The Relevance of Royalty Rates in the Valuation of Intangibles

The FASB Lists 29 Different Intangible Asset Categories. Here’s What You Need to Know.

Intangible assets have comprised an increasing proportion of the value of assets of most companies in the last decade, Gregory Marsh explains. Often a collection of intangible assets is accounted for as a single asset labeled “goodwill.” Here’s why that sometimes doesn’t make sense.

With the issuance of Financial Accounting Standard 141–Business Combinations (FAS 141) in 2001, the Financial Accounting Standard Board (FASB) recognized that intangible assets comprised an increased proportion of the assets of most companies.  Since a collection of acquired intangible assets were often accounted for as a single asset  labeled as “goodwill,”  there was an apparent need for an explicit set of criteria for the determination whether an intangible asset should be recognized separately from goodwill.
 
To this end, the FASB provided a list of 29 different intangible asset categories to assist in the identification of intangible assets.  The categories provided range from those expected to be owned by businesses—trade names, patents, and non-compete agreements—to those less commonly encountered, such as song lyrics, ballets, and newspaper mastheads.

The following categories are examples of identifiable, intangible assets that must be valued and accounted for separately:

• Marketing-related Assets: trademarks, trade names, and brand names
• Technology-based Assets: such as patents, trade secrets, proprietary documentation, engineering drawings and schematics
• Data Processing-related Assets: proprietary computer software and databases
• Customer-related Assets: customer lists, relationships, and contracts
• Contract-based Assets: supplier contracts, license agreements, franchise rights and non-compete agreements
• Artistic-related Assets: copyrights, illustrations, and images
• Human Capital-related Assets: employment agreements and assembled workforce
• Location-related Assets: leasehold interests, easements, air rights, and water rights

Venture capital fund portfolios often consist of investments in companies that have only intangible assets underlying the prospective value of the investment.  In the startup stage, that asset may take the form of a well-documented plan to create wealth for the owners, but it is still just an idea that often requires several years to refine and implement.  If that effort is successful to the extent that the idea is developed into the form of a technology that can be used by an operating company to generate revenue in a competitive market, it can be sold or licensed to an operating company that has the capability to profit from the additional revenue or cost savings arising from the use of the technology.  The premise that the value of an intangible asset (such as a trade name, copyright, or intellectual property) can be converted to tangible property (by way of a sale or license agreement) is the foundation of most venture capital investment proposals.

The FASB’s, AICPA’s, and venture capitalists’ recognition that the value of many companies is concentrated in intangible assets is confirmed by observing the various separately identified and valued intangible assets reported on the balance sheet of any company that has made an acquisition in the past 20 years.   Even companies emerging from a Chapter 11 bankruptcy adopting fresh-start accounting are required to value and report separately those intangible assets that comprise the company’s reorganization value. There are also numerous opportunities during a Chapter 11 proceeding for the debtors and creditors to submit evidence of and refute the value of the debtor’s intangible assets.  These include motions for adequate protection of creditors’ interests, determinations of solvency in relation to preferential and fraudulent transfers, determination of whether a creditor’s claim is secured or unsecured, and determining the reorganization value to be distributed to claim holders.

The FASB’s Statement of Financial Accounting Standards 157, Fair Value Measurements (FAS 157) became fully effective for both financial and nonfinancial assets in 2009.  FAS 157 requires the reported values of both assets and liabilities to reflect current realizable market prices, whether or not a real market exists.  What the acquirer actually paid for the asset or how it is actually used is, with limited exceptions, ignored under FAS 157.  Its effects are now appearing in the financial statements of companies that experienced a merger, reorganization, goodwill impairment, or other revaluation event since 2007.

Although determining the value of a company’s intangible assets is central to the decision process of venture capital investors, corporate acquirers, and bankruptcy litigants, the default valuation methodology that is too often selected is the use of observed royalty rates combined with a revenue projection to arrive at an estimate of the royalty income stream that an intangible asset is likely to produce for its owner.   This short-form version of the relief from royalty method is ill-suited to arriving at realistic and realizable values because it often relies on royalty rates derived from the terms of a random sample of transactions.  Another common oversight is poorly supported revenue assumptions that violate the Entire Market Value Rule, or do not reflect the competitive alternatives available to licensors.  The result is widely diverging expectations of value at the negotiating table and in the court room.

Relying on observed royalty rates derived from past transactions as a primary indicator of value can be misleading because so many of the underlying factors and contract terms of the underlying agreements were negotiated by parties considering investment alternatives, economic conditions, competitive position, stage in the product and market development cycle, and strategic motivations that, in combination, present a unique scenario. Embodied in every implied or explicit royalty rate are a multitude of distinctive expectations, estimates and risk factors that shaped the terms of the license agreement. Even so, a randomly reported population of royalty rates negotiated long ago, for different intellectual property, used in different industries by companies having different profit margins continues to be widely accepted by experienced advisors as a valid input to the valuation analysis. 

Those familiar with the relief from royalty method recognize that using observed royalty rates negotiated by others for the use of similar property under widely differing conditions and limitations is merely the result, and not the true determinant of value. The effective royalty rate is little more than an incomplete partial indicator of the amount by which the end user of the subject intangible asset expects to benefit from its use, and what portion of that incremental benefit the end user is willing and able to pay to the owner of the intellectual property.

An equitable sharing of the after tax incremental profit generated by an intangible asset is, as the basis of a fair and economically feasible arrangement, in reality, the primary driver of negotiated royalty rates. The difficult determinations to make are:

1. How much the incremental profit to be shared is, and
2. How the licensee and licensor would share the incremental profit

The old, worn-out attempt to avoid the hard work of quantifying these amounts is known as the “25% rule of thumb”, in which up to 25% of the licensee’s pretax operating profit is designated as a fair royalty.  Generally speaking, the licensor can reasonably expect to demand and receive some significant portion of the licensee’s incremental after-tax profit. So, without any information about how the licensed asset increases the profitability of any particular operating business, up to 30% of operating profit serves as a popular estimate simply because it is half of the net after-tax profit, if a marginal income tax rate of 40% is assumed.

Valuation analysts often attempt to quantify the variations in risk associated with realizing the profits anticipated in the underlying license contract by increasing the discount rate used to calculate the present value of projected royalty payments. While such an exercise does include a respectable effort to consider the impact of variations in the terms of license agreements and the conditions under which they were formed, quantifying the increments by which the discount rate is increased for the risk associated with realizing each contractual term, business condition, and expectation remains a subjective and unsystematic process.

Rather than retrofit a combination of historic royalty rates and denatured discount rates in an unconvincing attempt to arrive at a estimate of realizable value, quantifying intangible asset values in direct relation to the actual business and economic environment in which they are used is always a more valid and relevant approach .  That is, intangible assets only have value in the context of their effect on the competitive position of a profitable enterprise that is a going concern.  If at least one such firm cannot be identified, then no amount of historical royalty or discount rate data can make an unprofitable or unlikely revenue stream a valid basis for determining value.

The FASB continues to issue new fair value accounting guidance that has significantly changed how the value of intangible assets and liabilities are determined and reported. This has presented a significant opportunity for well-informed investors and creditors to identify under- or over-valued assets and protect their position in a sale, financing, or restructuring scenario.

Gregory Marsh is a managing director with Invotex Group. He has more than 20 years of financial and accounting experience and is responsible for performance and oversight of client engagements in the areas of business valuation and reorganization services. With a focus on valuation for financial reporting, tax, and restructuring purposes, Mr. Marsh has been retained to value intangible assets, intellectual property, options, debt and equity securities and corporate reporting units of both private and public companies. For more information, write him at gmarsh@invotex.com.