The Valuation of Intellectual Property

You can Measure the Intangible

Many companies grow and nurture thanks to something that sets them apart: a product, an idea, a way of doing things. This can often be an idea, a method or a set of curriculum. These intangible can be hard to translate into an actual financial value. Many startups (and larger companies) hence sit on a hidden treasure and carry their innovation at no value, making it more complex to build a commercial, financial or VC agreement.

This should not be the case and there is a comprehensive field of knowledge that could help companies assess and recognize the value of their Intellectual Property and more broadly Intangible Assets.

The discipline of valuation is populated with many experts who can help determine a substantiated valuation of their intangible assets or intellectual property. Moreover, the value of these intangible assets can be recorded into the audited financial statements, amortized and treated as any illiquid asset.

This paper is aiming at showing entrepreneurs and established companies that their IP’s value can be measured, should be protected and finally, should be recognized in their books.

The Key Methods of Valuation and Characteristics of IP

Market valuations have in common that they really do not take into account the opinion of the creators. Of course, everybody’s baby is the prettiest, but this is business: the true value will always be the one that someone is ready to pay for the asset. A common misunderstanding is to calculate the value of Intellectual Property based on the cost of its creation. Although it might have some bearing, this approach is dead wrong: if you spend thousands of hours crafting the perfect fishing fly: if nobody buys it, its value is zero, even if its cost is sky high. So, let’s figure out how to put a price tag on Intellectual Property.

A problem can be that you want to assess the value of an IP asset without having to put it for sale for real. The valuation methods then include the comparative analysis with a relevant commercial transaction (Market Based Valuation), and / or the calculation (internal / accounting) of the income generated and to be generated until the end of the Useful Live (Remaining Life Value).

Key characteristics of an (intangible) asset must be well understood to master the valuation process, such as the Useful Life of the asset, especially its subset, the Remaining Useful Life (RUL). Some assets retain their full value forever (e.g.: royalties), while others have a life-span limited by other factors (competition, technology obsolescence, etc.).

Another (and related) aspect is the accounting treatment of the asset. The natural obsolescence of an asset implies that the asset upon the end of its useful life, will reach a net value of zero; the Decay is the amount of loss of value over time, until the final null value. Whether the decay is linear or goes by a cycle (e.g.: exponential decay, starting slow and gaining speed over time) will have a major impact on the calculations of valuation.

A rapid dive into these characteristics will help us define more accurately the value of an Intangible Asset. By the end of this piece, you might have a better sense of how much money your brainchild is worth.

The Useful Life Estimation

The Useful Life of an asset is the time during which the asset is creating / producing value, from beginning to end. It can be broken down into the following categories:

Category	Description
Legal	The term of the IP / asset’s legal registration, as defined by the law (e.g.: patents, trademarks). The terms of the law define the Useful Life without ambiguity, unless challenged in court.
Judicial	The life and associated costs as established by a judge (e.g.: payment of royalties) with specific value and time limitation boundaries (or not).
Contractual	The aggregate terms of all existing agreements creating a business agreement between the “owner” of the asset’s rights and business using the asset. This could vary over time as new contractual agreements are generated.
Technological	The combination of the effective life of the technology supporting the asset including its operating environment. An application developed in COBOL language and requiring a Mainframe computer to run would likely have reached its useful life end by now. This value varies mostly due to technology advances.
Commercial / Economic	The period during which the asset / property generates revenue or creates positive income. This value can vary with market dynamics and competitive pressure. It could be complex to determine whether an asset reached its end of life, or if the revenue generation / sales associated are less efficient.
Analytical	Historical and contextual comparative analysis of the total useful life and parameters of similar assets. If the asset is a complete novel concept (Blue Ocean), then the comparison will need to rely on comparable assets life cycle, if any. In the absence of historical or contextual comparison, this approach would not work.

The table above reflects the Total Life of the asset. In some cases, the valuation of the asset is taking place after the beginning of the useful life of the asset; in such case, the useful life will be the total life minus the time already gone during which the asset was creating value (the Incurred Life of the asset). For instance, a product that carries a 10 years Useful Life, three years after its launch, will retain 7 years of RUL (Remaining Useful Life). The recognized formula is: RUL = (Total Life – Incurred Life).

When an economic approach analysis is used, the RUL should factor in the value of the obsolescence. In this context, the terms (duration) of the projected period of income actually defines the RUL.

Specific classes of assets (and groups of assets within the same class) might have different longevity and decay patterns. For instance, a methodology or process could evolve to adapt to changes to the technological environment while others could be replaced with a new approach, etc. Typically, assets which are tightly coupled or dependent on rapidly changing (e.g.: software, technology, business intelligence) are the most vulnerable to rapid obsolescence. Hence their RUL is going to be a lot shorter. On the other hand the use of a name or capability can generate royalties which can be lasting as long as the name remains, with little or no decay. This can have deep implications into how an intangible asset is “packaged” for a commercial transaction to maximize its value.

The RUL can be used in the Market Approach to assess how comparable are potential candidate transactions to be used as guidelines, providing guidance to potential adjustments making the guideline transactions more effective as a comparison.

As a side note, although there is an effective unlimited legal life of IP, its economic life is usually shorter. The asset might remain, but its value could be gone already.

The Cost / Accounting Based Valuation: Calculating the Decay

The rate of decay over time is an important factor in an Economic analysis: assuming a targeted obsolescence date (e.g.: 100% obsolescence of a training curriculum over 10 years), a projection at 6 years would give a 6/10 or 60% obsolescence, assuming a linear decay.

Obsolescence can be estimated as the ratio of age to total expected life. Detailed analysis might be necessary for a business, especially when the actual asset is separate from the income generation; for instance, a testing methodology which supports of an Application Maintenance service offering, contributes to the income generation, but not in an exclusively. The recognized contribution of the asset to the income stream is the value that needs to be carried in the assessment. A complexity could arise when the useful life of one of the entangled assets (the overall service offering) has a Useful Life which is separate from the other asset: the Testing approach might remain after the Offering has been removed or replaced. In the same time, the same Testing IP could be used in multiple, separate Offerings, increasing its useful value over time.

The individual RUL and decay ratio need to be explicitly called out, which could lead to somehow complex valuation efforts.

Known Transactions for Analytical (Market) Valuation

A key question when preparing the valuation of a business, a class of a group of assets is whether comparable commercial transactions (transfer of price or value) exist, that can be used as a guideline.

A past transaction such as an M&A, a licensing agreement, assigned royalties are examples of transfer of value against a monetary equivalent. If the transfer is related to a class of asset or a business which is fairly comparable to the IP valuation in discussion, then it can help anchor the valuation of the price.

Multiple transactions are even better, as it is unlikely that a single transaction would be a perfect match, and each transaction can be compared to the subject of the study to determine a market-based calibration. We saw earlier that factors such as RUL and Obsolescence (Decay) must be thoroughly analyzed to calibrate the comparison, especially in the case of entangled Intellectual Property assets.

In particular the actual price for the transaction, but also the estimated remaining life of the asset are key elements for the valuations methods illustrated below.

The remaining useful life (RUL) of the asset can be used to determine:

1. The duration of the period of income / revenue generated by the asset. If the revenue will not cease to be generated, than the useful life of the asset is perpetuity. (The useful life of an asset can be shorter than its legal equivalent, as IP can have an unlimited legal life).
2. The date at which the residual value of the asset will reach zero will trigger the calculations of the “decay”, or the depreciation of the value over time.
3. Internal or external factors that could alter the useful life or the income generated by the asset. A great concept for instance, could create a large market value (e.g.: the Apple iPhone), but as soon as competitors enter the market, the net value takes a plunge, as the organic market for the product just got smaller. Both Value and Useful Life would be impacted in this case, as the life of the asset would become shorter, and the revenue would be shared with competitors (e.g.: Samsung).

So the Comparative Valuation of an Intellectual Property “object” is primarily the substantiated analysis of the price paid in comparable instances for similar IP, correlated with the impact of uniqueness, desirability, stability of the income or competitive pressure (commercial or technologic).

In some cases, examples of recognition of a similar or comparable IP can be captured in the financial statements and declarations of other companies or organizations. Although they might need to be calibrated in the same way a comparable sale or M&A would need to be adjusted, this information would greatly reduce the effort of establishing a comparison guideline.

The Income / Revenue based valuation

The number of periods during which a projected income will happen (the Intellectual Property RUL) is practically defining the Asset Value. A longer RUL results in a higher value, because there is more economic income to be capitalized. The same potential annual revenue generated by an IP Asset, over a 5 years Useful Life will be half of the value generated by an similar income stream over a 10 years Life.

If the asset is used in creating a new market segment, the growth of the segment over time will trigger an annual income growing every year in absolute value. This becomes more complex as the valuation will rely on estimates of market growth, which can be less “tangible” than projected current revenue for a mature product. It is predictable that in such case the valuation of the Intangible Asset will need to be revised periodically, as the economic context is evolving.

Because the expected future economic income is discounted to the present, the total value of the asset is very sensitive to changes in RUL, especially for short periods. An innovative asset which factored market growth in the valuation, and which is suddenly facing a reduction in half of its useful life due to competition or technology changes would see its value likely reduced by more than half.

The rate of decay of an individual intellectual property asset in an income based valuation would be the expected reduction of the amount of income generated related to the use of the asset over time. It is not unexpected that by the time the asset will be replaced or retired (the end of the Useful Life), some income (although reduced) would still be generated. In such case the decay would not reach a null value but a reduced value.

So, How Much is My IP Worth?

Various methods and parameters of Intangible Asset valuation are described in the sections above. In practical terms, these are usually used simultaneously and complement each other. Unless the substantiation of the valuation is non-ambiguous and relies of a large number of absolutely comparable transactions or disclosures, there always remain some level of ambiguity in the assessment. The potential bias carried by one method can be greatly reduced or eliminated by using at least two completely independent valuation methods, relying of separate criteria and parameters.

The value to be estimated will always be the Residual Life Value (RLV): the value to an analyst or a potential “buyer” will be the value to be generated during the Remaining Useful Life, with no practical regard for when the Intellectual Property asset has been released or launched.

Because the RUL is likely to be more than a fiscal year, it is advisable to calculate the Present Value of the RLV, especially if the value is compared to similar assets carrying various life expectations and remaining lives.

So how do we get started?

A first step would be to describe and qualify a candidate for Intellectual Property Asset. The Asset must be clearly identifiable, without ambiguity and remain stable in its nature and characteristics during the period of reference. Updating a methodology or upgrading the operating system of a computer does not really change its characteristics (although it might expand its Useful Life).

Then the asset need to be linked in direct or indirect (contribution ratio) to a revenue stream, which will carry the value. The evaluation of the Useful Life, and in particular the Remaining Useful Life of the asset will determine both the duration for all calculations, and the range of revenue recognition for income streams. Analysis of factors that could reduce or alter the RUL or / and the generated income are critical to determine a credible Useful Life.

The Decay or Obsolescence of the asset’s value over time, and its decay profile (linear, exponential, YoY ratio) will determine the value for each period of income, and need to be thoroughly analyzed.

Finally, additional factors such as external (competition, market, technology) and internal (evolution, change of direction, strategic shift) can impact the value and decay, in a positive or negative way.

Sourcing the analysis of the valuation to a registered professional is important, especially if a potential commercial transaction, partnership, negotiation with a bank etc. is on the horizon. Self-evaluation is always a good practice, especially for the “light bulb” factor, when some of the implications of this valuation dawn on the owners of the IP.

Take your IP to the Bank

Now that you have performed a dual analysis and settled down on a number for your IP in Present Value, the One Million Dollar question is (as a matter of fact), how to make it appear in Financial Statements, especially those checked by investors, banks and potential business partners?

A simple answer is: just like that. Create an entry into your Assets List (either under Other Assets or Intangible Assets) that records each Intangible Asset separately, with its final valuation number. The Balance Sheet is a good place to start, where Intangible Assets can be reported into the non-current assets (current assets are either cash, Account Receivable or liquid assets that can be converted into cash within a year or so). The depreciation can then be calculated based on the Decay and the evaluation of the economic cost / amortization over the Useful Life, as seen earlier. This is where the accounting treatment of the asset matters, as choices of amortization, depreciation and other factors can impact how you are reporting the asset’s value. This level of details is beyond the scope of this paper, but your CFO or Accounting should be able to help you navigate through the options. You might want to watch the Year-on-Year changes to the valuation, if you decide to do periodic revisions; these are now declared assets in your books, and any change will need to be recorded in proper fashion, so it can be audited and verified.

Changes to the disposition of the asset, such as trade agreement, licensing, royalties etc. that would impact (positive or negative) the valuation or Useful Life of the asset should be treated like any other transaction impacting your books.

Now you have a firm valuation number for your IP that withstands scrutiny, is reflected into your Balance Sheet as an actual Asset and adheres to GAAP. By the time we got here, you probably have dropped the idea that the valuation of your Intellectual Property has anything to do with the hard work and passion you put into it.

Yes, this is just business… But this is business that can get you into a more constructive conversation with a potential partner or investor!

Invest in Developing or Protecting your IP

So you got yourself a dollar figure for your brainchild. How do you protect and support its sustained value? Two dimensions of the valuation can be contemplated, which are (no surprise) the same we reviewed earlier: the Remaining Useful Life and the economic value of the asset.

If your Intangible Asset has a finite useful life, say 10 years for a new technology widget or software construct. You will calculate the value from the income stream over the 10 years of useful life and record this value in your books. But in the 3^rd year of the life-cycle, you decide to extend the useful life (generating revenue) of the product, through investing into upgrades and refinements. With this upgrade being deployed, the Remaining Useful Life (7 years at this moment) has now been extended by another three years. Voila. Repeat the process periodically and you might extend the life of your product for a long time, provided that the changes actually extend the commercial life, that is.

If your product is growing its market share, it is likely that the income generated during the three years you added is higher than the revenue accrued during the first years. But it could be the other way around, and the life extension is supporting an aging product, with a slowly shrinking income stream. Either way, the added value will be the income generated each year of the extended period of reporting. Remember however that hopes and dreams are not facts; even if you are wishing very hard that your revenue is going to jump up, economic and financial rules are only looking at facts and hard data. If your revenue stream is shrinking, than the valuation will follow. Make it rebound and record a new growth, and you can revisit your valuation.

So you have a vested interest in not only recognizing the value of your intangible assets, but also in taking the steps to expand and support this value over time.

The flip side of this coin is that the declaration of the value into the books also states the ownership of the asset. Would the business be acquired or sold, the asset is likely going to go with it, along with associated property rights, unless a special clause or agreement states another disposition.

Intangible Assets Valuation is Good For You

The process of assessing and recognizing the value of Intangible Assets and Intellectual Property is not huge but very involving, probably including the use of a professional expert. There are financial and accounting implications, as well as property rights and other collateral aspects which can become rapidly complex. At the core of it however, is a relatively simple and effective process that will put a price on the asset, substantiated with facts and figures.

A practical use of an IP Valuation is to help with a planned acquisition or merger. In addition to the net economic and future economic value of a business or organization, the valuation of the IP of a company can be immensely helpful in choosing between candidates. Many M&A are driven by some level of IP acquisition in addition to the fixed asset. Being able to perform at least an elementary valuation could make the difference between a good and a bad deal.

If the targeted transaction is only an investment, the potential valuation if intangible assets could be precious, especially for startups or emerging businesses. It could also be used to determine if the price is right, and if the candidate for investment actually manages effectively and its intangible assets, which in many cases are the source for future growth or revenue streams.

The most compelling case is probably startup companies, often struggling to convince investors or banks of their value. If the IP valuation does not replace a solid business plan, it can help complement it, offer a more compelling view of the business savviness of the entrepreneurs, and offer an illiquid asset that can boost the initial capitalization of the startup.

In effect, many struggling entrepreneurs might just be seating on a pot of gold, unknowingly.

Your brains have a tagged value: make good use of it!