Valuation approaches of income attributable to intangibles

Intangible assets are not visible on the balance sheet as are other assets such as cash, inventories, plants, and equipment. However, intangibles are often the difference between earning a “normal” return on investment and enjoying “excess” earnings. By their nature, intangibles are unique  and because the nexus between intellectual property and its impact on operating profit is not always clear, the valuation of intangible assets requires disciplined, yet creative, thought.

INTANGIBLE ASSETS AND INTELLECTUAL PROPERTY

In the context of licensing. it is important to note a distinction between intangible assets and intellectual property. Intellectual property is a subset of intangible assets which confers legal protection, thus allowing for the transfer of these rights through licensing. However, not all intangible assets can be readily licensed or legally protected. For example, management experience and corporate procedures are recognized as intangible assets, yet these would be very difficult to license to third parties.

CONVERGING VIEWS ON VALUATION OF INTANGIBLES

The international best practice on intercompany transfer pricing, the appraisal profession, and the intellectual property community agree on the basic premise of value for intangible assets. While the terminology may vary, the common theme is that a reasonable or fair value should be based on an exchange of an asset between willing parties having knowledge of all relevant facts.

Appraisal Profession’s View

“no formula can be devised that will be generally applicable to the multitude of different valuation issues . . . a sound valuation will be based upon all relevant facts, but the elements of common sense, informed judgment and reasonableness must enter into the process of weighing those facts and determining their aggregate significance“.

VALUATION APPROACHES

Three generally accepted approaches apply to the valuation of assets: cost, market, and income. While these methods find their roots in real estate appraisal, they have been adapted to the valuation of intangible assets and determination of royalty rates.

(a) Cost Approach

The cost approach quantifies valuc based on the cost to create and develop assets. Values derermined using this approach are also viewed as the anticipated cost to replace an asset already owned. This theory assumes that a party would not be willing to pay more to use the property than the cost to replace it.

The cost approach is often used to value new property, such as embryonic technology, or when information needed for other approaches is not available.

The cost approach may also apply in situations where there are many substitutes for the intangible asset. An example would be a narrow patent which is easy to design around. The cost approach does not consider future income and/or profit streams, market conditions, useful life, and the risk associated with receiving future economic benefits.

(b) Market Approach

The market approach values assets based on comparable transactions between unrelated parties. When considering relevant comparable transactions, it is important to evaluate the extent to which they are truly comparable. Factors to be considered include: company structure, relative bargaining power between the parties, industry, market size, market share of the parties involved, gross and net profitability, any economic, legal, regulatory, political, or other barriers to entry, new product introductions, and the growth outlook for the relevant products. The time at which the comparable transaction took place may affect all of these factors, as may the terms and conditions contained in the license agreement.

lf exact comparables are available, the market approach provides powerful proof of an asset’s value. By their very nature, intellectual properties tend to be relatively unique, and it is unusual to find exact comparabies. However, inexact comparables might serve as a guide or indication of value. Under US Internal Revenue Service Treasury Reg. Section 482 (and OECD transfer pricing guidelines as well), adjustments may be made to inexact comparabies to compensate for differences “if the effect of such differences on prices or profits can be ascertained with sufficient accuracy to improve the reliability of the results.“ Examples might include adjustments for the costs of technical support or adjustments to the revenue base to account for different freight policies.

(c) Income Approach

The income approach values assets based on the present value of expected future income streams and is one ofthe most widely used methods for determining both lump sum values and royalty rates for intangibles. Three parameters must be quantified to use this method:

1. The future income stream from the asset
2. The duration of the income stream, that is, the remaining useful life of the asset
3. The risk associated with the realization of the income stream

The duration of the future income stream is determined by forecasting the useful life of the property, which may be limited by its legal life (e.g., from 10 to 20 years for a patent) or its technological life. The risk associated with the realization of the income stream may be captured by two of the parameters in the income approach: the forecasted annual amounts of income, and the discount rate used in the present value calculation. The future income stream from the intellectual property may be quantified using a variety of approaches depending on the specific circumstances. Four approaches are often considered in the context of valuation analyses.

(i) Excess Earnings Approach. The excess eamings approach is based on the premise that a property’s value can be measured by the incremental earnings achieved by a proprietary product relative to an essentially identical but nonproprietary product (i.e., a “generic” version). “Proprietary” product, as used here, means a product embodying an intangible asset such as a patent or trademark. The “excess earnings“ may result from the proprietary product commanding a price premium, delivering certain manufacturing cost savings, or achieving larger sales quantities.

The most significant challenge in attempting to use the excess earnings approach is finding a generic version of the proprietary product such that the only difference between the two is the presence or absence of the intangible being valued. For the earnings comparison to be appropriate, it is important that no external factors contribute to the excess earnings achieved by the proprietary product. Examples of such factors are: differences in the functionality/features of the products, post-sale and warranty services offered, and costs of components and labor necessary to make each of the products. When such factors are present the comparison remains useful as long as adjustments can be made to account for the impact of these differences.

(ii) Postulated Loss of Income Approach. The postulated loss of income approach quantifies the amount of income that would be lost if the owner did not have the asset, for example, a trademark right. The “income” stream would be the amounts by which total income would decrease absent the trademark. This decrease may be due to fewer units being sold and/or a lower per-unit price being received.

(iii) Relief from Royalty Approach. The relief from royalty approach is based on the theory that an asset’s value can be measured by what the owner of the property would pay in royalties if it did not own the intellectual property and had to license it from a third party. This method requires the selection of an estimated royalty. To the extent that the royalty is continuous (e.g.. a certain percentage of net revenues for as long as the license is in force), the property’s value is the net present value of the expected stream of royalty payments. ln determining the time horizon of the projection and the appropriate present value discount rate, one should consider the factors discussed earlier in connection with the income approach.

The relief from royalty approach is not mutually exclusive from other valuation approaches discussed earlier. For instance, the market approach (such as the internal or external CUP analysis) and excess earnings approaches may be used to derive reasonable royalty rates that are subsequently used in relief from royalty calculations.

(iv) Residual Income Approach (or Rate of Return Approach). The residual income approach requires a systematic segregation of the business into its component assets; for example, plant and equipment, cash, and marketable securities, working capitals. Starting with the business’ total income one deducts the expected or normal return associated with each asset class, except for the asset under consideration. The residual amount of income represents the return attributable to the asset being valued. While theoretically attractive, this approach often is difficult to implement in situations where multiple interrelated intangibles are employed in the business.

An alternative method pursuant this approach exists in the transfer pricing world under the name of profit split method.

Profit Split method

As for the residual approach described above, in the area of transfer pricing, the profit split approach requires a systematic separation of business in routine activities that make it up and that  typically are  production and distribution activities. One then attributes through benchmark analysis, a specific arm’s length profitability  to such routine functions, and so we get a residual income compared to the total produced by the company  that is attributable to the whole IP owned. The rationale behind this methodology is that the excess earnings (extra-profit) of a business, if compared to the typical functions remunerated at arm’s length rates, have to be attributed the IP that the company owns itself.

METHODOLOGIES PURSUANT ITALIAN PATENT BOX DISCIPLINE

According to the circular 11/E of April 7th, pursuant the Italian new Patent Box discipline two methodologies are strongly suggested to be provided for the procedure:

1. CUP method (internal and external) in order to determine sales, less relevant direct and indirect costs
2. Profit Split method

These methodologies are useful in order to determine the economic contribution attributable to the indicated IP. Accordingly, transfer pricing database and methodologies are here fully applicable.