Cost Approach to Intellectual Property Valuation

Part II: Valuation Methods

Part I of this four-part discussion considered the conceptual foundations for applying the cost approach to value intellectual property (including patents, copyrights, trademarks, and trade secrets). Part II summarizes the generally accepted valuation methods within the cost approach.

Introduction

Part I of this four-part discussion considered the conceptual foundations for applying the cost approach to value intellectual property (including patents, copyrights, trademarks, and trade secrets). Part II summarizes the generally accepted valuation methods within the cost approach.

Cost Approach Valuation Methods

There are several generally accepted intellectual property valuation methods within the cost approach. Each of these generally accepted valuation methods typically applies a different definition (or measurement metric) of cost. These various cost measurement definitions include the following:

1. Reproduction cost new
2. Replacement cost new

Reproduction cost new (RPCN) measures the total cost, in current prices as of the date of the analysis, to develop an exact duplicate of the actual intellectual property. The reproduction intellectual property is developed using the same types of materials (if any) and labor, development standards, design, layout, and quality of workmanship as the actual intellectual property.

The reproduction intellectual property includes all of the inadequacies, superadequacies, and other indicia of obsolescence (if any) of the actual intellectual property. The RPCN cost measurement metric is often applied (1) when the actual intellectual property is new and (2) when the actual intellectual property could still be considered a reasonable replacement for itself.

Replacement cost new (RCN) measures the total cost, in current prices as of the date of the analysis, to develop a new intellectual property having the same functionality or utility as the actual (seasoned) intellectual property. Functionality is an engineering concept that means the ability of the intellectual property to perform the task for which it was designed. Utility is an economics concept that means the ability of the intellectual property to provide an equivalent amount of satisfaction to the owner/operator.

The replacement intellectual property is developed using modern materials (if any) and labor, development standards, design, layout, and quality of workmanship. The replacement intellectual property typically excludes all curable inadequacies, superadequacies, and obsolescence that may be present in the actual intellectual property.

The RCN cost measurement metric is more often applied (1) when the actual (seasoned) intellectual property is old and (2) when the actual (seasoned) intellectual property would no longer be considered a reasonable replacement for itself.

There are other cost measurement definitions that may also be applicable to an intellectual property cost approach valuation. Some analysts consider a measure of cost avoidance as a cost approach method. However, in the valuation literature, a cost avoidance valuation method is more appropriately categorized as an income approach valuation method.

Some analysts apply trended historical cost as a cost measurement metric in the application of the cost approach. In this method, the historical development costs are identified, these historical costs are trended to the valuation date by applying an appropriate inflation-related index factor.

This trended historical cost measurement metric is particularly applicable when:

1. The actual intellectual property is relatively new or
2. The owner/operator has substantially complete records related to the historical development costs and efforts related to the actual intellectual property.

The specific inflation-related trend index applied in the analysis should be appropriate to the type of intellectual property development costs that are being indexed to current costs.

There are two principles that the analyst should be aware of with regard to the application of the cost approach in an intellectual property valuation.

First, regardless of the specific cost definition applied in the cost measurement analysis, all cost measurement metrics (including RPCN, RCN, or any other cost measurement metric) should consider a comprehensive cost analysis.

Second, regardless of the cost measurement metric applied, all cost approach valuation methods should develop approximately the same value indication for the same intellectual property. That is, there will be a different cost metric quantified for each cost approach valuation method. There will also be a different appraisal depreciation and obsolescence measurement quantified for each cost approach valuation method.

The differences in the various cost metrics are generally offset by the differences in the appraisal depreciation and obsolescence metrics. And, therefore, the intellectual property value indications developed from the alternative cost approach valuation methods should be similar.

Cost Measurement Procedures

All intellectual property cost measurement metrics should consider the following four cost components:

• Direct costs (such as materials, labor, and internal owner/operator overhead)
• Indirect costs (such as engineering and design expenses and legal and consulting fees)
• The intellectual property developer’s profit (as in, a profit margin percentage applied to the direct cost and indirect cost investment)
• An opportunity cost/entrepreneurial incentive (such as a measure of lost income or other opportunity cost during the intellectual property development period adequate to motivate the development process)

Direct costs and indirect costs are typically easy to identify and quantify. The developer’s profit cost component can be estimated using several generally accepted procedures. This cost component is often estimated as a profit margin percentage applied to the developer’s investment in the material, labor, and owner/operator overhead costs.

The entrepreneurial incentive cost component is often measured as either:

1. The income that the developer would lose during the intellectual property replacement/development period or
2. A fair rate of return on the amount of the investment in the total intellectual property cost metric—during the intellectual property replacement/development period.

The lost income concept of entrepreneurial incentive is often considered in the context of a willing buyer’s “make versus buy” decision. For example, consider a hypothetical willing buyer and a hypothetical willing seller (as in, the current owner) in a negotiation related to a patent sale.

Let’s assume that it would require a two-year period for a hypothetical willing buyer to develop a replacement patent (as in, the elapsed amount of time required to develop a new noninfringing invention).

If the buyer decided to buy the seller’s actual patent, then the buyer could start earning income from the intellectual property (either operating income or ownership license income) immediately. In contrast, if the buyer decided to make and register its own hypothetical, noninfringing replacement patent, then the buyer would earn no income (either operating income or ownership license income) from the replacement patent during the two-year replacement/development period.

The total of the two years of lost income during the hypothetical replacement patent development period represents the opportunity cost of making (i.e., developing) a de novo, noninfringing replacement patent.

All four cost components—direct costs, indirect costs, developer’s profit, and entrepreneurial incentive—typically should be considered in the intellectual property cost approach valuation analysis. The cost approach applies a different set of analyses than does the income approach. However, the cost approach does include certain economic considerations.

These economic considerations can help indicate which of the following two cost approach components should be included in the analysis:

1. Entrepreneurial incentive or lost income opportunity cost (if any)
2. Economic obsolescence or an inadequate return on investment (ROI) (if any)

The intellectual property development cost metric (however measured) should be adjusted for any value decreases due to:

• Physical deterioration,
• Functional obsolescence, and
• External obsolescence.

All types of physical deterioration and obsolescence are collectively referred to as depreciation. Depreciation is the valuation profession’s term for a reduction in value, and the term depreciation is applied to both tangible property and intangible property.

Physical deterioration is a reduction in property value due to physical wear and tear. It is unlikely (but not impossible) that an intellectual property will experience physical deterioration. Nonetheless, the analyst should consider the existence of any physical deterioration in any cost approach valuation analysis.

For example, physical deterioration can be considered in the cost approach valuation of the trade secrets component of a trained and assembled workforce (with consideration of whether some employees are nearing retirement age, for instance).

Functional obsolescence is a reduction in intellectual property value due to the property’s inability to perform the function (or to yield the economic utility) for which it was originally designed. The technological component of functional obsolescence is a decrease in value related to technological advancements that make the subject intellectual property less than the ideal replacement for itself.

Let’s consider functional obsolescence in the context of a valuation of computer software copyrights and trade secrets, for example. If the source code is written in an obsolete programming language, then the software may suffer from functional obsolescence.

External obsolescence is a reduction in intellectual property value caused by effects, events, or conditions external to—and not controlled by—the current use or condition of the property. The impact of external obsolescence typically is beyond the control of the intellectual property owner/operator.

There are two types of external obsolescence:

1. Locational obsolescence
2. Economic obsolescence

Locational obsolescence is a decrease in the intellectual property value due to changes in neighborhood conditions. This type of obsolescence typically affects any intangible property related to real estate, such as easements, drilling rights, air rights, construction permits or rights, environmental operating permits, water extraction rights, and the like. Locational obsolescence typically does not impact most intellectual property.

Economic obsolescence relates to the inability of the intellectual property owner/operator to earn a fair rate of ROI related to the intangible property. Economic obsolescence can affect most types of intellectual property. The measurement of economic obsolescence is described later in this discussion.

Obsolescence of any type is considered curable when the owner/operator’s cost to cure (as in, resolve) the inefficiency is less than the decrease in value caused by the inefficiency. Obsolescence of any type is considered incurable when the owner/operator’s cost to cure the inefficiency is greater than the decrease in value it causes.

Let’s assume that an owner/operator operates inefficient copyrighted computer software that was written in an inefficient third-generation programming language. It would cost the owner/operator $1 million to reprogram the software using a more efficient fifth-generation programming language. For the owner/operator, the new software system would create a savings in both computer hardware and clerical support expense that exceeds $1 million (on a present value basis).

Therefore, that intellectual property’s obsolescence is considered curable. If the savings was projected to be less than the cost to reprogram the software, then the intellectual property functional obsolescence would be considered incurable.

In any cost approach analysis, the analyst should estimate the amount (if any) of physical deterioration, functional obsolescence, and external (potentially economic) obsolescence related to the actual intellectual property. In estimating the depreciation components, the analyst should consider both:

1. The intellectual property’s expected useful economic life (UEL) and
2. The intellectual property’s actual ROI.

Useful Economic Life Considerations

After the analyst selects the appropriate valuation approaches and methods, the next procedure is to consider the intellectual property’s expected UEL. The estimation of the intellectual property’s UEL (often called a lifing analysis) is an important consideration in any generally accepted intellectual property valuation approach.

A property’s UEL is the total period over which the property is expected to generate economic benefits. In estimating useful economic life, analysts typically consider the financial projections of the owner/operator entity (or the actual intellectual property), its industry, the economy, or economies of the geographic regions in which the owner/operator operates, and other market participants or competitors.

In the application of the cost approach, a lifing analysis may be performed to estimate the total amount of obsolescence, if any, from the estimated cost measurement metric—that is, the intellectual property RPCN, RCN, or other cost metric.

In the application of the cost approach, a longer expected UEL estimate results in a greater intellectual property value. This result is because a longer UEL generally indicates less obsolescence in the intellectual property. Normally, a shorter UEL estimate results in a greater obsolescence allowance consideration in the intellectual property value.

Some of the factors that the analyst typically considers in the expected UEL analysis include the following:

• Legal factors
• Regulatory factors
• Contractual factors
• Functional factors
• Technological factors
• Economic factors
• Analytical factors

The analyst typically considers each of the above-listed categories of factors that influence the UEL estimation. Typically, the factor that indicates the shortest UEL deserves primary consideration in the intellectual property UEL estimate.

Physical Depreciation Measurement Procedures

There is no one individual formula or equation to quantify intellectual property physical depreciation (or deterioration). One procedure related to quantifying intellectual property physical deterioration is to estimate the cost to cure the deterioration (if it is, in fact, curable).

An intellectual property is typically not subject to wear and tear—like a tangible property is. However, an intellectual property can be “used up” over time. That is, the intellectual property UEL may become shorter over time. This decrease in UEL can decrease the intellectual property value.

For example, an intellectual property that is contract-related or otherwise has a legal UEL typically decreases in value as that UEL expires. Intellectual property licenses, permits, contractual rights, agreements, and franchises typically have legally determined finite lives. As that contract (or legal) life expires, the value of that intellectual property typically decreases.

Let’s assume that the cost to obtain a Food and Drug Administration (FDA) license for a new drug product is $10 million. That cost would include all drug development and laboratory work, all clinical tests, all application and documentation fees to the FDA, and a lost income/opportunity cost component during the drug development period.

Let’s further assume that the FDA license period for the new drug is 10 years. On the date that the FDA license is granted, the license’s value probably equals the RCN of $10 million. Nine years later (with only one year remaining in the FDA license term), the license value will likely have decreased.

Even ignoring the effect of any economic obsolescence, the willing buyer will assume that it will soon need to incur new drug development costs in order to obtain a new FDA license for an improved drug product.

The analyst should decide whether the license value decrease is linear over the 10-year life. However, the license value typically decreases as the UEL decreases. The illustrative FDA license value at the end of year nine will typically be its replacement cost new less depreciation (RCNLD) estimate, not its RCN estimate.

Some analysts question whether this value decrease should be called technological obsolescence instead of physical deterioration. Regardless of the terminology used, the analyst should recognize the decrease in the value of contract-related or regulatory-related intellectual property as the UEL of each such property decreases.

The analyst should realize that some types of intangible property may actually experience physical deterioration. All intangible property has some physical manifestation. Even institutional goodwill may be manifested by the owner/operator’s financial statements (historical or prospective), articles of incorporation, books and records, and so on. Personal goodwill may be manifested by an individual’s personal income tax returns, compensation statements, employment or other contracts, client lists, and so on.

The physical manifestation of some intangible property may experience wear and tear. For example, in an assembled workforce example, some employees may become old (and be ready to retire) or become injured (and be on disability leave). Laboratory notebooks and other technical documentation may become tattered over time. Non-CAD engineering drawings and designs or nonelectronic patient charts and records may show wear and tear over time.

The analyst should consider the occurrence of physical deterioration during the cost approach valuation process of a general intangible property. The analyst should at least consider the concept of physical deterioration in the cost approach valuation of an intellectual property.

Functional Obsolescence Measurement Procedures

For all property, both tangible and intangible, functional obsolescence is usually related to inefficiencies associated with the operation of the property. These inefficiencies typically involve either inadequacies or superadequacies. An inadequacy occurs when there is not enough of the property (as in, the property is too small) for it to operate efficiently. A superadequacy occurs when there is too much of a property (as in, the property is too large) for it to operate efficiently.

Regarding intellectual property functional obsolescence, the analyst typically considers the following two factors:

1. Excess capital costs
2. Excess operating costs

The consideration of excess capital costs compares (1) the current cost to develop a replacement intellectual property with (2) the historical cost to develop the actual intellectual property. In other words, if it would cost less to develop the replacement intellectual property today than it cost to reproduce (i.e., to duplicate) the actual intellectual property, then that difference is one measure of functional obsolescence.

The consideration of excess operating costs compares the current cost of maintaining or using the intellectual property to the historical cost of maintaining or using the property when it was first developed or put into service. The present value of any relative excess operating costs over the intellectual property’s UEL is another measure of functional obsolescence. This present value calculation is typically referred to as the capitalized excess operating cost method.

Analysts often consider the following two methods for quantifying intellectual property functional obsolescence:

• The excess capital cost method
• The capitalized excess operating cost method

Although it is called the excess capital cost method, this method can be applied to measure obsolescence related to either an inadequacy or a superadequacy. However, this method is more frequently applied to measure intellectual property superadequacy.

Economic Obsolescence Measurement Procedures

The analysis of economic obsolescence is typically the last procedure in any intellectual property cost approach valuation. The objective of the economic obsolescence analysis is to determine whether the owner/operator can earn a fair rate of return on the value indication.

If the owner/operator can earn a fair rate of return, then the cost approach value (before an economic obsolescence allowance) provides the intellectual property value indication. If the owner/operator cannot earn a fair rate of return, then the value indication should be reduced by the amount of the economic obsolescence allowance.

The cost approach value should be reduced to the level at which the owner/operator can earn a fair rate of return on the cost approach value indication. The value indication adjusted for economic obsolescence results in the cost approach final value indication.

It may be easy for the analyst to identify physical deterioration (if any) in the intangible property. It also may be easy for the analyst to identify functional obsolescence (if any) in the intangible property. This is because these depreciation components are inherent in the intangible property.

Economic obsolescence is more difficult to identify than physical deterioration or functional obsolescence. Typically, the causes of economic obsolescence are external to the intangible property.

The analysis of intellectual property economic obsolescence is usually a two-step process:

1. Identify the existence of economic obsolescence
2. Quantify the amount of economic obsolescence

Procedures to Identify the Existence of Economic Obsolescence

The analyst typically considers economic obsolescence in every intellectual property cost approach analysis. Several conditions can indicate the existence of economic obsolescence. Exhibit 1 lists some of these conditions that may indicate the existence of intellectual property economic obsolescence.

Exhibit 1: Owner/Operator Conditions That Can Indicate the Existence of Intellectual Property Economic Obsolescence

1. The owner/operator’s income approach business value indication is less than the entity’s asset-based approach business value indication.
2. The owner/operator’s market approach business value indication is less than the entity’s asset-based approach business value indication.
3. The owner/operator’s revenue decreased in recent years.
4. The owner/operator’s profitability decreased in recent years.
5. The owner/operator’s cash flow decreased in recent years.
6. The owner/operator’s product pricing decreased in recent years.
7. The industry/profession’s revenue decreased in recent years.
8. The industry/profession’s profitability decreased in recent years.
9. The industry/profession’s cash flow decreased in recent years.
10. The industry/profession’s product/service pricing decreased in recent years.
11. The owner/operator’s profit margin decreased in recent years.
12. The owner/operator’s ROI decreased in recent years.
13. The industry/profession’s profit margin decreased in recent years.
14. The industry/profession’s ROI decreased in recent years.
15. The industry/profession’s competition increased in recent years.
16. The industry/profession experienced regulatory changes in recent years.

While none of the conditions in Exhibit 1 specifically measures the amount of economic obsolescence, the existence of one or more of these conditions may indicate the existence of economic obsolescence. To measure economic obsolescence, the analyst typically considers either (or both) of the following:

1. Owner/operator-specific factors
2. Industry factors

Procedures to Measure Economic Obsolescence

Economic obsolescence analyses are typically performed on a comparative basis. The comparative basis can be:

1. The owner/operator’s actual operating results with the economic obsolescence effect in place compared to
2. The owner/operator’s hypothetical (e.g., historical or projected) operating results without the economic obsolescence effect in place.

Alternatively, the comparative basis can be:

1. The owner/operator’s actual operating results with the economic obsolescence effect in place compared to
2. One (or more) comparable entity’s operating results without the economic obsolescence effect in place.

Given the comparative nature of economic obsolescence analyses, a noncomparative analysis is unlikely to be adequate for measuring economic obsolescence. To quantify many types of economic obsolescence, the analyst may review the owner/operator’s financial documents or operational reports. Such owner/operator documents can include the following:

• Financial statements or financial results of operations
• Financial budgets, plans, projections, or forecasts
• Production statements, production cost analyses, or operating cost variance analyses
• Material, labor, and overhead cost of goods sold (or cost of services delivered) analyses
• Fixed expense versus variable expense operating statements
• Unit or total entity cost/volume/profit analyses
• Unit/dollar sales analyses or average selling price analyses

The analyst typically considers the owner/operator’s data and documents in the preceding list on a comparative basis, such as the following:

• Actual results versus historical results
• Actual results versus budgeted results
• Actual results versus specific comparative entity results
• Actual results versus specific competitor results
• Actual results versus industry/profession average or benchmark results
• Actual results versus the owner/operator’s practical or normal production capacity

To identify the causes of the economic obsolescence, the analyst typically analyzes the owner/operator’s financial data. Regarding intellectual property specifically, the analyst often analyzes the following financial and operational data:

• Business enterprise profit margins
• Business enterprise ROIs
• Industrial/commercial product unit average selling price
• Industrial/commercial product unit cost of goods sold
• Industrial/commercial product unit sales volume

The analyst seeks to identify any external factors that could cause the owner/operator to earn less than a fair rate of return on the cost approach value indication.

Concluding the Cost Approach Value Indication

By this point in the analysis, the analyst has performed all the following intellectual property valuation procedures:

1. Concluded that the application of the cost approach is appropriate for the intellectual property
2. Confirmed that adequate current cost information is available to perform a cost approach analysis
3. Selected the appropriate cost measurement measure or metric for the intellectual property current cost
4. Included all appropriate cost components in the current cost measurement
5. Identified and quantified any necessary allowance for physical deterioration
6. Identified and quantified any necessary allowance for functional obsolescence
7. Identified and quantified any necessary allowance for economic obsolescence

To conclude a cost approach value indication, the only remaining procedure is to subtract all appraisal deprecation and obsolescence allowances from the current cost measure.

Summary

This part of our four-part discussion described the generally accepted valuation methods that analysts may apply in the development of the intellectual property cost approach valuation. To apply any cost approach valuation method, the analyst should have sufficient reliable data in order to develop (1) a cost metric and (2) an obsolescence measurement. And, that obsolescence measurement often involves consideration of the intellectual property’s useful economic life.

Part III of this four-part discussion will review the practical procedures conducted in the application of the cost approach to intellectual property valuation.

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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.