How to Value your Intellectual Property in an M&A Transaction?

Posted On January 13, 2021January 13, 2021

Companies across the world have recognized the power of valuation of Intellectual Property (IP) assets as it provides a highly competitive advantage for trade in a competitive market place. During the last few years, the commercial environment has experienced a paradigm shift with the effect of intangible assets as a notion receiving attention and becoming an active tool for retainment and survival in the competitive international economy. IP assets are now seen as assets that escalate the value of the business.

Evaluating the role of IP in Mergers and Acquisitions (M&As) is vital to see how IP led M&As have become the leading cause of such deals today. Mergers and Acquisitions take place due to several reasons such as growth, synergy, diversification, and in most recent times, the biggest reason being the need to acquire the newest technology. A prime cause of the majority of merger deals is the urgent need to acquire the newest and valuable IP assets such as ground-breaking technology, trade secrets, patents, copyright, trademarks, and the company’s goodwill.

Why Value your IP?

Changes in the international economic atmosphere have influenced the progress of business models where IP is a dominant element for establishing value and probable growth. Apart from these universal changes, several jurisdictions such as the United States, European Union, and international accounting organizations have started to mandate businesses to identify and value all recognizable intangible assets. Due to these developments, the precise valuation of IP assets along with the means to protect that value has become a crucial component of the success and capability of a modern organization.

Whether a company acquires IP assets alone or completely merges with a target company, its fundamental IP can significantly affect the price of the acquisition. M&As may take place due to business reasons or brand (IP) reasons. For instances where IP is the driving force for the merger or acquisition, the importance and necessity for the precise valuation of the IP assets become even more important.

Amid the intangible assets are the conventional IP assets such as patents, trademarks, copyright, know-how, and trade secrets. More newly involved in this class and of gradually progressing importance are domain names. In the case of a merger or acquisition, there are various types of business rearrangements due to which the acquiring entity must get impartial and documented ownership of these IP assets, or at least acquire the suitable license to use such IP.

The Challenges Faced while Valuing IP

Despite being frequently bought and sold, IP attracts scepticism because there is doubt whether or not its value can be measured reliably. Placing a value on physical assets and depreciating the value over time is a well understood financial exercise; however, there is no comparable globally recognized approach concerning IP assets. This doubt has held back recognition of the value of acquired IP in the companies’ financial statements. Calculating the precise value of different forms of IP is difficult as the canons of any such valuation may vary from one viewpoint to another and also from one situation to another. Having a higher level of subjectivities and due to various dynamic factors involved, such valuations have their limitations. Companies need to reflect the intangible assets in their annual inventories as they do with hard assets.

A major issue that arises due to improper valuation of IP is brand destruction after the merger or acquisition. The same can happen due to showing inflated values of the intangible assets before the deal, or in several cases, acquisition of the brand by a competitor simply to destroy and bring down the value of IP. To avoid such outcomes, both parties need to follow appropriate IP valuation methods. The kinds of deals, including IP, are as diverse as the rights in question. It is vital to examine each deal comprising IP in adequate detail to regulate the matter of the deal. Traditional valuation methods are not always enough to perform consistent valuations on IP assets since they cannot consider the many outcomes possible with the use of new technologies that have not yet been commercialized.

For an M&A to be successful, it is imperative to understand the acquired intangible assets, their growth potential, uses, limitations, encumbrances such as pending litigations etc. Both parties in an M&A transaction need to have appropriate IP valuation standards set in place or better yet, agree upon a method of valuing the intangible assets.

Methods of IP Valuation

Before beginning an IP evaluation, there are some vital questions, which need to be addressed to reach a meaningful outcome. These form a part of the ‘due diligence’ process. The due diligence process can be a basis of substantial data for both sides in a Merger and Acquisition transaction. IP due diligence is fundamentally tough due to the problems that occur in the valuation of IP. Ill-structured or unsuitably implemented business strategy is amid the topmost recorded explanations for the eventual failure of IP led M&A. Thus, a well-structured, elaborate due diligence is necessary. It offers crucial data relevant for understanding future advantages, economic lifespan, ownership rights, and the boundaries of the assets. The following questions need to be answered in the due diligence process:

• Why are you assessing the IP?
• What exactly is the IP asset?
• How will the IP be utilized?
• Who is the supposed purchaser of the IP?
• What entities presently use given technologies or other IP, what is their place concerning the acquirer, and which other companies in the market are concerned about the given technology?
• Is the particular industry frequent to litigation or not?
• How developed is the IP policy of the target business?
• What is the amount of concentration in a particular market?

The conventional methods commonly used to fix the value of Intellectual Property Rights (IPRs) are:

• The Cost Method
• The Market Method
• The Income Method
• The Relief from Royalty Method

While negotiating a merger or acquisition deal, the ability to develop precise valuation methods will result in more informed decision making. The method to choose often depends on the situation, type of deal, the motive behind the deal, and the data available.

The IP valuation methods are further discussed below in detail:

1. The Cost Method

This method examines the upcoming financial profits of ownership by counting the sum that would be needed to substitute the remaining utility of an IP. It is known as the cost of replacement. The central supposition is that the cost of a new IP is proportionate to the current value of the economic advantage and that the asset can be expected to yield throughout its remaining lifetime. The market repeatedly examines this supposition. For instance, if the cost of a new machine were fixed at a stage much greater than the current value of the upcoming economic profits of owning the asset, then none would be sold. If the contrary were true, then demand would exceed supply, and probably the price would increase.

The cost method is usually the slightest utilized method, as in maximum situations, it is thought to be appropriate just as an addition to the income approach (if the valuation is not for accounting reasons). The approach is generally adopted in cases where the particular IP asset is presently making no income.

2. The Market Method

This method is based on comparing with the actual amount paid for a similar IP asset in similar conditions. To perform valuation with this approach, you need to have a dynamic market, exchange of a similar intangible asset, or a cluster of similar IP assets. If the IP assets are not comparable exactly, variables are needed for the dissimilarities. More is the data accessible about the scope and degree of IP exchanged, the comprehensive terms, the surroundings of that deal (such as cross-license), more precise is the valuation. This method is more likely to show the market realities than a valuation based merely on the income approach.

For performing an IP valuation using the market method, the following steps are undertaken:

1. Research the relevant market to obtain data on sale transactions, listings, and offers to purchase, sell, or license IP assets that are similar to the subject IP.
2. Verify the information by confirming that the data obtained is factually accurate and that the market transactions reflect arm’s length market considerations.
3. Select relevant units of comparison (for instance, income multipliers or dollars per unit-units such as ‘per drawing,’ ‘per customer,’ ‘per location,’ and ‘per line of code’) and develop a comparative analysis for each unit of comparison.
4. Compare ‘guideline’ IP asset transactions with the subject IP asset using the variables or factors for comparison and make adjustments to the price of each guideline IP asset transaction appropriately to the subject IP asset or eliminate the transaction as a guideline for future consideration.
5. Merge the various value indications produced from the analysis of the guideline transactions into a single value indication or a range of values.

The market value approach uses a product’s performance in the market to reach a valuation. Dealings concerning comparable products are also utilized for comparison purposes. Again, this approach to valuation has advantages and disadvantages. Market value offers a comparatively dependable valuation basis and is founded on supply and demand in the economy, but when it comes to comparison with other goods, there is not a lot of publicly accessible data. If suitable data is obtainable, the market method is usually considered to be a fair approach to valuing IP assets as it takes into consideration consumer behaviour.

3. The Income Method

The income method, in a lot of manners, is of the utmost importance among the valuation methods. The simple explanation of ‘value’ is founded on the capability of the asset to yield future income in some way. This fundamental characteristic is frequently denoted as the ‘intrinsic value’ and is defined by the capability to directly or indirectly produce a definite cash flow. The cash flow, if suitably discounted, is the fundamental principle of this approach. Cash flows are usually predicted during the expected financial lifecycle of IP. Outside the fiscal life of the IP, an estimate of residual value might be suitable.

This approach comprises of three parts – projected cash flows, the economic life of the intellectual property, and the discount rate. Projected cash flows are the future income that can be allotted to the IP. The economic life denotes the span in which the intangible asset can grasp the price or ‘cost premium.’ The fiscal lifespan is usually limited by the legal lifespan of the IP, but actually, it is shorter. For example, it is usual for innovation to be outdated in just three years, usually even before patent expiration. The ‘discount rate’ denotes the anticipated price of funding the particular asset.

This approach, even though exceedingly logical, is also rather variable. Variability is present everywhere in the approach, with specific attention needed to evaluate each commercial and economic hint that affects the probable progressing cash flows.

4. The Relief from Royalty Method

The relief from royalty method is based upon the theory of ‘deprival value,’ meaning that it looks at the sum of revenue that a business will be deprived of if it does not own a particular IP and requires licensing it from someone else. The royalty signifies the license charge that will be given to the licensor if this imaginary agreement existed. The capability to regulate a suitable royalty rate is based on the particular conditions and necessitates the recognition of apposite similar dealings and amounts concerning third parties.

Obtaining a royalty rate is just a primary stage, and a dependable sales prediction is additionally required to guess the income that comes straight from the IP. Like in other income methods, a suitable cost of capital has to be decided. This approach is valuable since the market size and probable market share is usually conveniently available data. Additionally, the approach is also instinctive since the value of a property is known “as a rental charge other business would pay to use it.” A noticeable disadvantage of this approach is that a rental cost can continually be presumed when, in truth, it might never happen.

Choosing the Best Method

Conventional valuation approaches are not always suitable to perform dependable valuations on IP assets since they cannot reflect the multiple results possible with the use of new technologies that are not in the market yet. Furthermore, there is no single precise method for valuing IP. All IP valuation methods can be clubbed into income, cost, or market method. The results vary according to the method used, and different valuation methods are suitable for different conditions. Accordingly, it is imperative to understand what IP is being valued and why.

Many IP valuation specialists suggest using a combination of these approaches for more dependable valuation results. It is also advisable to combine valuation methods to suit the particular IP, gather accessible data about, and accordingly determine the method of valuation. All the methods can be used in several circumstances, and at least two of the many methods should always be utilized to calculate the outcomes. In the case of Whelan vs. Abell, the US District Court for the District of Columbia excluded “expert testimony on financial valuation and damages” because the plaintiff’s professional had used only one valuation approach.

An IP valuation based on careful analysis, experience, expert knowledge, expert advice, and acute diligence may very well result in almost foolproof responses. Valuation is an art more than a science and is an interdisciplinary subject intersecting economics, law, finance, accounting, and speculation. Apart from this, a futuristic brand strategy and understanding the needs of the market and consumers are exceedingly vital for the success of any IP-based merger or acquisition. ✅ For more visit: https://www.kashishipr.com/