An introduction to valuing intellectual property

RMA Journal, The, May, 2002 by Rick Hoffman, Roger Smith

Last month, we addressed methods of identifying and monitoring intellectual property already owned by the clients who make up your existing loan portfolio. This month we discuss the most common methods of valuing intellectual property. Continuing on from last month's discussion, we are referring to IP that is established, saleable, and makes for reasonable collateral. It is most likely that this IP is a patent or a trademark. However, the approaches discussed (or derivatives thereof) can be applied to nearly every type of IP. Generally, the valuation of IP is based on one or more approaches, discussed below.

Income Approach

The Income Approach estimates the value of IP based on the cash-generating ability of the asset. This approach quantifies the present value of the future economic benefits that would accrue to the owners of the IP. These benefits, or future cash flows, are discounted to the present at a rate of return commensurate with the asset's inherent risk and expected growth.

This common approach is also used in valuing businesses and real estate, as well as IP. When this approach to value is used, a projection is made that forecasts the anticipated revenues and expenses expected to be generated by the IP. For instance, if your client manufactures a patented product, the revenue generated by the product is forecasted. Next the expenses incurred to generate the revenues are subtracted to arrive at a "Gross Profit" type of a number. This approach is not the same as normal Gross Profits in accounting, as often times the expenses subtracted from revenue include amounts not typically included in the cost of goods sold (i.e., selling expenses).

Typically, the costs subtracted per the above do not include any depreciation or other noncash-related expenses. Instead, a separate charge is made against the Gross Profit number that accounts for depreciation as well as a normal return on the capital needed to generate the IP-related revenues. Similarly, if the IP is used in conjunction with other IP not being valued, a charge is made to reduce the Gross Profits to allow for a "payment" on the IP not being valued. Finally, a charge is also made to account for any requisite investment in working capital. Figure 1 provides a typical calculation of one year's worth of cash flows.

The projection is done for the expected life of the product. Frequently, the product life is much shorter than the patent life. In fact, in many industries, a patented technology lasts no more than six to eight years.

Just as with any valuation of future cash flows, the future projections must be discounted to the present. Most valuation professionals value IP based upon relatively high discount rates.

Once the projections are discounted, the sum of the projected years' discounted value indicates the value using the Income Approach.

This approach also works when the IP does not generate revenue but instead saves expenses. For example, assume the technology allows for the automation of a process. The same calculation as above is performed. However, instead of projecting revenue, the saved expenses are projected. As in the calculation described in Figure 1, any extra expenses that will be incurred (such as buying the equipment) must be subtracted from the saved expenses. Finally, the net saved expenses are discounted back to the date of the valuation.

Market Approach

The Market Approach leads to an estimate of the IP's value that is based on what other purchasers and sellers in the market have paid for similar IP. This approach is based on the principle of substitution, which states that the limit of prices, rents, and rates tends to be set by prevailing prices, rents, and rates for equally desirable assets.

When the Market Approach to value is used, data is collected on the price paid for IP that is reasonably similar to the subject IP. Such data represents the "Guideline IP." Adjustments are made to each Guideline purchase to compensate for differences between the Guideline asset and the IP being valued. Use of the Market Approach results in an indication of value based on an estimate of the price one may reasonably expect to realize on the sale of the subject asset.

This approach is largely intuitive. Most people use a similar approach when buying a house. The approach is most commonly performed by using information on IP transactions from the Internet. An increasing number of sites are dedicated to making information on such transactions known. Even so, there is not usually a large amount of identifiable transactions to act as appropriate "Guidelines." Accordingly, most often the Guideline transactions can act only as a reasonableness check because the IP does not resemble the subject IP closely enough.

Cost Approach

The Cost Approach is based on the theory that a prudent investor would pay no more than the cost of constructing a similar asset, of like utility, at prices applicable at the time of the appraisal. Again, most people buying a home use this process. It is easy to illustrate by way of example. Imagine that an individual wants to move into a new home during the next year. She finds a suitable home being offered for sale for $200,000. Further, assume the home for sale has 1,000 square feet and the owner needs six months to vacate. Finally, assume the homebuyer determines that she could hire a contractor to build the same home on an adjacent lot in six months for $100,000. The homebuyer would not be willing to pay more than $100,000 for the home.