Intangible assets are not abstract

It can be among a company’s most valuable assets and yet the true worth of intellectual property may not show up in the accounts, as Kelvin King discovers

Intellectual property is the most important asset of many of the world’s largest, most powerful companies, underpinning market dominance and profitability. It is often the key objective in mergers and acquisitions, and knowledgeable companies are increasingly adopting licensing strategies.

However, company accounts have not traditionally reflected the worth of intellectual property rights (IPRs) and intangible assets.

When IP represents a company’s dominant asset, it can also be its primary collateral. A popular cash generator for companies is to sell some or all of their IP to their pension funds: raising capital, generating income and enabling pension trustees to meet deficit obligations. And pension trustees are increasingly willing to take a brand, patent, trademark or copyright as security.

Effective IP management brings: greater returns on capital invested in the business – and particularly in IP – and increased shareholder value; better informed decision-making about IP development, exploitation or acquisition; the possibility of creating new revenue streams; and the ability to differentiate between valuable IP, which should be protected, and IP of no significant value, which might be sold or abandoned. This is where IP valuation can play an important role.

Valuation brings together the economic concept of value and the legal concept of property

IP valuation does not generally present problems when IPRs have been protected by trademarks, patents, design rights or copyright. However, other intangibles, such as know-how, training systems and methods, unregistered design, technical processes and distribution networks, are also valuable assets; yet it is harder to identify their value in terms of revenue and profit generation.

Valuation brings together the economic concept of value and the legal concept of property. The cardinal rule of commercial valuation is that value cannot be stated in the abstract; it needs to relate to place, time and circumstances. The questions “to whom?” and “for what purpose?” must always be asked. IP valuation should reflect corporate and business risk, and risk assessment should reflect IP value.

There are four main value concepts: owner value; market value; tax value; and fair value. Owner value determines the price in negotiated deals and is often led by a proprietor’s view of value, if he were deprived of the property in question. Market value is based on the assumption that, if comparable property has fetched a certain price, the subject property will realise a similar amount. The fair value concept reflects the desire to be equitable to both parties. Tax valuation has been the subject of case law worldwide since the turn of the century and is an esoteric practice. Other potential considerations include investment value, liquidation value and going-concern value.

IP valuation methods fall into three broad categories: market based; cost based; or based on estimates of future economic benefits. A valuation expert will prefer to determine a market value of a physical entity by reference to comparable market transactions. This is not compatible with IP valuation because IP is not generally developed to be sold. When IP is sold as part of a larger transaction, the details are often confidential.

Methodologies around cost of creation or replacement assume a relationship between cost and value, but ignore changes in the time-value of money.

A more rigorous valuation methodology uses an estimate of future economic benefits and contribution, which can be broken down into capitalisation of historic profits, gross profit differential methods, excess profits methods, and royalty relief.

Discounted cash flow (DCF) analysis sits across all three methodologies. DCF mathematical modelling allows for the fact that income today is worth more than income next year or income the year after. The time-value of money is calculated by adjusting expected future returns to today’s monetary values. The discount rate to be applied to the cash flow can be derived from a number of different models: common sense; build-up method; dividend growth models; and the capital asset pricing model utilising a weighted average cost of capital. The discount rate used to calculate economic value includes compensation for risk, expected rates of inflation and the physical, technological, economic and legal life of the IP.

In too many businesses, the understanding and active management of IPRs and intangible assets have not been taken seriously enough. This should be on every boardroom agenda and at the forefront of every chief executive’s strategic thinking.