Cost Approach to Intellectual Property Valuation

Part I: Conceptual Principles

This is a four-part article series. The articles and discussion focus on the conceptual principles and the practical applications of the cost approach in the development of intellectual property valuations. Part I of this discussion focuses on the conceptual principles that support the application of the cost approach to intellectual property valuation. Part II describes the generally accepted cost approach valuation methods. Part III describes the practical measurement procedures related to intellectual property cost metrics and obsolescence metrics. Part IV presents several illustrative examples of the application of the cost approach in hypothetical intellectual property valuation scenarios.

Introduction

Valuation analysts (analysts) are often called on to value intellectual property for various reasons. These reasons include the pricing and structuring of sale and license transactions, income tax and property taxation planning and compliance, fair value measurements for financial accounting, corporate strategic planning, forensic analysis and dispute resolution, and many other reasons. Analysts may be asked to estimate the fair market value—or some other standard of value—of intellectual property for any of the above-mentioned reasons. Analysts may be asked to estimate an arm’s-length price (or royalty rate) of intellectual property for taxation, corporate accounting, or license negotiation reasons. Also, analysts may be asked to measure damages related to intellectual property related to a breach of contract claim or an infringement (or other tort) claim.

For purposes of this discussion, the term intellectual property includes the following four categories of intangible property: patents, trademarks, copyrights, and trade secrets. This discussion encompasses all four categories of intellectual property. It is noteworthy that most of the valuation methods and procedures—and the illustrative examples—included in this discussion are also applicable to other categories of general intangible personal property.

Analysts typically apply income approach and market approach valuation methods in the development of (and in the reporting of) intellectual property valuations. Typically, analysts have experience and expertise regarding the generally accepted income-based and market-based intellectual property valuation methods and procedures. However, these analysts (and their clients—and their clients’ legal counsel) often have less experience and expertise about the application of cost-based valuation methods and procedures.

Therefore, this discussion focuses on the conceptual principles and the practical applications of the cost approach in the development of intellectual property valuations. This discussion is presented in four parts: Part I of this discussion focuses on the conceptual principles that support the application of the cost approach to intellectual property valuation; Part II describes the generally accepted cost approach valuation methods; Part III describes the practical measurement procedures related to intellectual property cost metrics and obsolescence metrics; and Part IV presents several illustrative examples of the application of the cost approach in hypothetical intellectual property valuation scenarios.

Intellectual Property Valuation

There are various situations in which an analyst may develop and report intellectual property—and other intangible personal property—valuations. These situations can generally be grouped into the following categories:

1. Concluding a sale (or other transfer) transaction pricing determination
2. Assisting the client with regulatory compliance
3. Assisting the client (or client’s counsel) with taxation planning, compliance, and controversy (including income, gift and estate, and property taxation)
4. Calculating fair value measurements for acquisition accounting and other financial accounting purposes
5. Developing a collateral value appraisal for asset-based (including sale/licenseback) financings
6. Concluding the intellectual property asset value component of an asset-based approach business valuation
7. Conducting negotiations of an intellectual property use license or other commercial exploitation license or agreement
8. Conducting a royalty rate or other license fee negotiation
9. Concluding the value of an intellectual property contribution to (or a distribution from) a joint venture or a new business formation
10. Measuring intellectual property damages as part of a forensic analysis or dispute resolution assignment

This final category of situations—damages measurement as part of a forensic analysis or dispute resolution—often includes the application of the cost to cure damages measurement method related to an intellectual property tort claim or breach of contract claim

As indicated in the American Institute of Certified Public Accountants (AICPA) Statement on Standards for Valuation Services (SSVS), Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset, there are three generally accepted intellectual property (and other intangible property) valuation approaches:

1. The income approach
2. The market approach
3. The cost approach

Most analysts (and their clients and their clients’ legal counsel) are generally familiar with the application of the intellectual property income approach and market approach valuation methods. These generally accepted intellectual property valuation methods include the multiperiod excess earnings method, the capitalized excess earnings method, the profit split method, the relief from royalty method, the sales comparison method, and other methods.

Unlike real estate and tangible personal property appraisers, however, analysts often have less experience and less expertise in the application of intellectual property cost approach valuation methods. Accordingly, this discussion focuses on the conceptual principles of the cost approach valuation methods.

This discussion summarizes best practices related to the application of the cost approach to intellectual property valuation. This discussion also describes a theoretical framework for the application of the cost approach to intellectual property valuation.

Individual Reasons to Value Intellectual Property

Each of the above-listed 10 categories of valuation situations may encompass numerous individual reasons why analysts may be asked to value intellectual property. Space constraints limit our discussion of each and every reason. However, as an illustrative example, let’s consider one category of intellectual property valuation reasons: taxation reasons. Exhibit 1 presents many of the taxation-related reasons why an analyst may be asked to value an intellectual property (or a related intangible property).

Exhibit 1: Taxation Planning, Compliance, and Controversy Reasons to Value Intellectual Property

• Forming an intellectual property holding company and structuring the intercompany use license of the intellectual property to the subsidiary operating companies of a parent corporation
• Performing an income tax basis allocation of a business acquisition purchase price (among the acquired tangible assets and intangible assets) in a taxable business acquisition transaction (such as in a transaction structured as an Internal Revenue Code Section 1060 asset acquisition)
• Quantifying the amortization income tax deduction associated with a purchased intellectual property
• Valuing owned intellectual property as part of a taxpayer corporation insolvency analysis to quantify the Section 108 exemption related to the recognition (or nonrecognition) of cancellation of debt income
• Valuing a corporation’s intellectual property related to the built-in-gain tax deferral on the corporate taxpayer’s election to convert from C corporation to S corporation income tax status
• Supporting the amount of a charitable contribution deduction related to a donated intellectual property
• Estimating the arm’s-length price for the cross-border transfer-and-use license for a multinational taxpayer corporation’s intellectual property (for example, for Section 482 compliance)
• Complying with state and local ad valorem property taxation requirements related to intellectual property that is either subject to—or exempt from—property taxation
• Defending against any Service allegations of private inurement, excess benefits, or intermediate sanctions regarding intellectual property transfers between a for-profit entity and a not-for-profit entity at less than (or more than) fair market value
• Estimating the fair market value of individual intellectual property included in a decedent’s estate or gifted from a transferor to a transferee

In an intellectual property valuation developed for any reason, the analyst typically selects the particular valuation approach or approaches that:

1. Are supported by the greatest quantity and quality of available data;
2. Best reflect the actual transactional negotiations of market participants in the intellectual property owner/operator’s industry;
3. Best fit the characteristics of the subject intellectual property, such as its use and its age; and
4. Are most consistent with the practical experience and professional judgment of the individual analyst.

Within each generally accepted valuation approach, there are several valuation methods that the analyst may consider. Further, within each generally accepted valuation method, there are various procedures that the analyst may perform. To conclude an intellectual property value indication, the analyst develops valuation procedures within a valuation method and valuation methods within a valuation approach.

If, after developing the intellectual property valuation approaches, methods, and procedures, the analysis provides several value indications, then the analyst considers and reconciles these various value indications. This process of reconciling and synthesizing alternative value indications results in the final value conclusion.

Cost Approach Fundamental Principles

The economic principle of substitution is fundamental to the cost approach. That is, the value of a fungible intellectual property is influenced by the cost to create a substitute (typically, a new) intellectual property.

All cost approach property valuation methods apply a comprehensive definition of cost. Such a definition of cost typically includes consideration of an opportunity cost during the intellectual property development stage.

After considering all cost components, the value of the substitute (new) intellectual property should be adjusted to make the hypothetical (new) intellectual property more comparable to the actual (seasoned) intellectual property. In valuation terminology, such an adjustment to the cost measurement (as in, a decrease in value) is referred to as depreciation. Appraisal depreciation should not be confused with accounting depreciation.

Some analysts (and their clients and clients’ legal counsel) erroneously believe that the cost approach relies exclusively on historical information. For example, one misinterpretation is that the cost approach should be based on the subject accounting book value of the intellectual property. This misconception implies that the intellectual property value should be calculated based on the property’s historical cost—adjusted for any financial accounting accumulated amortization or impairment recognition.

Analysts (and their clients and their clients’ legal counsel) should recognize that cost approach valuation methods are forward-looking estimates. For example, the cost of developing a new intellectual property typically involves estimates of developer’s profit and entrepreneurial incentive. These estimates result in a value indication that has little resemblance to the historical-cost-based accounting book value of the intellectual property.

Not all intellectual property is fungible. Legally, some intellectual property is unique and, therefore, cannot be replaced. For intellectual property that is unique, a substitute or replacement intellectual property may not actually be available at any cost.

In such an instance, the cost approach is still applicable to the valuation of unique intellectual property. This is because the cost approach involves the analysis of a hypothetical intellectual property. In developing the hypothetical analysis, the analyst (and the cost approach methodology) assumes that the actual intellectual property does not exist.

In the application of the cost approach, the hypothetical (new) intellectual property does not compete with the actual intellectual property. This is because, in the cost approach hypothetical scenario, the actual (seasoned) intellectual property does not exist.

In a cost approach analysis, the actual (or seasoned) intellectual property is “assumed away”. The actual intellectual property is assumed not to exist. The assumed hypothetical (new) intellectual property never exists in the same space as the actual “assumed away” intellectual property.

In the intellectual property valuation, the cost approach considers the cost to replace the utility of the actual intellectual property. The application of the cost approach assumes that the actual intellectual property does not already exist.

Real estate appraisers call this assumption the “Greenfield Premise”. Based on the assumed greenfield (or empty field) premise, the subject building and other property improvements are assumed not to exist. The real estate appraiser faces an undeveloped greenfield (as in, a vacant site) in the appraiser’s application of the cost approach analysis.

In the intellectual property valuation, the replacement intellectual property provides the same utility as the actual (seasoned) intellectual property. Because the analyst assumes a greenfield, the hypothetical (new) intellectual property does not infringe on the actual (seasoned) intellectual property.

An FCC license may be an example of a fungible intangible property. A buyer may refuse to accept the seller’s asking price for, say, an FCC broadcast license. Instead, the buyer can go to the marketplace (or to the FCC) and buy a perfectly identical substitute license. Even though there is only one (the actual) license, the cost of the hypothetical alternative—or substitute—license is relevant to the actual FCC license valuation.

Accordingly, the cost approach may still be an appropriate valuation approach for an intellectual property that is not fungible. In the case of a patent, the willing buyer may buy a functionally similar patent, or the willing buyer may develop a new noninfringing invention. Let’s assume this noninfringing invention results in a substitute patent.

A perfectly identical substitute patent would, by definition, infringe on the actual patent. However, the actual (or seasoned) patent is “assumed away”. In applying the cost approach, the analyst considers the cost for a willing buyer to develop a noninfringing substitute with the equivalent utility to the actual (but “assumed away”) patent. Accordingly, the cost approach may be applied in the patent—or similar intellectual property—valuation.

Application of the Cost Approach

Cost approach valuation methods are particularly applicable for the valuation of a recently developed intellectual property. With a relatively new intellectual property, the owner/operator’s development cost and development effort data may still be available (or can be accurately estimated).

Cost approach valuation methods are also particularly applicable to the valuation of (1) an in-process intellectual property and (2) a noncommercialized, defensive intellectual property. An example of a noncommercialized intellectual property is a patent or a trademark held primarily for its strategic defensive use (to ensure that the owner’s competitors’ cannot own or operate the actual patent or trademark, for instance).

When applying the cost approach, the analyst should realize that the intellectual property value does not derive solely from the current cost measure. Rather, intellectual property value derives from:

1. The current cost measure (however defined) less
2. Appropriate allowances for all components of appraisal depreciation and obsolescence.

Reasons to Apply the Cost Approach

For the most part, the analyst’s selection of the intellectual property valuation approach or approaches to apply in any analysis is a process of elimination. In any intellectual property valuation, the analyst typically attempts to apply all valuation approaches for which reliable data are available.

When there are sufficient reliable data with which to develop all three valuation approaches, the analyst will apply all three approaches. When there are sufficient reliable data with which to develop only two valuation approaches, the analyst will develop those two approaches. Similarly, when there are sufficient reliable data with which to develop only one valuation approach (for example, the cost approach), then the analyst develops that one valuation approach only.

If sufficient guideline sale or license transaction data are not available or if the intellectual property is not the type of property that generates a measurable amount of income (however defined), then the analyst may have to rely on the application of the cost approach by default.

The development of a cost approach valuation is particularly applicable to the following types of intellectual property:

1. Intellectual property that are recently developed (as in, relatively new)
2. Intellectual property that are fungible or that may be easily exchanged or substituted
3. Intellectual property for which the owner/operator’s historical development cost data are still available
4. Intellectual property of an owner/operator with the expertise to assist the analyst in the estimation of a current development cost
5. Intellectual property of an owner/operator with the expertise to assist the analyst in the estimation (a) of an expected useful economic life (UEL) and (b) of obsolescence
6. Intellectual property that are used (or used up) in the production of income but which themselves do not produce any income; examples of such contributory intellectual property include trade secrets—in the form of product formulae, employee or workstation training/operator manuals, operating procedures, computer software, the proprietary knowledge of an assembled workforce, and so forth (such contributory intellectual property types are sometimes referred to as “back room” intellectual property)

When considering the application of the cost approach, the analyst considers whether there are sufficient reliable data available in order to estimate both:

1. The intellectual property current cost metric (such as replacement cost new or reproduction cost new) and
2. All components of intellectual property appraisal depreciation and obsolescence (including economic obsolescence).

Summary

There are many reasons why an analyst may be asked to value intellectual property. This discussion considered many of these reasons—and the associated client motivations. For purposes of this discussion, the general category of intellectual property includes patents, copyrights, trademarks, and trade secrets. There are many reasons to apply the cost approach to value many types of intellectual property—and to value intellectual property in many types of client situations.

This first part of our four-part discussion considered the conceptual foundations for the application of the cost approach. Part II of this discussion describes the generally accepted cost approach valuation methods.

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Robert Reilly, CPA, ASA, ABV, CVA, CFF, CMA, is a Managing Director in the Chicago office of Willamette Management Associates,  a Citizens company. His practice includes valuation analysis, damages analysis, and transfer price analysis.

Mr. Reilly has performed the following types of valuation and economic analyses: economic event analyses, merger and acquisition valuations, divestiture and spin-off valuations, solvency and insolvency analyses, fairness and adequacy opinions, reasonably equivalent value analyses, ESOP formation and adequate consideration analyses, private inurement/excess benefit/intermediate sanctions opinions, acquisition purchase accounting allocations, reasonableness of compensation analyses, restructuring and reorganization analyses, tangible property/intangible property intercompany transfer price analyses, and lost profits/reasonable royalty/cost to cure economic damages analyses.

Mr. Reilly has prepared these valuation and economic analyses for the following purposes: transaction pricing and structuring (merger, acquisition, liquidation, and divestiture); taxation planning and compliance (federal income, gift, estate, and generation-skipping tax; state and local property tax; transfer tax); financing securitization and collateralization; employee corporate ownership (ESOP employer stock transaction and compliance valuations); forensic analysis and dispute resolution; strategic planning and management information; bankruptcy and reorganization (recapitalization, reorganization, restructuring); financial accounting and public reporting; and regulatory compliance and corporate governance. 

Mr. Reilly can be contacted at (773) 399-4318 or by e-mail to RFReilly@Willamette.com.