Intellectual Property Valuations

The Relief From Royalty Method (Part I of V)

This is the first article of a five-part series that focuses on what valuation analysts and owner/operators need to know about one category of intangible property: intellectual property. There are generally accepted cost approach, market approach, and income approach methods that may be used to value intellectual property. This discussion focuses on the application of the market approach. This discussion focuses on one market approach valuation method: the RFR method. The RFR method is often applied to value an owner/operator’s intellectual property for transaction, taxation, financing, accounting, litigation, and many other purposes. That is because the RFR method is particularly applicable to the valuation of intellectual property across a range of purposes. This first article sets forth why intellectual property is valued. The article series culminates with an example of how the RFR method is employed.

Introduction

This discussion focuses on what valuation analysts (analysts) and owner/operators need to know about one category of intangible property: intellectual property. There are generally accepted cost approach, market approach, and income approach methods that may be used to value intellectual property. This discussion focuses on the application of the market approach. This discussion specifically focuses on one market approach valuation method: the RFR method.

The RFR method is often applied to value an owner/operator’s intellectual property for transaction, taxation, financing, accounting, litigation, and many other purposes. That is because the RFR method is particularly applicable to the valuation of intellectual property across a range of purposes.

This five-part discussion considers the following topics related to the market approach valuation of intellectual property for transaction, taxation, litigation, or other purposes:

• The four categories of intellectual property
• The three types of intellectual property economic analyses
• The use of royalty rate data in intellectual property valuation analyses
• The various intellectual property license royalty rate data sources
• The two types of intellectual property license royalty rate data
• The purpose of making royalty rate data normalization adjustments
• The typical royalty rate data normalization adjustments
• A royalty rate selection analysis illustrative example
• An RFR valuation method illustrative example

The term “property” is a legal term. Property is subject to certain legal rights and protection, usually under state law. The term “asset” is an accounting term. An asset is recorded on an equity’s balance sheet under the guidance of U.S. generally accepted accounting principles (GAAP).

Not all property is recorded on a balance sheet prepared in compliance with GAAP. Not all assets qualify as property. These two terms are not synonymous. However, many analysts use these two terms interchangeably. For purposes of this discussion only, we will consider the term intangible personal property to be equivalent to the term intangible asset.

Categories of Intellectual Property

Royalty rate data are often applied in many types of intellectual property economic analyses. This statement is true with regard to intellectual property valuation, damages measurement, and transfer price determination analyses. This statement is particularly true for intellectual property valuations developed for transaction, taxation, litigation, or other purposes. This discussion explains and illustrates the use of royalty rate data within the context of an intellectual property valuation prepared for taxation purposes.

For various purposes, there are four categories of intellectual property:

• Patents
• Trademarks
• Copyrights
• Trade secrets

Each of these intellectual property categories is summarized below.

As discussed below, royalty rate data are typically extracted from arm’s-length, third-party commercial license agreements. Analysts should be aware that many arm’s-length, third-party intellectual property license agreements encompass the use of both (1) intellectual property and (2) other intangible personal property. Therefore, when using royalty rate data for taxation (and other) valuation purposes, analysts should consider the bundle of intangible property that may be included in each license agreement—as well as the bundle of intellectual property legal rights that are included in each license agreement.

Patents and Related Intangible Property

This category of intellectual property includes the following:

• Utility patents
• Design patents
• Plant patents
• Process/method patents

In addition, third-party licenses (and other transfers) of patents often include the following intangible property:

• Patent applications
• Technology sharing agreements
• Unpatented proprietary technology
• Regulatory approvals and licenses (e.g., FDA approvals, OSHA approvals)
• Technology development rights
• Engineering drawings and designs
• Schematics and technical documentation

Trademarks and Related Intangible Property

This category of intellectual property includes the following:

• Trademarks
• Trade names
• Service marks
• Service names
• Logos
• Trade dress

In addition, third-party licenses (and other transfers) of trademarks often include the following intangible property:

• Brand names
• Advertising programs
• Brochures and marketing materials
• Name-related goodwill

Copyrights and Related Intangible Property

This category of intellectual property includes copyrights related to:

• Literary works
• Musical works
• Dramatic works
• Pantomimes and choreographed works
• Pictorial, graphic, or sculptural works
• Motion pictures and audiovisual works
• Sound recordings
• Architectural works
• Computer software (including both object code and source code)

Third-party licenses (and other transfers) of copyrights may include the following intangible property:

• Engineering drawings
• Blueprints
• Manuals and procedures
• Training films

Trade Secrets and Related Intangible Property

This category of intellectual property includes the following trade secrets:

• Customer information
• Books and records
• Product formulas and recipes
• Procedures and know-how
• Pricing and cost information
• Accounting documentation

To maintain their confidentiality, trade secrets are rarely licensed in third-party license agreements. However, the sales and other transfers of trade secrets may include the following intangible property:

• Employee training materials
• Process flow charts
• Facility operation diagrams and schematics
• Financial plans and projections

Types of Intellectual Property Economic Analyses

License agreement royalty rate data are often used in the following types of intellectual property analyses:

• Valuation analyses (prepared for taxation and many other purposes)
• Damages measurement analyses (typically related to breach of contract claims and tort claims)
• Transfer price analyses (including both intercompany transfers and third-party transfers)

Third-party arm’s-length license royalty rate data are often used in intellectual property valuation analyses. Such arm’s-length license agreement royalty rate data are typically used in the application of the market approach and, in particular, the RFR valuation method. These arm’s-length data may be used to estimate a defined value for the owner/operator’s intellectual property.

In addition to valuation analyses, such royalty rate data are also used in transactional fairness opinion analyses.

Such an independent opinion may be requested by any transaction participant or contract counterparty to assess the fairness of the following:

• A proposed intellectual sale transaction price
• A proposed intellectual property license royalty rate
• The terms of a proposed intellectual property (or portfolio of intellectual property) exchange or other transfer transaction

License agreement royalty rate data are also used in intellectual property lost profits and other damages measurements. Such empirical data may be used to conclude a reasonable royalty rate damages measurement to an aggrieved intellectual property owner/operator. Such a reasonable royalty rate may be used in a tort damages measurement or in a breach of contract damages measurement.

Finally, arm’s-length royalty rate data are also used as a component of intellectual property transfer price analyses. For intercompany transfer price determination purposes, royalty rate data are often used in the comparable uncontrolled transaction (CUT) transfer price measurement method. Such transfer price analyses are typically performed in transactions related to the following:

• International intercompany transfers of intangible property
• Interstate intercompany transfers of intangible property
• Intercompany intellectual property transfers between controlled entities where one of the entities has a noncontrolling ownership interest
• Arm’s-length transfers of intellectual property use rights in a third-party license agreement

Uses of Royalty Rate Data in Intellectual Property Analyses

License royalty rate data are routinely applied in various intellectual property analyses developed for many purposes. These various analyses include the following:

• Transaction analyses related to:
  • arm’s-length sales of intellectual property,
  • arm’s-length licenses of intellectual property,
  • intercompany transfers of intellectual property within a controlled entity, or
  • third-party transfers of intellectual property between a for-profit entity and a not-for-profit entity.
• Financing analyses related to:
  • intellectual property sale/license-back and other financing collateral valuations or
  • debtor in possession or other intellectual property secured financing collateral valuations.
• Fair value measurement analyses related to:
  • GAAP acquisition accounting fair value measurements,
  • GAAP intangible asset impairment testing fair value measurements, or
  • GAAP post-bankruptcy fresh start accounting fair value measurements.
• Federal taxation valuation analyses related to:
  • taxable (asset) acquisition transaction purchase price allocations,
  • basis in an intellectual property contributed by an equity holder to a corporation or a partnership,
  • charitable contribution deduction substantiation,
  • gift and estate tax planning and compliance,
  • intercompany transfer price arm’s-length price (ALP) determination,
  • taxpayer corporation solvency/insolvency analysis related to COD income recognition, or
  • the conversion of a C corporation to S corporation income tax status.
• Forensic analyses related to:
  • intellectual property infringement claim damages measurements,
  • intellectual property license breach of contract damages measurements,
  • condemnation and eminent domain taking of an entity’s intellectual property, or
  • bankruptcy solvency/insolvency analysis of the intellectual property owner/operator.

Intellectual Property Valuation Approaches and Methods

There are generally accepted intellectual property valuation approaches and methods. These generally accepted valuation approaches and methods are described in numerous valuation textbooks, are included in valuation professional organization (VPO) professional standards, are taught in VPO training and credentialing materials, and are tested on VPO valuation credentialing examinations.

A description of each of these generally accepted approaches and methods is beyond the scope of this discussion. All intellectual property valuation methods are typically grouped into three generally accepted intangible property valuation approaches: the market approach, the cost approach, and the income approach. A listing of the generally accepted intellectual property valuation methods within each approach is presented below:

• Market approach methods
  • Relief from royalty method
  • Comparable uncontrolled transactions method
  • Comparable profit margin method
• Cost approach methods
  • Replacement cost new less depreciation method
  • Reproduction cost new less depreciation method
  • Trended historical cost less depreciation method
• Income approach methods
  • Multiperiod excess earnings method
  • Capitalized excess earnings method
  • Incremental income method
  • Differential income method
  • Profit split method
  • Residual profit split method

Market Approach Intellectual Property Valuation Considerations

In the application of market approach valuation methods, the selected valuation pricing metrics are typically based on either comparable or guideline:

• licenses of intellectual property,
• sales of intellectual property, or
• companies that use intellectual property.

In the application of the market approach, the valuation variables that analysts select—and the valuation procedures that analysts perform—typically include the following:

• Quantitative/qualitative analyses of the intellectual property
• Documentation of the guideline license/sale/company selection criteria
• Application of the guideline license/sale/company selection process
• Verification of the selected sale or license transactional data
• Quantitative and qualitative analysis of the selected sale or license transaction data
• Selection of the appropriate financial or operational pricing metrics to apply in the valuation analysis
• Selection of the specific pricing multiples to apply to the intellectual property
• Application of the selected pricing multiples to the intellectual property financial or operational metrics

Some of the factors that analysts consider in the application of the market approach valuation methods include the following:

• Comparison of any seasoned guideline intellectual property to an owner/operator’s development stage intellectual property
• Comparison of any development stage guideline intellectual property to an owner/operator’s seasoned intellectual property
• Assessment of the current state of the competition in the intellectual property owner/operator’s industry
• Assessment as a part of a comparable profit margin (CPM) valuation method analysis, including consideration of whether the intellectual property the only reason for the difference in profit margins between the owner/operator and the selected CPM companies

Conclusion

The first of this five-part discussion introduced the RFR method of intellectual property valuation. This discussion considered the many reasons why an analyst may be asked to value an owner/operator’s intellectual property.

Part two considers the various elements of the intellectual property valuation analysis.

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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.