Invisible Value

Intellectual Property Valuation Principles—Part 1

This article examines the types of intellectual property analyses, different standards of value that may apply in valuation as well as the alternative types of intellectual property ownership interests and the alternative terms of intellectual property ownership interests.

Introduction

This discussion summarizes the basic principles related to intellectual property valuation. The business appraiser should consider these general principles with regard to each intellectual property valuation. Before conducting the quantitative or qualitative analysis, the appraiser should consider how these principles apply to the intellectual property valuation assignment.

First, this discussion considers the objectives of the various types of intellectual property analyses. Second, it lists the different standards of value that may apply in an intellectual property valuation. These alternative standards of value may be thought of as the different objectives of the valuation. Third, it summarizes the alternative types of intellectual property ownership interests and the alternative terms of intellectual property ownership interests. Fourth, it describes the factors that the business appraiser may consider in the specific identification of intellectual property.

Intellectual property valuations may be performed for transaction, notation, and controversy purposes. These alternative purposes are explained in the following sections. Transactional valuations relate to an article exchange of the property and of cash. Examples include opinions issued with regard to sales or licenses. Notational valuations are performed for accounting, taxation, or regulatory purposes where no exchange of property or cash results from the opinion. Examples include analyses performed for acquisition accounting, intercompany transfer price, or private inurement purposes. Controversy valuations relate to analyses performed within a litigation context. In such cases, judicial finders of fact may order compensation payments, but the property does not change hands. Examples include lost profits and reasonable royalty rate opinions related to breach of contract or tort claims.

Business appraisers may be asked to render various types of valuation-related opinions. These alternative types of opinions are summarized. Finally, this discussion addresses the considerations related to valuations performed for specific purposes. Some of these considerations relate to valuations performed for controversy, financial accounting, federal and state tax compliance, transaction financing, and bankruptcy purposes.

Objectives of Various Intellectual Property Analyses

For purposes of this discussion, intellectual property includes patents, trademarks, copyrights, and trade secrets only. These four types of intangible assets are recognized and protected by specific federal or state statutes.

Business appraisers may be asked to perform various types of analyses regarding general intangible assets or to perform an even greater range of analyses related to intellectual property. The objectives related to the various types of intellectual property analyses include the following:

1. To estimate the intellectual property price between a willing buyer and a willing seller
2. To estimate the highest price that the intellectual property owner/operator could obtain from a specific buyer
3. To estimate the highest price that a specific buyer should be willing to pay for the intellectual property
4. To estimate the value of the intellectual property to the current owner/operator
5. To measure the lost profits experienced by the owner/operator due to an identified damages event
6. To quantify the prospective royalty rate that will make the owner/operator economically “whole” based on the wrongful party’s continued use of the intellectual property
7. To determine the amount of unjust enrichment earned by the damaging party as a result of a wrongful use of the intellectual property
8. To calculate other measures of economic damages to the owner/operator due to an intellectual property damages event
9. To estimate the fair arm’s-length price (ALP) for the intercompany transfer and use of an intellectual property between controlled foreign corporations of a multinational taxpayer
10. To estimate the royalty rate related to the third-party intellectual property license between an independent licensor and an independent licensee
11. To measure the intellectual property remaining useful life (RUL)
12. To opine on the fairness (from a financial perspective) of an intellectual property sale, license, transfer, or financing transaction

The appraiser may be called on to prepare intellectual property valuation, economic damages, transfer price, license royalty rate, RUL, or fairness analyses. There are basic economic principles that underlie each of these types of analyses. The appraiser should understand the objective of the analysis before accepting the client engagement to ensure he or she has the appropriate experience and expertise to perform the proposed engagement. The appraiser’s objective may affect (1) the data gathering and due diligence procedures; (2) the appropriate approaches, methods, and procedures; and (3) the content and format of the engagement work product.

Intellectual Property Alternative Standards of Value

The appraiser may be asked to value the intellectual property under numerous alternative standards (or definitions) of value. The appraiser may conclude many different values for the same intellectual property depending on various factors including the standard of value applied.

The appraiser should understand the applicable standard of value before accepting the valuation engagement and should be instructed about the appropriate standard of value by the client or counsel. Normally, it is not the responsibility of the appraiser to select the applicable assignment standard of value for the client. If the appraiser is not certain of the specific definition of the assignment standard of value, he or she should obtain advice from counsel or other appropriate experts.

The standard of value is not the same as the premise of value. The appraiser can typically apply several different premises of value to the same standard of value assignment. Usually, the client or counsel will instruct the appraiser on the appropriate premise of value (based on the purpose and objective of the analysis).

Alternative Intellectual Property Ownership Interests

The standard of value typically addresses to whom the intangible asset is valuable. The property ownership interest typically addresses what bundle of legal rights is the subject of the analysis. The appraiser needs to understand what bundle of legal rights will be the subject of the valuation, damages, transfer price, or other analysis. This question is probably more important in the analysis of an intellectual property than in the analysis of a general intangible asset. With an intellectual property, it is much more common to disaggregate various bundles of legal rights between, say, the original inventor, the current owner, the current operator, and several licensees.

This discussion lists and defines some of the common alternative ownership interests. These definitions are general in nature. They are not intended to be legal definitions. If needed, the appraiser should consult with counsel to obtain guidance related to these ownership interests.

Common intellectual property ownership interests include the following:

1. Fee simple interest
2. Life interest
3. Term interest
4. Licensor or franchisor interest
5. Licensee or franchisee interest
6. Reversionary interest
7. Development rights
8. Exploitation rights
9. Use rights
10. Other fractional ownership interests

The appraiser should understand the bundle of ownership rights that is the subject of the valuation, damages, or transfer price analysis. The client or counsel should instruct the appraiser on the appropriate bundle of ownership rights to include in the analysis. It is not the responsibility of the appraiser to select the ownership rights to be included in the analysis.

The subject ownership interest can have a significant impact both on the intellectual property analysis and on the appraiser’s conclusion. This is true for valuation, damages, transfer price, and other types of analyses. For example, consider two patent valuations. Both analyses encompass the valuation of a utility patent with a 15-year RUL. The first valuation involves the value of a fee simple interest. The second valuation involves the value of a residual interest at the conclusion of a 10-year license term. Assuming all other valuation variables are the same, the values of the two different ownership interests should be materially different.

Next, consider an economic damage analysis related to the breach of a copyright contract. Both analyses relate to the same copyright on the same software source code for an accounting application. The first copyright use contract includes the exclusive rights to manufacture and sell the copyrighted software in any industry for any application anywhere in the world. The second copyright use contract includes the rights to manufacture and sell the copyrighted software in the commercial banking industry for demand deposit accounting only and in Canada only. Assuming all other analysis variables are the same, the damages estimate related to the first contract breach should be greater than the damages estimate related to the second contract breach.

Finally, consider a transfer price analysis related to the intercompany transfer of a trademark. Both analyses involve the same trademark transferred between the U.S. parent and a German subsidiary. The first transfer allows the trademark to be used on an entire family of current products and to-be-developed new products. These products may be manufactured in Germany and sold throughout the European Union. The second transfer allows the trademark to be used on one current product only. That product must be manufactured in Germany and sold in Germany. Assuming all other ALP variables are the same, the ALP related to the first trademark transfer should be greater than the ALP related to the second trademark transfer.

The appraiser should note that the sum of two or more fractional interests do not always equal the fee simple interest. That is, the fee simple interest can be divided many different ways into fractional (or partial) ownership interests. The sum of the term interest plus the residual interest does not always equal the fee simple interest. The sum of the licensor’s interest and the licensee’s interest does not always equal the fee simple interest. Disaggregating the total bundle of ownership rights into fractional interests can either decrease or increase the intellectual property overall value. The sum of the fractional interests will equal the fee simple interest only when the ownership interest disaggregation will not increase or decrease both the expected income from the various fractional interests and the investment risk related to the various fractional interests.

Alternative Terms of the Intellectual Property Ownership

Particularly with regard to a fractional ownership interest, the appraiser should consider the term (or the duration) of that ownership interest. For example, whether related to a term interest, a license interest, a use interest, or other interest, it makes a difference whether the remaining term of that ownership interest is five years, 10 years, or 20 years. The consideration of the remaining term of the ownership interest is typically not an issue with respect to the general intangible asset valuation. Often, the appraiser will value the intangible asset fee simple ownership interest. This is because intangible asset owner/operators do not usually disaggregate fractional interests. By contrast, intellectual property owner/operators typically do disaggregate fractional interests.

The remaining term of the subject ownership interest is not necessarily the same as the RUL. The remaining term of the subject ownership interest (other than the fee simple interest) is usually less than the intellectual property RUL. The remaining term of the ownership agreement is typically a function of a contract, license, or agreement. Such a contract term is generally less than the expected RUL.

Accordingly, the appraiser should estimate the ownership interest value, damages, or transfer price for the remaining term of the ownership interest. For example, let’s consider a valuation assignment in which the subject of the analysis is a patent income interest with a nine-year commercialization agreement contract term. Assume that the patent has a 15-year RUL. If the appraiser estimates the patent income interest value, damages, or transfer price for the entire 15-year RUL (instead of over the nine-year contract term), then the appraiser will reach an erroneous analysis conclusion.

Whether the term of the ownership interest is a function of a contract, a license, a life interest, or another agreement, the correct consideration of that term interest will likely affect the value, damages, or transfer price of that interest. With regard to valuation, the appraiser will typically consider only the operating income or the license income during the remaining term of the ownership interest. The intellectual property may have a residual or reversionary value after the ownership interest term, but that value will usually not be included in the subject ownership interest valuation.

Likewise, the appraiser will usually consider only the breach of contract damages or tort damages over the ownership interest remaining term. The intellectual property may experience damages beyond the ownership interest period. Those damages are generally not included in the analysis of the subject ownership interest (unless an extension of the term would be reasonably expected). Similarly, the transfer price (or ALP) will probably be different if the ownership interest term is five years, 10 years, or 20 years. This is because market-derived comparable uncontrolled transaction (CUT) royalty rates, profit split percentages, residual profit margins, and so on would all likely be different if they relate to a short-term license agreement instead of a long-term license agreement.

The sum of all of the ownership interest values may not necessarily equal the fee simple (or total life) value for the intellectual property. Let’s assume the Zeta intellectual property has a 20-year total RUL. However, the assignment is to value a 10-year term ownership interest and a second, follow-on, 10-year term ownership interest. The sum of the two value indications may not equal the fee simple (20-year life) value for Zeta. This is because the investment risk and expected return on a 10-year life ownership contract (or on two such contracts) is typically not the same investment risk and expected return to the fee owner as a 20-year term.

Identification of Intellectual Property

The identification should be sufficient to ensure that there is no misunderstanding about which intellectual property is included in (or excluded from) the analysis. The identification should also be sufficient to identify the bundle of rights included in (or excluded from) the analysis.

For a patent, the description typically includes the registration number, the registration jurisdiction, the date of the patent grant, and a summary narrative description of what the patent covers. If the analysis includes any other intangible assets (for example, engineering drawings, laboratory notebooks, or unpatented technology), these intangible assets should also be identified and described.

For trademarks, the description typically includes the registration number, the registration jurisdiction, the date of the trademark grant, and a depiction of the actual trademark. To the extent that the analysis includes trade names, trade dress, or other intangible assets, these intangible assets should also be identified and described.

For a registered copyright, the description usually includes the registration information, including the date of registration. For an unregistered copyright, the identification typically includes a description of the copyright materials, the name of the author, and the date of the copyright. The description should be adequate to identify the copyright work (play, musical composition, manuscript, and so on). The copyright covers the specific expression of an idea. If the analysis includes the intangible asset to which the copyright applies (for example, computer software source code or training and procedures manuals), then these intangible assets should also be identified and described.

It is often difficult to adequately describe a trade secret. This is because the owner/operator desires the trade secret to remain secret. Even under a strict, “highly confidential” agreement, the appraiser may identify the trade secret database, documentation, manuals and procedures, product or process drawings, production reports, cost information, and so forth without actually revealing the confidential information. Usually, the appraiser can describe the format of the trade secret, the function of the trade secret, and the date on which the trade secret was created. If the analysis includes any general intangible assets (like know-how and non-proprietary information), these intangible assets should also be identified and described.

The noted identification procedures are common with regard to a valuation, damages, or transfer price analysis. If the analysis relates to a general intangible asset only, the identification and description procedures are typically more relaxed. This should not imply that it is not important to adequately identify a general intangible asset, but most intangible assets do not have the same identifying characteristics (like registration numbers, author or inventor, date of creation, and the like) that most intellectual property has. Therefore, the identification of most intangible assets is less rigorous than the identification of most intellectual property for practical reasons.

This article first appeared in the Third Quarter 2013 of Business Appraisal Practice.

Robert F. Reilly, CFA, ASA, CPA, CBA, is a managing director in the Chicago office of Willamette Management Associates, a valuation consulting, economic analysis, and financial advisory services firm. Mr. Reilly can be reached at rfreilly@willamette.com.