Intellectual property is a source of significant value for many businesses today, but it can be difficult to value. There are three main reasons it’s hard to value. First, it can be hard to understand, because it’s often technical in nature. Second, there are many types of intellectual property and each asset is unique by nature. (For example, the U.S. Patent Office only grants patents for novel products and production techniques.) And, third, there’s not much transaction data on direct sales of intellectual property. The relief from royalty method is one technique valuators have adopted to overcome these obstacles.
Intellectual Property 101
Before driving head-first into a discussion of how to value intellectual property, it’s important to set the scene. Intellectual property generally falls into one of four broad categories:
- Trademarks, and
- Trade secrets.
Related intangible assets that businesses own may include unpatented proprietary technology, trade names, trade dress, brands, computer software and customer lists. Intangible assets may require an appraisal for the following purposes:
- Financial reporting (such as fair value measurements or annual impairment tests),
- Tax compliance (gift and estate taxes or charitable contributions),
- Litigation (damages calculations, shareholder disputes, divorce or bankruptcy), and
- Sale or licensing transactions (mergers and acquisitions, as well as intellectual property sales or licenses).
Accounting Compliance Issues
Companies also may be required to value intangible assets if they follow Generally Accepted Accounting Principles (GAAP). For example, FASB Accounting Standards Codification Topic 805, Business Combinations, requires an acquiring entity to allocate the purchase price of an acquired company among its tangible and intangible assets.
Alternatively, FASB Accounting Standards Codification Topic 350, Intangible Assets — Goodwill and Other, requires companies to test acquired goodwill and other intangibles annually for impairment and write them down if their fair values drop below their carrying amounts. Testing goodwill for impairment is a complex process. However, in general, the value of goodwill depends on the value of a company’s tangible and identifiable intangible assets, including intellectual property.
Rather than test for impairment, private companies may elect to amortize goodwill straight-line generally over 10 years under FASB Accounting Standard Update 2014-02. Companies that elect this alternate method must continue to test for impairment when certain triggering events occur, such as the loss of a key person or an unanticipated increase in competition.
Relief from Royalty Method
One of the most common techniques for valuing intellectual property is the relief from royalty method, which borrows concepts from the cost, market and income approaches to valuing a business.
The relief from royalty method estimates the portion of a company’s earnings that are attributable to an intellectual property asset based on the royalty rate the company would have paid for the use of the asset if it didn’t own it. In other words, the asset’s value is equal to the value of the royalty payments from which the company is relieved by virtue of owning the asset.
A valuator applies this method by selecting a royalty rate based on available market data for licenses involving similar assets, industries, territories and other characteristics. The Georgia-Pacific case (see “Deciding What’s ‘Reasonable'” below) sets out 15 factors that are relevant when determining a reasonable royalty. Then the valuator selects an appropriate, risk-adjusted discount rate to determine the present value of the royalty payments.
Typically, this hypothetical license is treated as a perpetual license. To estimate value, the valuator calculates the present value of projected royalty payments over a certain period (for example, 10 or 15 years) and then calculates the present value of the residual at the end of that period.
A Time-Tested Approach
Although the relief from royalty method approach may be new to you and your clients, professional valuators have been using it for many years. Whether you’re valuing intellectual property for litigation, sale, accounting or tax purposes, the relief from royalty method is a viable appraisal method.
Deciding What’s “Reasonable”
The following 15 factors provide a starting point for determining a reasonable royalty:
(Georgia-Pacific Corp. v. U.S. Plywood Corp., 318 F. Supp. 1116, 6 USPQ 235, SD NY 1970.)