Valuing intellectual property – the basics explained.
Intellectual property (“IP”) has been defined as “rights which are legally recognised exclusive rights to creations of the mind” and covers a broad range of intangible asset categories including but not limited to ideas protected by patent or copyright, royalty entitlements, software and trademarks.
There are three fundamental approaches when valuing IP:
- The cost approach
- The income approach; and
- The market approach
The cost approach is based upon the accumulation of the costs incurred in acquiring the IP and promoting it. This approach is usually the least applicable because the cost of developing the IP bears no relationship to its income producing ability although it is the easiest to apply.
The income approach seeks to measure the economic benefit of the IP to be generated from a future earnings stream. It utilises discounted cash flow techniques to calculate the net present value of this earnings stream applying an appropriate discount rate which would reflect the degree of risk inherent in the IP. One application of this approach attempts to isolate the premium in the selling price attributable to the use of the IP, the incremental income method. Another application projects the earnings of the business as a whole from which the contribution generated by other assets is deducted leaving the residual income stream attributable to the IP. Offset against this income stream would be the attributable promotional and on-going advertising costs. It can be difficult to isolate the net income stream attributable to the IP with any precision unless it forms the basis of the whole business.
The market approach estimates the value of the IP by reference to market transactions involving similar IP. The most common approach is the relief-from-royalty method which is based on how much the IP-owner would have to pay to use the IP (“the royalty rate”) if it licensed it from a third party. The royalty rate is generally a market rate derived from an analysis of actual royalty or licence agreements for similar assets (“the guideline sample”). This rate is applied to the forecast net revenues to be generated by the brand with the results discounted to net present value. The main problems with this approach are both identifying actual market transactions sufficiently comparable to the IP to be valued and the degree of subjectivity involved in comparing the IP to be valued with the guideline sample.
The valuer would generally attempt to apply all three approaches in order to provide counter-checks to the final conclusion. Appropriate to such a nebulous asset, its valuation is perhaps the most artistic of the services we offer!