Intangible assets and intellectual property are increasingly important commodities in today's knowledge-based economy.
We have extensive experience valuing a broad range of intangibles and intellectual properties. Our experience extends to determining the value of intangibles and intellectual property as stand alone assets or in the context of purchase price allocations.
These assets include:
Why Valuation of Intangible Assets and Intellectual Property?
There are many reasons why intangible assets and intellectual property may need to be valued. The most common reasons would be:
- Transaction with the Intangibles or Intellectual Property
- Financial Reporting
- Other Reasons
Transaction with the Intangibles or Intellectual Property
Common transaction events where owner of the Intellectual Property wants to know its actual fair market value are buying or selling the Intellectual Property, investing the Intellectual Property into partnership or joint venture and mergers and acquisitions. In cases such as these, a valuation of the Intellectual Property is performed.
The accounting of Intangible Assets is defined by the International Financial Reporting Standard 38 – Intangible Assets. The IFRS 38 - paragraph 75 states:
“After initial recognition, an intangible asset shall be carried at a revalued amount, being its fair value at the date of the revaluation less any subsequent accumulated amortization and any subsequent accumulated impairment losses. For the purpose of revaluations under this Standard, fair value shall be determined by reference to an active market. Revaluations shall be made with such regularity that at the balance sheet date the carrying amount of the asset does not differ materially from its fair value.”
In addition to the fair value measurement and disclosure of the Intangible Assets, the new accounting rules require that goodwill emerging from acquisitions be tested to determine whether it has been impaired. IFRS 38 require specific expertise and application of professional judgment rather than a simple mathematical reduction of goodwill based on a fixed annual charge.
IFRS 36 and 38 IFRS requires firms to effectively undertake a market test to see if goodwill has been impaired. This test needs to be completed in two steps.
1. The first simply requires a revaluing of the reporting unit. If this value is equal to or greater than the unit’s carrying value then goodwill has not been impaired. On the other hand, if the calculated value is less than the unit’s carrying value, then step 2 must be undertaken.
2. The purpose of step 2 is to assign the value of the reporting unit to its identified and recognized assets and liabilities. These assets are valued as standalone entities. The sum of recognized asset values less the market value of liabilities is the fair market value of net assets. The difference between the carrying value of net assets and its fair market value is the implied fair market value of goodwill. If this value is less than the carrying value of goodwill, then the difference is equal to the value of goodwill impairment loss.
The purpose of IFRS 36 and 38 is to provide investors with better financial information as to the success of past acquisitions. In the process of doing this, the IFRS has forced firms to deal with a number of thorny and, in some cases, unresolved valuation issues. These issues include:
- Valuing the reporting unit from the perspective of hypothetical new buyer or from the perspective of the acquiring firm implementing its strategy for deploying the acquired assets.
- Applying a marketability discount to the value of a reporting unit when the unit no longer has equity trading in a liquid market.
- Estimating the proper cost of capital when the discounted cash flow approach is used to value the reporting unit.
There are many other reasons for valuation of the Intellectual Property. Some of these include: Allocation of Purchase Price, Reorganization of a Business, Financing, etc.
Methodology for Intangibles and Intellectual Property Valuation
The erosion of the tax base through transfer pricing strategies has become a key concern for tax authorities throughout the world.
Most authorities expect to see extensive documentation in support of the intellectual property value and transfer prices including descriptions of the company and transaction, details of the transfer pricing method applied and the assumptions on which the method is based.
Three primary methods in valuation of the intellectual property and analysis of transfer pricing are considered acceptable, depending upon the circumstances.
1. One method is known as Comparable Uncontrolled Price (CUP). Prices of OEM sales of identical products form the basis for this method. However, this gross data must be adjusted to reflect value differences without a trademark. One drawback to this technique is that internal transfer prices are typically company private; also, general averages may have insufficient particularity to prevail at trial.
2. Second method is the Resale Price Method (RPM). RPM suffers from similar weaknesses. In most instances, the catalog retail list price is known. Also, some transaction prices are accurately reported such as real property sales subject to documentary transfer tax or consumer goods with bar-code labels. However, due to discounts, or differences in credit terms, actual retail transaction prices may vary significantly, resulting in unreliable gross margin measurements. From the outset, a taxpayer using either of these methods will usually have the fundamental disadvantages of incomplete or unreliable information. In contrast, the taxpayer has total access to complete and accurate information regarding his own revenue, production costs, and operating assets. Therefore, a calculation based on projected return on investment, using the taxpayer data, has inherent accuracy advantages.
3. The best method is known as CPM, Comparable Profit Method. Essentially, this method focuses on return on investment, as compared with similar public company data. The most supportable opinion involves a refinement of CPM, in which intellectual property value or transfer prices are determined based on the present value of projected future income.
Other generally accepted methods include:
- PROFIT SPLIT METHOD, allocating the profit in the transaction based on the relative value of each participant's contribution to the combined profit.
- COST PLUS, calculating an appropriate mark-up to be added to the cost of providing the good or service to the other group company.
- RESALE PRICE/RESALE MINUS, starting at the final selling price and deducting appropriate gross margins to arrive at the transfer price in the intra-group transaction
- TRANSACTION NET MARGIN, analyzing the net margin achieved in an intra-group transaction relative to a base such as turnover, cost or capital employed.
The most contentious area within valuation of intellectual property concerns return for the use of intellectual property including patents, trade marks, brands, copyrights, customer lists and software. Our expertise in intellectual property valuation means that we are often in the best position to provide clients with advice concerning acceptable valuation methods that could be applied in valuation of the intellectual rights and to prepare documentation to support pricing decisions.
Process of the Intellectual Property Valuation
The following analytical procedure is suggested as the best method for most firms, as a refinement of the CPM method. This method is based on the widely accepted marginal cost/marginal revenue model. The model allows maximum profit for each location, resulting in clear evidence arm’s-length pricing.
Asset Value. Determine the market value of all assets by location and product line, including intangible assets. The pricing must allow adequate yield on the investment for these assets, by location and product line.
Discount Rate. Calculate the cost of capital for each product line and location, based on the risk free rate for each country and product line risk, compared to public firms in similar markets.
Market Demand. Derive the demand curved for each product line based on price vs. quantity; estimate future shifts in the demand curved based on the product life cycle and promotion strategy.
Supply Cost. Derive the cost versus quantity curves for each product line, based on factory level cost plus required return on investment.
Cash Flow. Project future cash flow for each product line and location, using transfer prices designed to maximize profit, based on marginal revenue.
Present Value. Maximize the present value of future cash flow for each product line and location; iterate the model using alternative transfer prices to determine the optimum price.
For this refined method, the requirement for obtaining data from comparable firms is simplified; data from similar firms is limited to beta (variations in industry stock prices as an indication of risk) and the debt/capital ratios, which are reported for public firms. Demand curve data can be calculated from company records. This method does not require private data from competitors, such as individual transaction data or detailed cost data.