Intellectual Property Valuations
Elements of the Valuation Analysis (Part II of V)
This second article of the five-part series on Intellectual Property Valuations summarizes the typical elements of the intellectual property valuation analysis. This part of the discussion focuses on benchmarking and the use of research databases.
This five-part series of discussions introduces the market approach and the relief from royalty (RFR) method of intellectual property valuation. Part one of this discussion introduced the typical types of intellectual property and the generally accepted intellectual property valuation approaches and methods.
This part summarizes the typical elements of the intellectual property valuation analysis.
Elements of the Intellectual Property Valuation Analysis
The first element in any valuation is a complete definition of the intellectual property. This statement is true for intellectual property valuations developed for any purpose. But this statement is particularly true for intellectual property valuations performed for controversy purposes. This is because such valuations are often subject to a contrarian review.
The intellectual property definition should specify exactly what patent, copyright, trademark, or trade secret is included in the valuation subject. This definition may include the registration number and country for an individual patent, copyright, or trademark (if registered). And this definition will typically describe any other intangible property that are included in the intellectual property valuation.
The second element in the valuation is a description of the bundle of legal rights included in the analysis. For example, the description of the bundle of intellectual property rights will typically indicate which one of the following bundles is included in the valuation:
- Fee simple interest
- Term/reversion interest
- Licensor/licensee interest
- Sublicensee interest
- Territory (domestic/international) interest
- Product line/industry interest
- Life/residual interest
- Use rights
- Development rights
- Commercialization/exploitation rights
The third element of the valuation typically describes any contract or license terms in effect regarding the intellectual property. If the intellectual property is subject to either an inbound or an outbound license, the analyst typically summarizes the following licensor/licensee responsibilities and license/contract terms:
- Identity of the licensor and the licensee
- Term of the license agreement (including any renewal options)
- The intellectual property legal protection requirements
- The dollar amount and responsibility for research and development expenditures
- The dollar amount and responsibility for marketing, advertising, or other promotional expenditures
- Each partyâs responsibility to obtain and maintain any licenses, permits, or other regulatory approvals
- Any milestone dates for regulatory approvals, commercialization events, sales levels, etc.
- Any contractual minimum use, production, or sales requirements
- Any contractual minimum marketing, promotion, or commercialization expense requirements
- The responsibility for any research and development technology development payments, development completion payments, etc.
- Each partyâs responsibility to obtain the required regulatory approvals
- Any milestone license payments made for any reason
- Each partyâs rights to any future intellectual property developments
- Each partyâs rights to sublicense the taxpayer intellectual property
The fourth element of the valuation is the standard (or definition) of value that the analyst is asked to conclude. For valuations developed for various purposes, the following standards of value may apply:
- Fair value
- Fair market value
- Use value
- User value
- Owner value
- Investment value
- Acquisition value
- Collateral value
For valuations performed for various taxation purposes, the appropriate standard of value is typically determined by statutory authority, judicial precedent, or administrative rulings.
The fifth element of the valuation is the premise of value that the analyst applies. For taxation various purposes, the premise of value is often determined by statutory authority, judicial precedent, or administrative ruling. For valuations developed for other purposes, the appropriate standard of value may be selected based on the analystâs highest and best use analysis of the intellectual property. The intellectual property premises of value include the following:
- Value in continued use
- Value in place (but not in use)
- Value in exchangeâor an orderly disposition basis
- Value in exchangeâon a voluntary liquidation basis
- Value in exchangeâas an involuntary liquidation basis
Purpose of the Intellectual Property Valuation
The purpose of the intellectual property valuation considers the following questions:
- What will the valuation be used for?
- Who will rely on (or receive a copy of) the valuation?
- What form and format of valuation report is required?
- Are there any legal instructions (e.g., specific statutory definitions, judicial precedent, or reporting requirements) that the analyst should consider?
In a valuation developed for taxation purposes, the answers to the questions should be agreed to between the analyst and the taxpayer (or tax counsel). Particularly for taxation purposes, the answers to these questions may come in the form of instructions or directions from the taxpayerâs legal counsel.
Data Gathering and Due Diligence
For virtually all purposes, the analyst typically gathers and analyzes information related to the owner/operator. Such owner/operator information typically includes the following:
- Owner/operator historical and prospective financial statements
- Owner/operator historical and prospective intellectual property development/maintenance costs
- Owner/operator current and expected resource/capacity constraints
In this stage of the valuation, the analyst typically documents a description and estimate of the intellectual property economic benefits to the owner/operator. Such economic benefits may include the following:
- Any revenue increase associated with the intellectual property (e.g., related product unit price/volume, market size/position)
- Any expense decrease associated with the intellectual property (e.g., expense related to product returns, COGS, SGA, R&D)
- Any investment decrease associated with the intellectual property (e.g., inventory, capital expenditures)
- Any business risk decrease associated with the intellectual property (existence of intellectual property licenses/contracts, decrease of cost of capital components)
- An assessment of the intellectual property impact on the owner/operatorâs strategic position: strengths, weaknesses, opportunities, and threats (SWOT)
The analyst may also consider the intellectual propertyâs market potential outside of the owner/operator. In this assessment of market potential, the analyst may consider the following factors:
- Change in the market definition or in the market size for an alternative owner/user
- Change in alternative/competitive uses to an alternative owner/user
- The subject intellectual propertyâs ability to create inbound/outbound license opportunities to an alternative owner/user
- Whether the owner can (1) operate the intellectual property and also (2) outbound license the intellectual property (in different products, different markets, different territories, etc.)
Review of Financial Projections
As part of the valuation, the analyst often receives financial projections related to the owner/operatorâs business operations. These financial projections may relate to the following levels within the owner/operatorâs business enterprise:
- The total company
- The business unit that operates the intellectual property
- The intellectual property only.
As part of the valuation, the analyst may review and challenge:
- any owner-prepared financial projections and
- any owner-prepared measures of intellectual property economic benefits.
In this due diligence of the owner-prepared financial projections, the analyst may perform the following benchmark analyses:
- Compare any prior projections to prior actual results of operations
- Compare any projections to current capacity constraints
- Compare any projections to the current total market size
- Consider published industry average CPM profitability metric data
- Consider guideline publicly traded company CPM profitability metric data
- Consider the quality and quantity of available inbound or outbound license data
- Develop an intellectual property useful economic life (UEL) analysis, with consideration of the following:
- Legal/statutory life
- Contract/license life
- Technology obsolescence life
- Economic obsolescence life
- Lives of any prior generations of the intellectual property
- Position of the intellectual property in its life cycle
As part of the due diligence of the owner/operatorâs financial and operational dataâand particularly of the financial projectionsâthe analyst often considers industry data sources. These industry data sources may be used as benchmarks to test the reasonableness of owner-projected profit margins and other financial metrics. Some of the industry data sources that analysts typically use for such comparative benchmark analyses are listed in Exhibit 1.
Exhibit 1: Due Diligence Benchmark Analyses | Intellectual Property Valuations | Typical Industry Data Sources
- Occupational Safety & Health AdministrationâThe U.S. Department of Labor, Occupational Safety & Health Administration website provides Standard Industrial Classification (SIC) codes. Codes can be searched by keyword, or the SIC code âtreeâ can be viewed and browsed. This resource is available at https://www.osha.gov/pls/imis/sicsearch.html.
- S. Census BureauâThe U.S. Census Bureau North American Industry Classification System (NAICS) website provides a searchable database of NAICS codes. NAICS codes are a more recent classification system than SIC codes. Therefore, they can be better for newer industries, such as some highâtech industries. More information is available at https://www.census.gov/eos/www/naics/.
- FirstResearchâFirstResearch is an industry research database that was developed to provide information for sales people. It provides an overview, valuation pricing multiples, growth rates, and information on how to analyze a company in a particular industry. Information is updated regularly. It is available from several different sources, including Business Valuation Resources, www.bvresources.com.
- IBISWorldâIBISWorld is one of the largest independent publishers of U.S. industry research. Research includes information on major companies in the industry, growth rates, key financial data, and outlook for the industries. The research covers approximately 700 different market segments. Some international reports are also available. Information is updated quarterly for some industries and less frequently for other industries. IBISWorld is available at www.ibisworld.com and also through other database aggregators.
- CFRA Industry SurveysâCFRA Industry Surveys (formerly S&P Industry Surveys) are available on approximately 50 industry sectors. The reports provide global industry information as well as information on U.S. industries. Major companies are discussed, and detailed information on the recent past and the outlook for the future are provided. A glossary of specialized terms is provided. Also, comparable financial information on major companies in the industry is provided. The information is updated twice a year. These surveys are available from CFRA MarketScope Advisor, www.advisor.marketscope.com.
- ABI/InformâArticles from U.S. and international general interest and trade publications may be searched. This database is available at most libraries and through database aggregators.
- Bloomberg IndustriesâThis component of the Bloomberg database provides industry data, interactive charting, and written analysis from a team of industry experts. Contact information for each industry expert is provided so that an analyst can follow up with questions if needed. More information is available at www.bloomberg.com/professional/.
- comâThis database provides access to industry and market research reports from many different sources. It provides information on products, trends, regions, demographics, industries, and companies from its collection of over 700 research publishers. More information is available at www.marketresearch.com.
- S&P Capital IQâThis database provides access to analyst research as well as some market research reports. Capital IQ uses S&P industry classifications. These classifications can be helpful in grouping companies in comparable industries. In addition, comparative ratio information is available. More information is available at www.capitaliq.com.
- Thomson ONE/EikonâThis database provides access to analyst research and market research reports. More information is available at www.thomsonreuters.com.
- FactSetâFactSet also provides access to market research reports as well as analyst reports. The FactSet database is available at https://www.factset.com.
- WestlawâArticles from U.S. and international general interest and trade publications may be searched. Westlaw also provides access to the Investext analyst research database. More information is available at www.westlaw.com.
- Annual Statement Studies: Financial Ratio Benchmarks and eStatement Studies, The Risk Management AssociationâBoth the book and the online database contain financial statement ratios and commonâsize balance sheet and income statement line items, arrayed by asset and sales size. Six different asset and sales size categories are presented. The book and database cover over 700 industries, sorted by NAICS codes. The book is issued annually. More information is available at www.rmahq.org and through BVDataWorld.
- Duff & Phelps Cost of Capital NavigatorâThis is an online platform that guides analysts through the process of developing global cost of capital estimates. The Cost of Capital Navigator provides users with multiple alternative models and corresponding required inputs as they use their professional judgement in developing their own estimates. Equity risk premiums (historical, supply-side, and Duff & Phelps recommended), industry risk premiums, full information betas, and size premiums are available in this platform. In addition, industry profiles are available by GICS code. These profiles provide various financial ratios, capital structure, industry betas, and other industry-specific information.
- IRS Corporate Ratios, Schonfeld & Associates, Inc.âThis book includes 76 financial ratios that are based on the most recently available income statement and balance sheet data compiled by the IRS. The data focuses on the comparison of financial ratios for companies with and without net income. The contrast between profitable and unprofitable companies highlights which ratios are critical in the achievement of financial success. The book is issued annually. More information is available at www.saibooks.com. The data from this book are also available in database form through BVDataWorld.
In addition to industry data sources, analysts may consider financial and operational data related to guideline public companies that operate in the same industry as the owner/operator. The analyst may use these guideline company data as benchmarks to test the reasonableness of owner-prepared profit margins and other financial metrics. Some of the guideline company data sources that analysts typically use for such comparative benchmark analyses are summarized in Exhibit 2.
Exhibit 2: Intellectual Property Valuations | Due Diligence Benchmark Analyses | Guideline Company Data Sources
- BloombergâBloomberg is a fully searchable online database that provides financial information on nearly all (over 99 percent of total market capitalization) active and inactive U.S. publicly traded companies and active and inactive international companies. Companies may be searched by industry sectors or by SIC codes. Detailed financial information is available and updated frequently. More information is available at www.bloomberg.com/professional/.
- MergentOnlineâMergentOnline is a fully searchable online database that provides financial information on over 25,000 active and inactive U.S. publicly traded companies and 95 percent of non-U.S. publicly traded companies. Companies are listed by SIC codes and by NAICS codes. More information is available at www.mergentonline.com.
- S&P Capital IQâS&P Capital IQ contains detailed information on approximately 62,000 publicly traded companies (both domestic and foreign), approximately 47,000 of which are active. The information is derived from documents filed with the Securities and Exchange Commission (SEC) and similar global stock regulators (as well as proprietary research). The database may be searched by SIC code or by Standard & Poorâs industry classifications. The information is updated frequently. More information is available at www.capitaliq.com.
- Refinitiv WorkspaceâRefinitiv (formerly Thomson ONE and Thomson Eikon) is a fully searchable online database that provides financial information on approximately 77,000 public companies (54,000 of which are active). Companies may be searched by Global Industry Classification Standard (GICS) codes or SIC codes. Detailed financial information is available. The information is updated frequently. More information is available at www.refinitiv.com.
- FactSetâFactSet is an online database that can be screened by numerous criteria, including industry; business description; financial data such as revenue, earnings, or assets; geographic location; closing price; and other criteria. The database contains information on over 75,000 companies worldwide. Over 2,000 unique financial data items are provided. More information is available at www.factset.com.
The various industry financial research and guideline publicly traded companies databases may be useful to analysts looking for industry profit margins and other financial metrics. For purposes of intellectual property valuations, analysts should be aware that all of these databases have certain application strengths and weaknesses. Several of the application strengths regarding the use of industry and guideline company databases are summarized in Exhibit 3.
Exhibit 3: Intellectual Property Valuations | Industry and Guideline Company Research Databases | Application Strengths
First, these guideline publicly traded company and industry financial research databases are generally organized and searchable by industry classification. This organizational structure allows the analyst to identify financial data that may be relevant to the owner/operatorâs intellectual property.
Second, many of these databases have relevant benchmarks and financial data already compiled and presented in a useful format. This format allows the analyst to efficiently identify, select, and utilize relevant industry data.
Third, these databases generally present numerous financial benchmarks (gross profit margin, pretax profit margin, liquidity ratios, etc.). The variety of the available data allows the analyst to select the financial data that are most relevant to the owner/operatorâs intellectual property.
Fourth, many of these databases allow the analyst to narrow search parameters to identify financial data only from companies of a specific size (based on asset size, revenue size, market capitalization size, etc.). This size feature may be useful to analysts as many financial benchmarks such as profitability may be affected by either economy of scale or diseconomy of scale.
Several of the application weaknesses regarding the use of industry and guideline company databases are summarized in Exhibit 4.
Exhibit 4: Intellectual Property Valuations | Industry and Guideline Company Databases | Application Weaknesses
First, the identification of the individual companies that are included in each industry may not be available.
Second, the analyst may not have access to the underlying financial data that are used to calculate the industry benchmarks. And, these data may include outlier observations, adjusted data, or other data anomalies that are not meaningful.
Third, some of the companies listed in each industry category may be incorrectly categorized.
Fourth, the owner/operator may not be sufficiently similar to any of the industries that are included in the database.
Fifth, there is often a time lag in the aggregation of the data presented in some of these data sources. Therefore, the data presented in the databases may be a few years old.
The second of this five-part series summarized the typical elements of the intellectual property valuation analysis. This part of the discussion focused on benchmarking and the use of research databases.
Part three summarizes the application of the RFR method.
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.