Download approaches to valuing intellectual property

APPROACHES TO VALUING INTELLECTUAL
PROPERTY
JULIAN STEPHENS
WEALTH CREATOR MAY/JUNE ISSUE 22
In our last article titled Intellectual Capital (IC) we dealt with its basic concepts and discussed why companies
choose to protect and value it. We will now focus on the various approaches to valuing the intangible assets that
make up intellectual capital, discussing the benefits and weaknesses of each approach. Specifically, we discuss the
various approaches to valuing intellectual property (IP) which comprises of legal forms of intangible assets, so that
the commercial benefits of the IP to the firm can be most clearly measured.
Nonetheless, we must keep in mind the difficulty in valuing IP; unlike tangible assets, such as land, it is difficult to
directly attribute the commercial success of a product to an individual intangible asset, such as a trademark. The
accuracy of IP valuations is therefore affected by the degree to which the asset can be separated from other assets
in the business.
The Valuation of Intellectual Property
The valuation of IP uses the same basic valuation concepts used to value other business assets. These include a
cost approach, market approach, income approach or a combination of all three.
Cost Approach
The cost approach of valuing IP relies on data relating to the cost of replacing a product by purchasing or
developing a similar product. The cost approach is useful in situations where there is limited other data available
that would indicate the fair market value of the product.
The cost approach takes into account the cost of labour and other direct expenditures such as consulting fees,
research and development expenditures, prototype costs and other direct out-of-pocket expenses to redevelop the
product. For example, a trademark valuation using the cost approach might consider the legal costs of registering
the trademark and promotional expenditures used to develop the brand name.
The cost approach has a limited function because the economic benefits from IP are not always commensurate
with the costs of developing the product. Its main use is in the preparation of notional valuations used to apportion
the price of a business among its underlying assets in an income tax or financial reporting context.
Market Approach
The market approach values IP in terms of what a notional purchaser would pay for a substituted product and
relies on empirical data obtained from arm's-length transactions in an open-market. Usually, companies that make
comparable products or are at least in the same industry as the company whose asset is being valued are selected
for the analysis.
A drawback of the market approach can be a lack of available data on market transactions for similar products. IP
often relates to technology that exists in a niche market, such as some hospital diagnostic equipment. In such
cases, it can be hard to find comparable products to use as a guideline. Moreover, the details contained in these
transactions may not be publicly available.
Income Approach
The income approach for valuing IP provides a general present value of the asset by considering the income that is
expected to be generated from ownership of the asset. The most popular methodology is the discounted cash flow
method and methods derived from it. These methods usually have three variables:
1. level of prospective income (cash flow),
2. period of time of the income stream, and
3. the risk of achieving the prospective income level.
The income approach may be used to measure long-term cash flows, particularly when cash flows are not stable.
Further Considerations
Valuation approaches of IP, which consider performance outcomes must take into account the strength and
duration of the asset prior to estimation. Some forms of intellectual property (patents, trademarks, trade secrets,
franchise) are stronger than others, and are therefore capable of generating greater income.
Conclusion
The cost, market and income approaches each have their benefits and drawbacks when applied to valuing IP. The
cost approach of valuing IP presents difficulties because the economic value to a company of its IP is not
necessarily represented by costs. While the market and income approaches for valuing IP aim to reflect the
economic worth of the IP more fairly, they can suffer from accuracy where there if a lack of transparency data, and
assets are not separable.