In 2020, intangible assets accounted for 90% of the total assets of companies in the S&P 500. Intangible assets are part of an over $21 trillion industry, which continues to grow today. Within this industry, clients often have urgent needs for a valuation of their intangible assets, including intellectual property. These needs commonly arise during mergers and acquisitions, establishment of joint ventures, execution of licensing agreements, litigation, taxation, bankruptcy and strategic planning.
However, valuing IP assets may be speculative. For example, you cannot touch or hold an idea, logo, sound or expression of creative ideas. Further, IP derives its value from the right to exclude — whoever owns this property may prevent competitors from using it. These features may cause uncertainty about an IP asset's current value and what the demand for the asset will be in the future.
This article will highlight the three generally accepted methods used to value IP. While using a single method will not be definitive, together these methods may provide an effective perspective on the value of IP.
3 generally accepted methods
There are many approaches to value intellectual property assets, but the three generally accepted methods include: the cost method, the market method and the income method. Within each method there are several approaches, and within each approach there are many procedures. Highlights of each method are described below.
1. The market method
When is it most effective?
The market method is usually determined first because it is the least speculative of the three methods. This method is best used when there is information for comparable IP transactions, such as similar sales or licensing agreements.
How is it applied?
This method measures the value of an asset based on comparable transactions between unrelated parties. When the IP is similar to IP that was the subject of a prior transaction, the market method becomes a significant indicator. This approach is based on the principles of supply and demand and efficient markets.
There are two different approaches that may be used to apply the market method. The first is the comparable uncontrolled transaction, or CUT, approach. This approach looks for sales or licenses of similar IP. The second is the comparable profit margin, or CPM, approach. This approach involves searching for publicly traded companies that are comparable to the client's company, with the exception that the publicly traded companies do not have the unique IP. These publicly traded companies provide a baseline value that does not include the IP. Then, to account for the client's unique IP, a profit margin is added to this baseline value. The profit margin is typically the earnings before interest and taxes, or EBIT.
2. The income method
When is it most effective?
In most cases, the income method is the easiest method to apply. This method is most significant (i) when the owner's business uses the IP to create income, or (ii) when the IP is licensed.
How is it applied?
This method values an asset based on the present value of the economic benefit it is expected to produce. One common approach is to determine the net future income produced over the remaining useful life, or RUL, of the IP. The RUL represents the number of years until the IP is retired. This generally occurs when the IP is no longer actively used or when no further economic benefit is expected from the IP.
For example, a U.S. patent automatically loses its useful life after 20 years from the effective filing date (excluding patent term adjustment and patent term extension). After 20 years, patent owners can no longer prevent others from making or using the originally patented invention. In other words, this right expires. Therefore, a business would not license a patent for 21 years because after year 20 the business could simply copy the design. Similarly, as a general rule, a copyrighted work has a statutory end date of no later than 70 years after the life of the author. Conversely, both trademarks and trade secrets have potentially unlimited terms. Trademarks are retired when they are no longer used, and trade secrets are retired when they lose their economic value or become known to others.
3. The cost method
When is it most effective?
The cost method is generally used when the economic value of the asset cannot be accurately calculated. This may be the case for newly developed IP or when IP is being held primarily for defensive use.
How is it applied?
This method evaluates an asset by determining the cost to replace the asset with an identical or comparable asset. The cost method emphasizes that the value of the asset over its life will correspond to the cost to purchase or develop it.
To apply the cost method, four components are often considered: (i) direct costs, (ii) indirect costs, (iii) IP developer's profit and (iv) opportunity costs. Direct costs are costs that are directly attributable to the IP, including, for example, materials, equipment and labor used to make the IP. Indirect costs are costs that are not directly associated with the IP, such as overhead costs and operating costs. The developer's profit is often calculated as the rate of return made on the direct and indirect costs. Opportunity costs are what the business sacrificed by procuring or developing the IP.
Conclusion
In conclusion, IP valuation can be complex. Valuation analysts are often consulted to perform IP valuation. However, lawyers need to be involved in the IP valuation process because they lead many different actions involving IP, including, for example, structuring transactions, performing due diligence, complying with taxation requirements, litigating claims, negotiating financings and defending commercialization of the IP. Understanding how to value a client's IP assets will make an attorney a more valuable asset to their client.
Originally published by The Indiana Lawyer.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.