July 2003

Valuing Intangible Assets

An intangible asset of seemingly low value can provide a welcome surprise when properly appraised

If a company owns intangible assets that do not seem to generate revenue, their value may be overlooked. That can be a costly mistake. Patents, trademarks, customer lists, copyrights and proprietary processes are examples of intangible assets that may represent an untapped source of revenue, and having a valuation for licensing or sale of intellectual property can be a real eye-opener. It can even affect the bottom line.

Ascertaining the value of those assets has many applications, including the following:

• determining damages in an infringement case;

• knowing how much to ask or offer in a potential sale of a business or the intangible assets that it owns;

• satisfying the taxing authorities in deducting the value of property donated to a charity;

• negotiating a property settlement as part of a divorce; or

• collateral valuation.

Valuation Problems

Intangible assets can be hard to price. To complicate matters, for intangible assets that aren’t generating income, the technology associated with the asset may be too new to properly evaluate how much money it can make for its owner or what competitive advantages it may offer.

How to set a value. In determining value, an experienced business valuation professional can use factors such as projected revenue from use of the asset and its importance in a specific product or process. Although no standard formula exists for intangible asset valuations, the courts, valuation specialists and the IRS do concentrate on factors such as:

• the significance of the property to the company’s product or process;

• the sales revenues, income and cost savings the company can derive from using the property;

• the property’s economic life; and

• the competitive alternatives to its use.

With respect to patents, the IRS recognizes three main valuation factors: (a) the income that can be attributed to it or its application, (b) its safe interest rate at the valuation date, and (c) what the IRS considers to be its most reasonable, speculative capitalization rate, which must be calculated in an explainable and well-reasoned way.

Valuation Process

Generally, valuation professionals follow several logical steps to determine the value of an intangible asset. They may not conduct every step in every case, or they might do them in a different order or with variations. But reviewing the steps does give an idea of the valuation process.

A valuator derives an intangible asset’s present value or fair market value by measuring its future returns – cost savings, income or royalties – which are discounted at a rate of return the valuator considers appropriate.

Company, Industry and Market. The valuator might begin by evaluating the industry and market in which the property will be used. Market size and prevailing economic conditions can help indicate how much market share the property can obtain for the company and how long obtaining that market share is likely to take. Other parts of this determination are the distribution network the company uses and its manufacturing capacity, management structure and financial status, as well as the product’s position in its life cycle.

Income and Revenue. Next, a valuator tries to project how much income and revenue a company will realize from the intangible asset during its estimated useful life. In performing this projection, the valuator tries to come up with economic income rather than accounting income, as measured by generally accepted accounting principles (GAAP). Economic income reflects the company’s real expenses, which may be higher than those reflected by GAAP.

Benefit Base. The benefit base is the likely economic return from the intangible asset. To do so, the valuator looks at the operational income the company can expect to bring in because of the property, taking into account expected royalty rates, cost savings or excess income associated with the property. If the benefit base is determined via the cost savings or excess income approach, it will appear as a percentage of the excess income or cost savings. Under the royalty approach, it will be a percentage of the company’s projected revenues. Under the income from operations approach, it will be a percentage of projected income.

Fair Market Value. Finally, the valuator calculates a present or fair market value for the property by discounting the expected benefits by an appropriate rate of return. The rate should account for the risk associated with the returns. A greater risk produces a higher rate and a lower value for the intellectual property.

Pleasant Surprise

Valuators may use several valuation methods to arrive at an intangible asset value, depending on the nature of the property, the type of company that owns it, and why the valuation is needed. The result may be a pleasant surprise for a company that has been taking its intangible assets for granted. ■