Intellectual Property Valuations

Application of the Relief from Royalty Method (Part III of V)

This is the third article of a five-part series on valuation of intellectual property describing the application of the RFR method.

Intellectual Property Valuations: The Relief from Royalty Method (Part I of V)

Intellectual Property Valuations: Elements of the Valuation Analysis (Part II of V)

Introduction

This five-part discussion focuses on the market approach and the relief from royalty (RFR) method of intellectual property valuation. Prior parts of this series summarized the many reasons to develop the intellectual property valuation and the research and due diligence procedures conducted as part of the valuation analysis.

This third of the five-part series describes the application of the RFR method.

Relief from Royalty Valuation Method

The RFR method is one of the market approach methods that analysts apply to value intellectual property for various purposes. The RFR method is based on a foundational assumption. The foundational assumption is that if the owner/operator did not own its intellectual property, it would have to inbound license that intellectual property from a third-party licensor.

An important procedure in the RFR method is the estimate of the amount of a license royalty rate the owner/operator would have to pay to inbound license the intellectual property from the third-party licensor.

Of course, the owner/operator does own its intellectual property. So, the owner/operator is “relieved” from having to pay a royalty payment related to such a hypothetical inbound license. Because the owner/operator owns its intellectual property, it experiences a “relief from royalty.”

Of course, the analyst must select a subject-specific royalty rate. That royalty rate is used to quantify the amount of license royalty expense the owner/operator is “relieved” from paying.

In the application of the RFR valuation method, analysts typically consider two types of arm’s-length license agreement royalty rate data:

• The actual license compensation data (i.e., the raw royalty data)
• Royalty compensation normalization adjustment data

First, analysts select and assess base (or raw) royalty rate data. The base royalty rate is the contractual compensation specified in the selected arm’s-length intellectual property license agreement. These base rate data include the “noise” of the actual royalty license consideration arrangements.

Second, the royalty adjustment data are the license-specific terms needed to “normalize” the actual CUT royalty arrangements—to make these CUT license data more comparable to the hypothetical license of the intellectual property. So, to identify and extract the normalization adjustment data, analysts need to read each of the selected CUT license agreements.

License-Specific “Noise” May Be Encountered in the CUT Data

In applying the RFR method, analysts often deal with extraneous and unusable transactional data in their search for arm’s-length CUT license agreements. These CUT license agreements are used to extract the market-derived, empirical royalty rate data needed to perform the RFR method. These normalization adjustments typically reduce the “noise” in what appears to be a wide range of aberrational and unrelated license royalty rate data.

Analysts should thoroughly review the third-party license agreements that are selected for consideration in the RFR method. The purpose of this review is to identify any terms and conditions that may need to be normalized to make that CUT license agreement more useful to the RFR valuation analysis. Some of the license agreement normalization adjustments that analysts may look for include the following:

• Upfront fixed payments
• Milestone fixed payments
• Minimum/maximum fixed payments
• Litigation settlements or judicial orders
• Intercompany intellectual property transfers
• Equity transfers as part of the intellectual property license
• Unusually short or long license term periods
• An intellectual property sale transaction that is not a license
• A license royalty rate that is not expressed as a percent of licensee revenue
• A license royalty rate based on licensee sublicense income
• Multiple intellectual property assets included in the single license
• Product sale/distribution agreements
• Treatment of main/complementary products
• Relations of the intellectual property license to supplier, production, or other agreements

Other Factors That May Affect License Royalty Rates

In addition to the license-specific “noise” terms that may need to be normalized in the selected CUT agreements, analysts may consider industry and other general factors that affect license royalty rate levels. Analysts may consider these general factors that affect license royalty rates when analyzing the CUT data with respect to the intellectual property:

• State of the economy—at the CUT license inception date versus at the valuation date
• Size of the owner/operator’s industry compared to the CUT industry
• Growth of the owner/operator’s industry compared to the CUT industry
• Profitability of the owner/operator’s industry compared to the CUT industry
• Market position of the owner/operator’s intellectual property compared to the CUT intellectual property
• Market position of the CUT intellectual property in the CUT industry
• Position in the life cycle of the owner/operator’s intellectual property
• Position in the life cycle of the CUT intellectual property

Procedures to Manage the “Noise” in Royalty Rate Data

Analysts often apply one of three procedures to manage the “noise” associated with any anomalous royalty rate data found in the CUT license agreements. These three royalty rate “noise” mitigation procedures follow:

• Eliminate the anomalous royalty rate observations from the selected royalty rate data
• Quantitatively adjust for the impact of the normalization factors
• Qualitatively assess the impact of the normalization factors

In addition to these three procedures, analysts may use central tendency analyses that minimize the impact of any anomalous CUT royalty rate observations:

• Median royalty rate calculation
• Trimmed mean royalty rate calculation
• Interquartile range of license royalty rates

In applying the RFR method, analysts often eliminate from consideration those anomalous royalty rate observations that cannot be normalized or adjusted. In any intellectual property valuation, it is generally inappropriate for analysts to eliminate from consideration any anomalous royalty rate observations just because they fall outside of the typical range of royalty rate observation (i.e., because the aberrational royalty rates are not “Goldilocks” observations).

Royalty Rate Data Sources

There are numerous commercial data sources that analysts may access to find arm’s-length intellectual property license agreement royalty rate data. Some of the commercial license agreement databases are summarized in Exhibit 5. The databases listed in Exhibit 5 are useful to analysts for identifying arm’s-length license agreement royalty rate data. Analysts should be aware that each of these databases has data reliability strengths and weaknesses.

Exhibit 5: Intellectual Property Valuations | Commercial Intellectual Property License Agreement Databases

1. ktMINE—ktMINE is an interactive intellectual property database that provides direct access to license royalty rates, actual license agreements, and detailed agreement summaries. The subscription-based database contains over 125,000 intellectual property license agreements. License agreements are searchable by industry, keyword, and various other parameters. The full text of each intellectual property license agreement is available. The ktMINE is available at www.bvmarketdata.com or at www.ktmine.com.
2. RoyaltySource—AUS Consultants offers a database that provides intellectual property license transaction royalty rates. This database, which is compiled from SEC filings and other sources, can be searched by industry, technology, and/or keyword. The information provided includes the license royalty rates, name of the licensee and the licensor, a description of the intellectual property licensed (or sold, if applicable), the transaction terms, and the original sources of the information provided. Preliminary results are available online, and a final report is sent to the subscriber via e-mail. A subscription is not necessary. Analysts can pay per search. RoyaltySource is available at www.royaltysource.com.
3. RoyaltyRange—The RoyaltyRange database consists of manually gathered and analyzed data. RoyaltyRange reports contain more than 50 detailed standardized comparability factors on royalty rates and license terms. Each report is supplemented with original unredacted agreements, as well as filings and other types of documents. The RoyaltyRange database focuses on European transactions, but also contains some U.S. transactions. It excludes agreements between related parties, agreements with undisclosed remuneration mechanisms, royalty‐free agreements, agreements where royalties are expressed in other forms than percentage, and agreements with individuals, universities, and other noncommercial entities. The RoyaltyRange database is available at www.royaltyrange.com.
4. RoyaltyStat—RoyaltyStat is a subscription‐based database of intellectual property license royalty rates and license agreements, compiled from SEC documents. It is searchable by SIC code or by full text. The intellectual property transaction database is updated daily. The full text of each intellectual property license agreement in the database is available. RoyaltyStat is available at www.royaltystat.com.
5. IntangibleSpring—IntangibleSpring is a subscription‐based database of royalty rates sourced from license agreements filed with the SEC. Using a combination of text mining, natural language processing, and manual review, this database identifies and extracts complete license agreements from filings with the SEC. This database excludes agreements with incomplete pricing data. IntangibleSpring is available at www.intangiblespring.com.
6. Markables—This database is different from the other databases discussed above. Rather than drawing royalty rates from actual license transactions of intellectual property, Markables gathers its data from purchase price allocations published in SEC filings. It has over 12,000 trademark valuations published in the financial reports of publicly traded companies from all over the world. Each record contains trademark value, revenues, reported or implied trademark royalty rates, customer value, enterprise value, trademark profit split, and a detailed description of the business as of the date of the valuation. Markables is available at www.markables.net.

Exhibit 6 presents some of the application strengths with regard to the intellectual property license databases.

Exhibit 6: Intellectual Property Valuations | Intellectual Property License Databases | Application Strengths

First, these databases allow the analyst to access thousands of license agreements. From these extensive collections of license agreements, the analyst may identify license agreements that are relevant to the intellectual property valuation.

Second, the extensive database search criteria allow the analyst to efficiently identify groups of potential license agreements that may be sufficiently similar to the owner/operator’s intellectual property. The analyst can search these databases based on (1) industry (SIC code or other classifications), (2) keyword, (3) time frame, (4) territory (worldwide or specific countries), and (5) a variety of other factors. Analysts may further narrow the search criteria to identify exclusive or nonexclusive licenses. These search criteria allow the analyst to identify a sample of potential license agreements through a relatively efficient, documented process.

Third, a strength of most of the above-mentioned databases is that the analyst may download the actual license agreements from the database. After selecting a sample of potential license agreements, the analyst should carefully review the actual license agreement in order to select royalty rate data that are sufficiently similar to the owner/operator’s intellectual property.

Analysts should be aware that there are also application limitations associated with the use of commercial intellectual license databases. Exhibit 7 presents some of the application weaknesses associated with the license databases.

Exhibit 7: Intellectual Property Valuations | Intellectual Property License Databases | Application Weaknesses

First, there may be numerous duplicate license agreements included in these databases.

Second, there may be multiple updates of the same license agreement in the database (i.e., another type of data duplication).

Third, some “license agreements” may actually be asset purchase agreements or other types of transactional agreements. Not every agreement is an intellectual property use license.

Fourth, some of the license agreements may be between related parties (and, therefore, may not be arm’s-length agreements).

Fifth, some of the license agreements may involve several different types of intellectual property (e.g., a trademark and a patent), making it difficult for the analyst to extract a specific royalty rate for a single intellectual property.

Finally, the royalty consideration formula in the license agreement may be presented in a form that is not particularly useful to the analyst (e.g., a royalty dollar per 1,000 barrels of beer sold—rather than a royalty payment as a percent of licensee revenue).

Analysts should consider all of these data reliability strengths and weaknesses when searching intellectual property license databases to extract royalty rates to use in the RFR method.

Conclusion

This third of this five-part series summarized the application of the RFR valuation method. This discussion focused on the strengths and weaknesses of commercial intellectual property license databases and on how to adjust the CUT data to make that data more meaningful to the intellectual property valuation.

The next part of this series presents an illustrative example of an application of the RFR method.

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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.