Intellectual Property Valuation for Bankruptcy Purposes

Part I: Three of the 12 Reasons a Valuation Is Needed in Chapter 7, 9, and 11

This two-part article summarizes the various types of intellectual property that valuation analysts (“analysts”) may encounter within a commercial bankruptcy controversy, lists the generally accepted intellectual property valuation approaches, and presents the reasons why analysts may be asked to value intellectual property within a commercial bankruptcy environment. In Part I, Mr. Reilly identifies three of the 12 reasons why a valuation is needed in a bankruptcy proceeding.

Introduction

This discussion summarizes the various types of intellectual property that valuation analysts (“analysts”) may encounter within a commercial bankruptcy controversy and lists the generally accepted intellectual property valuation approaches. The discussion  focuses on the many reasons why analysts may be asked to value intellectual property within a commercial bankruptcy environment.

Intellectual Property Types

For most valuation purposes, there are four types of intellectual property:

Patents

Trademarks

Copyrights

Trade secrets

Bankruptcy Code Section 101, subsection 35A, provides the following specific definition of intellectual property:

(35A) The term “intellectual property” means—

1. trade secret;
2. invention, process, design, or plant protected until title 35;
3. patent application;
4. plant variety;
5. work of authorship protected under title 17; or
6. mask work protected under chapter 9 of title 17; to the extent protected by applicable non-bankruptcy law.

Therefore, technically, the Bankruptcy Code definition of intellectual property does not include trademarks and trade names. While trademarks are not included in the Bankruptcy Code definition of intellectual property, executory contracts, and licenses related to a debtor company, trademarks are a common issue in commercial bankruptcy controversies.

Patents, trademarks, and copyrights are created by and protected by federal statutes. Trade secrets are created under and protected under state statutes. However, most states have either completely adopted—or adopted the essence of—the Uniform Trade Secret Act within their state statutes.

For purposes of this discussion, the debtor company is assumed to be either the intellectual property owner (and, possibly, the licensor) or the intellectual property non-owner operator (i.e., the licensee). Therefore, the debtor company is sometimes referred to as “the owner/operator.”

Generally Accepted Valuation Approaches and Methods

All of the generally accepted intangible asset valuation approaches are applicable to the analysis of intellectual property within a bankruptcy context. Cost approach methods are particularly applicable to the contributory (or backroom) types of intellectual property. Market approach methods are particularly applicable to intellectual property that is (or could be) licensed. And income approach methods are particularly applicable to intellectual property that produces a measurable amount of operating income for the owner/operator.

The cost approach is often applicable in the valuation of trade secret proprietary information or of copyrights on internal use software. For example, the cost approach may be used to value procedure manuals, training manuals, technical documentation and drawings, internal use training films, confidential books and records, confidential customer or supplier files, or the source code for internal use computer software. For these types of intellectual property assets, it may be difficult for the analyst to assemble comparable uncontrolled transaction (CUT) sale or license data or to identify asset-specific income measures.

The market approach is often applicable in the valuation of patents, trademarks, and certain copyrights. For such intellectual property, it is common for the owner/developer to license the intellectual property use to a third-party intangible asset operator. The various forms of royalty payments from the licensee to the licensor (for example, royalty as a percent of revenue, as a percent of income, or on a per unit basis) may be used to estimate the intellectual property value.

The income approach is often applicable in the valuation of patented or unpatented (trade secret) processes or technologies. The income approach is also applicable in the valuation of certain trademarks and copyrights. For example, it may be applicable if the patented product or process (or the trade secret product formulation in process) allows the owner to generate increased revenue or experience decreased costs. This income measure may occur when the owner/operator experiences increased unit sales or increased unit selling prices due to the proprietary feature. Alternatively, it may occur if the owner/operator experiences decreased operating expenses or decreased other expenses due to a property process. The income approach is often used in the valuation of copyrights related to books, plays, musical compositions, or films and film libraries. This is because the analyst can often identify a measurable stream of income associated with the commercialization of the copyrighted work.

Bankruptcy-Related Intellectual Property Valuations

The following discussion summarizes three common reasons why analysts are asked to value intellectual property within a bankruptcy context. The section citations refer to the United States Bankruptcy Code. The rule citations refer to the United States Bankruptcy Rules.

Reason 1: Preference Claims and Debtor Solvency (Section 547)

Creditors may retain an analyst to assess the debtor’s solvency prior to the bankruptcy filing date. The creditors may claim that (1) the debtor was in fact solvent prior to the bankruptcy filing and, therefore, (2) their receipt of either property or cash from the debtor was not an avoidable preference payment.

In a Chapter 11 bankruptcy, the appointed trustee may seek to avoid certain transfers of cash or property out of the bankruptcy estate. That avoidance brings more property and more cash back into the bankruptcy estate to allow the trustee to settle more of the debtor’s liabilities. Section 547 allows the trustee to avoid certain so-called preference payments under certain circumstances. The relevant Section 547 subsections follow:

(b) Except as provided in subsections (c) and (i) of this section, the trustee may avoid any transfer of an interest of the debtor in property

1. to or for the benefit of a creditor;
2. for or on account of an antecedent debt owed by the debtor before such transfer was made;
3. made while the debtor was insolvent; . . .

(f) For purposes of this section, the debtor is presumed to have been insolvent on and during the 90 days immediately preceding the date of the filing of the petition.

Of course, the creditor recipients of the debtor’s property or cash are not so willing to return the transaction proceeds to the bankruptcy estate. Hence, the creditors may retain an analyst to assess the debtor’s solvency prior to the date of the bankruptcy filing.

Reason 2: Fraudulent Transfers and Debtor Solvency (Section 548)

The trustee may retain an analyst to assess whether the debtor was insolvent on the pre-bankruptcy transfer dates. Alternatively, the affected creditors may retain an analyst to assess whether the debtor was solvent on the pre-bankruptcy transfer dates.

In the Chapter 11 bankruptcy, the trustee can avoid either transfers made by the debtor corporation or liabilities assumed by the debtor corporation under certain circumstances. An important factor in determining if the debtor’s transfer was fraudulent (and, therefore, if the transfer may be avoided) is whether the debtor was insolvent at the date of the transfer.

The relevant Section 548 subsections related to fraudulent transfers and debtor solvency follow:

(a)(1) The trustee may avoid any transfer (including any transfer to or for the benefit of an insider under an employment contract) of an interest of the debtor in property, or any obligation (including any obligation to or for the benefit of an insider under an employment contract) incurred by the debtor, that was made or incurred on or within 2 years before the date of the filing of the petition, if the debtor voluntarily or involuntarily–

1. made such transfer or incurred such obligation with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made or such obligation was incurred, indebted; or
2. (i) received less than a reasonably equivalent value in exchange for such transfer or obligation; and
   (ii)
   (I) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation;
   (II) was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital;
   (III) intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor’s ability to pay as such debts matured; or
   (IV) made such transfer to or for the benefit of an insider, or incurred such obligation to or for the benefit of an insider, under an employment contract and not in the ordinary course of business.

With regard to the conditions related to a fraudulent transfer, Section 548 lists three separate fraudulent transfer tests that are performed as of the transfer date. These three tests are often performed by the analyst. These three fraudulent transfer tests determine:

1. Whether the debtor corporation was insolvent—that is, whether the debtor liabilities exceeded the debtor assets at fair valuation
2. Whether the debtor corporation was expected to be able to pay its debts (including principal and interest payments) as such debts matured
3. Whether the debtor corporation had an unreasonably small amount of capital to continue to be able to operate as a going concern.

The trustee may claim that a fraudulent transfer has occurred if the analyst concludes that the debtor fails any of these three tests as of the transfer date. And, each of these tests is based on a financial analysis conducted by the analyst.

Section 101 – Definition of “Insolvent”

Claims of preference payments and fraudulent transfers are made, in part, based on the allegation that the debtor was insolvent as of a particular point in time (i.e., a point in time related to a specific pre-bankruptcy transaction). As presented in the subsection below, Bankruptcy Code Section 101 provides the relevant definition for the term “insolvent”:

(32) The term “insolvent” means—

1. with reference to an entity other than a partnership and a municipality, financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at a fair valuation, exclusive of—
   (i) property transferred, concealed, or removed with intent to hinder, delay, or defraud such entity’s creditors; and
   (ii) property that may be exempted from property of the estate under section 522 of this title;
2. with reference to a partnership, financial condition such that the sum of such partnership’s debts is greater than the aggregate of, at a fair valuation—
   (i) all of such partnership’s property, exclusive of property of the kind specified in sub-paragraph (A)(i) of this paragraph; and
   (ii) the sum of the excess of the value of each general partner’s non-partnership property, exclusive of property of the kind specified in sub-paragraph (A) of this paragraph, over such partner’s non-partnership debts; and
3. with reference to a municipality, financial condition such that the municipality is—
   (i) generally not paying its debts as they become due unless such debts are the subject of a bona fide dispute; or
   (ii) unable to pay its debts as they become due.

The principal provision of this insolvency definition can be summarized by asking: Are the debtor company debts greater than the value of the debtor company assets (including intellectual property), at fair valuation? The answer to that question is based on a valuation analysis. If the answer is yes (i.e., liabilities exceed the fair value of assets), then the debtor company is insolvent. If the answer is no (i.e., the fair value of assets—including intellectual property—exceeds liabilities), then the debtor company is solvent.

Reason 3: Asset Sales and Adequate Protection (Section 363)

The trustee may retain an analyst to assess whether the price of the proposed Section 363 asset sale is fair, thereby providing adequate protection to the creditors. If the proposed asset sale transaction is contested, the creditors may also retain an analyst to assess whether the price of the proposed asset sale is not fair (i.e., does not provide adequate protection to the creditors)—and, accordingly, the court should not approve the proposed asset sale.

During a protected bankruptcy, the debtor in possession (DIP) may attempt to sell off some of the debtor company assets included in the bankruptcy estate. Such assets subject to sale may be a DIP subsidiary, division, or other business unit. In particular, the DIP may attempt to sell off underperforming business assets. And, the DIP may be able to sell off any excess or non-operating assets that are not part of the debtor’s core business. Such asset sales (often referred to as “363 asset sales”) are intended to (1) eliminate or reduce any DIP operating losses and/or (2) generate cash that would become available to pay off some of the debtor company’s liabilities.

In a bankruptcy proceeding, the trustee has to make sure that such 363 asset sales are fair to the stakeholders of the bankruptcy estate, where such stakeholders are primarily debt holders. The following Section 363 subsection relates to asset sales from the bankruptcy estate.

(b)(1) The trustee, after notice and a hearing, may use, sell, or lease, other than in the ordinary course of business, property of the estate

(c)(1) If the business of the debtor is authorized to be operated under section 721, 1108, 1203, 1204, or 1304 of this title and unless the court orders otherwise, the trustee may enter into transactions, including the sale or lease of property of the estate, in the ordinary course of business, without notice or a hearing, and may use property of the estate in the ordinary course of business without notice or a hearing.

(p) In any hearing under this section—

(1) the trustee has the burden of proof on the issue of adequate protection; and
(2) the entity asserting an interest in property has the burden of proof on the issue of the validity, priority, or extent of such interest.

Robert Reilly, CPA is the managing director of Willamette Management Associates’ Chicago Office. His practice includes business valuation, forensic analysis, and financial opinion services. Mr. Reilly can be reached at (773) 399-4318 or by e-mail at rfreilly@willamette.com.

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