Intellectual Property Valuations

Analysts Caveats and Reporting Guidelines (Part V of V)

This fifth and final installment presents valuation analyst caveats and reporting best practices related to the intellectual property valuation.

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

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

Intellectual Property Valuations: Application of the Relief from Royalty Method (Part III of V)

Intellectual Property Valuations: Illustrative Example of the Relief from Royalty Method (Part IV of V)

 

Introduction

The first four installments of this five-part discussion summarized the conceptual support for—and the practical application of—the relief from royalty (RFR) method of intellectual property valuation.

This fifth and final installment presents valuation analyst caveats and reporting best practices related to the intellectual property valuation.

Intellectual Property Valuation Analyst Caveats

There are several caveats that analysts should consider with regard to the application of the RFR method to value intellectual property.

First, it is a best practice for the analyst to use several intellectual property license databases, if possible. Of course, there is a cost to using multiple databases. However, the use of several databases typically results in a more comprehensive sample of CUT license agreements.

Second, it is important for the analyst to understand what intellectual property is included in the valuation subject, what owner/operator industry is included in the valuation subject, and what bundle of intellectual property legal rights is included in the valuation subject.

Third, it is a best practice for the analyst to print and read each individual license agreement that may provide empirical royalty rate data.

Fourth, it is also a best practice for the analyst to examine each selected license agreement for terms and conditions that may justify the elimination, adjustment, or assessment of—or the analyst’s reliance on—the market-derived license royalty rate data.

Fifth, the analyst should be aware that the commercial license databases may include documents other than arm’s-length intellectual property license agreements. For example, these commercial databases may also include the following types of transactional documents related to intellectual property:

• Business acquisition asset purchase agreements
• Intangible property intercompany transfer price agreements
• Product sale, manufacturing, or distribution agreements
• Joint venture, collaboration, development, etc., agreements

Sixth, the analyst should be aware that there are various types of license royalty compensation formula that are not particularly useful to an RFR method royalty rate analysis. That is, these royalty formula present compensation methods other than a royalty expressed as a percent of licensee revenue. Examples of these other license compensation formula include the following:

• A dollar amount per unit sold or produced
• A dollar amount per time period
• Equity (stock shares) as a license payment
• A percentage of licensee gross profit or net profit

Seventh, the analyst should be prepared to eliminate, adjust, and assess the market-derived license royalty rate data in order to extract the most meaningful intellectual property pricing metrics. Intellectual property valuation analysts should be comfortable with this generally accepted valuation procedure. For example, real estate appraisers regularly eliminate, adjust, and assess empirical sales data when developing real estate appraisals. And business valuation analysts regularly eliminate, adjust, and assess guideline company pricing multiple data when developing market approach business valuations. Therefore, the procedure to eliminate, adjust, and assess empirical royalty rate data should be a well-used tool in the intellectual property valuation analyst’s toolbox.

The Effective Intellectual Property Valuation Report

In addition to developing the intellectual property valuation analysis, the analyst typically has to prepare a narrative valuation report. In order to encourage the intellectual property valuation report reader’s acceptance, the effective report should be:

• Clear, convincing, and cogent;
• Well organized, well written, and well presented;
• Free of grammar, punctuation, spelling, and mathematical errors; and
• Procedurally and mathematically replicable, without the use of any unexplained or unsourced valuation variables.

With regard to an intellectual property valuation report prepared for just about any purpose, the persuasive report should tell a narrative story that:

• Defines the analyst’s assignment;
• Describes the analyst’s data gathering and due diligence procedures;
• Justifies the analyst’s selection of (and rejection of) the generally accepted intangible asset valuation approaches, methods, and procedures;
• Explains how the analyst developed the valuation reconciliation and synthesis and how the analyst reached the final valuation conclusion;
• Defends the analyst’s intellectual property value conclusion; and
• Describes all of the data sources that the analyst relied on in the valuation (and includes copies of nonpublic source documents).

Particularly with regard to an intellectual property valuation report prepared for controversy purposes, an effective report will avoid these errors:

• Failure to apply the defined standard of value
• Failure to apply the defined premise of value
• Analytical internal inconsistencies
• Arithmetic errors in the intellectual property valuation analysis
• Insufficient support for the selected valuation variables
• Reliance on industry or other rules of thumb
• Insufficient data and inadequate market research
• Inadequate due diligence procedures

Expert reports prepared for controversy purposes should be comprehensive. Typically, all the analyst’s valuation procedures and thought processes will be documented in the expert report. Analysts who prepare valuation analyses in controversy matters may be familiar with this expert report guidance: “if it’s not in your report, you didn’t do it.”

Summary and Conclusion

Analysts understand that there is a lot of “noise” included in the license database royalty rate raw data. Nonetheless, analysts can effectively use these empirical royalty rate data to develop intellectual property valuations transaction, taxation, litigation, accounting, and other purposes.

Analysts often use the “eliminate, adjust, and assess” procedures summarized in this discussion to reach a reasonable range of royalty rates—and a final, supportable intellectual property royalty rate conclusion. However, analysts should not use the so-called “Goldilocks” procedure. That is, analysts should not:

1. Select a predetermined intellectual property royalty rate that is “just right” for the subject valuation and then
2. Eliminate, adjust, and assess the empirical data to justify the predetermined “just right” intellectual property royalty rate.

There are many reasons to value an owner/operator’s intellectual property. There are generally accepted approaches, methods, and procedures regarding the valuation of intellectual property. Analysts and owner/operators should be familiar with these generally accepted valuation approaches and methods. For many types of intellectual property, the market approach is a particularly applicable valuation approach.

This five-part discussion focused on the application of the market approach and the RFR method to value intellectual property. In applying the RFR method, analysts typically access various commercial databases. These databases are used to extract market-derived royalty rate from the arm’s-length licenses of intellectual property assets that are sufficiently similar to the owner/operator’s intellectual property. These arm’s-length intellectual property licenses are frequently referred to as comparable uncontrolled transactions—or CUTs.

This five-part discussion presented an illustrative example of the application of the RFR method to value intellectual property. This example considered the analyst’s valuation of the hypothetical Beta patent-related intellectual property for the Alpha Pharmaceutical Company.

Particularly regarding intellectual property valuations prepared for controversy purposes, the analyst should be prepared to explain all selections, rejections, or adjustments of available license royalty rate data. If the license market for the owner/operator’s intellectual property is efficient, then the analyst should be able to modulate the noise in the license royalty rate data—and be able to reach a reasonable range of royalty rates and a supportable intellectual property value conclusion.

The opinions and materials contained herein do not necessarily reflect the opinions and beliefs of the author’s employer. In making this presentation, neither the presenter nor Willamette Management Associates is undertaking to provide any legal, accounting, or tax advice in connection with this presentation. Any party receiving this presentation must rely on its own legal counsel, accountants, and other similar expert advisors for legal, accounting, tax, and other similar advice relating to the subject matter of this presentation.

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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.