IP valuation methods for SMEs

THE value of Intellectual Property depends on the expected future cash flow to be derived from the use or exploitation of that Intellectual Property, either immediately (for example, through sale) or over a period of time (e.g. through exploitation).

The cash-flow stems from the volume of the product sold and the margin made on that product. The key to valuing Intellectual Property is determining the incremental value or cost contributed by the Intellectual Property to each of the components of the overall value, over and above the situation without the particular intellectual property.

This incremental contribution will differ markedly depending on the Intellectual Property under consideration.

Severa l methodologies exist for applying the above framework to the valuation of Intellectual Property.

The valuer must choose from the alternative methodologies, based on the conceptual superiority of the methodology and the availability of adequate information, the latter often being a limiting factor.

The three main Intellectual Property valuation approaches are: The cost based Approach. The market value Approach; and The income based Approach. Cost Method Approach The cost approach seeks an indication of asset value by estimating the cost of reproduction or cost of replacement of the asset, less an allowance for loss in value due to physical, functional, and economic causes.

Cost method is based on the intention of establishing the value of an IP asset by calculating the cost of developing a similar (or exact) IP asset either internally or externally.

It seeks to determine the value of an IP asset at a particular point of time by aggregating the direct expenditures and opportunity costs involved in its development and considering obsolescence of an IP asset.

The cost method is generally the least used method as, in most cases, it is considered suitable only as a supplement to the income method (if the valuation is not for bookkeeping purposes).

The method is normally used in situations where the subject IP is currently not generating any income. Advantages of the Cost Method Approach Cost method is a useful method when:

Subject IP assets can be easily reproduced, for example, software — the income stream or other economic benefits associated with the asset being valued cannot be reasonably and/or accurately quantified.

There is no economic activity to review, such as early-stage technology that is not yet producing revenue.

There is no direct cash flow being generated from use of the subject IP assets.

Disadvantages Cost method does not account for wasted costs — often vast amounts sums spent on research and development result in no benefit.

It does not consider the unique and novel characteristics of IP. Therefore, it usually does not incorporate the expected economic benefits or the income generating potential of the IP asset.

It does not take into account the factors of risk and uncertainty associated with realizing the economic benefits associated with the IP asset.

The duration over which the economic benefits will be enjoyed is yet another element not considered in this method, as the Remaining Economic or Useful Life (RUL) of the IP is a vital component in valuation.

The Market Method Approach This method is based on comparison with the actual price paid for a similar IP asset under comparable circumstances. To do a valuation with this method, an SME needs to have: An active market (price information) An exchange of an identical IP asset, or a group of comparable or similar IP assets

If the IP assets are not perfectly comparable, variables to control for the differences

This method is much more likely to reflect market perceptions and moods than a valuation based on the income method. Advantages of the Market Method

Approach Simplicity Use of market based information. Can be very useful if exact comparables are available (e.g., license agreements related to the same technology).

Favored by tax authorities for deals with affiliates. Best for deriving inputs for the Income method.

Disadvantages By definition, an IP asset is unique. It is not possible to find an exactly alike or even a similar or comparable IP asset.

Even if that were possible, it is generally not possible to have readily available information, which could be used for valuing the subject IP asset.

Market method ends up comparing the general information available in the market; it is unable to consider specific factors leading to a specific transaction.

Income Method Approach The income method values the IP asset on the basis of the amount of economic income that the IP asset is expected to generate, adjusted to its present day value.

This method is the most commonly used method for IP valuation. How to determine economic income:

a. Project the revenue flow (or cost savings) generated by the IP asset over the remaining useful life(RUL) of the asset.

b. Offset those revenues/savings by costs related directly to the IP asset. Costs: labor, and materials, required capital investment, and any appropriate economic rents or capital charges

c. Take account of the risk to discount the amount of income to a present day value by using the discount rate or the capitalisation rate Different measures of economic income may be relevant to the various income methods.

Given the different measures of economic income that may be used in the income approach, an essential element in the application of the income method is to ensure that the discount rate or the capitalisation rate used is derived on a basis consistent with the measure of economic income used.

e various income methods may be grouped into the following two analytical categories:

Direct Capitalisation The valuer estimates the appropriate measure of economic income for one period (i.e., one period future to the valuation date) and divides that measure by an appropriate investment rate of return (Capitalisation rate).

The capitalisation rate may be derived for a perpetual period of time or a specified finite period of time, depending upon the valuer’s expectations of the duration of the economic income stream.

Discounted cash flow (DCF) (Discounted future economic benefits) The valuer projects the appropriate measure of economic income (cash flows) for several discrete time periods into the future.

This projection of prospective economic income (cash flows) is converted into a present value by the use of a present value discount rate.

The present value discount rate is the investor’s required rate of return over the expected term of the economic income projection period. Advantages of the Income Method,

especially DCF The DCF method is easiest to use for IP assets whose Ash flows are currently positive, and Can be estimated with some reliability for future periods, and

Where a proxy for risk that can be used to obtain discount rates is available.

It best captures the value of IP assets that generate relatively stable or predictable cash flows.

It forces you to think about the underlying characteristics of the firm, and understand its business. If nothing else, it brings you face to face with the assumptions you are making when you pay a given price for an asset.

Disadvantages The DCF method does not explicitly account for the total riskiness of these cash flows but only for the systematic component of that risk in the form of market determined discount rate.

It assumes that the investment in the IP asset is irreversible, irrespective of the circumstances in the future.

The method does not accommodate the option like nature of certain corporate investments and ignores managerial flexibility. It does not capture the unique independent risks associated with an IP.