiplying the assets’ economic contribution by a suitable factor, determined by an assessment of their strength, market position and profit trend.
- Profit differential – estimating the difference in the profit generated between a particular branded asset and a generic item, as a means of isolating the brand value.
- Excess earnings – a “family” of techniques containing a number of variants, all based on the principle that the value of the intangibles in a business can best be determined by subtracting from its overall worth the elements attributable to tangible assets.
- Relief from royalty – the assumption that a royalty would be payable by a third party licensing the intellectual assets, which can be applied to income streams in order to quantify the financial benefit to the assets’ owner from not having to pay the royalty.
The main advantage is that the method provides a market dimension by considering the benefit that the asset will deliver in the marketplace, without the need to reference external transactions.
The main disadvantage is that the valuation has to assume that the future income streams (or, potentially, cost savings) will be delivered in practice, or compensate for uncertainties in the projections by adjusting the discount rate used to bring these future incomes back to an equivalent present day value. (This latter reason is why Inngot has invested particular care in having a robust approach to discount rate calculation.)