How is intellectual property valued when selling a business?

Intellectual property (IP) often represents one of the largest asset classes that a company holds, and unlocking its value is a key element in any business sale. The value of intellectual property such as patents, trademarks, brands, databases, and trade secrets, can be valued using a number of methodologies.

But what makes these intangible assets so valuable to a business?

• Registered patents and designs prevent competitors from launching similar, competing products and potentially pushing the business aside within the market.
• Holding the rights to a product design enables a company to make a unique offering to their market, and price their products accordingly.
• The company’s position and profile as an innovative business can be boosted.
• For design-only businesses, the license for their IP, used by third parties to manufacture and sell their product(s), provides a significant and valuable income stream.

Essentially, intellectual property assets can increase revenue or reduce business costs, and when they generate an income for the business being sold, a number of valuation methods can be utilized.

There is no particular method of valuation that is suitable for every business sale, however – the most appropriate one depends on a number of factors, including whether the intellectual property rights (IPR) are fully developed and functioning,

Cost-Based Valuation Method

The cost method uses the costs incurred by the business in the creation and development of their IPR. It also takes into account the potential cost of recreating such an IP asset or developing a product that is similar in nature.

These costs might include:

• Research and development
• Equipment and materials
• The cost of labor
• Prototype creation
• Trialing and testing the product
• Obtaining approval and certification from the relevant regulatory bodies
• Registration of the intellectual property
• Overheads with regards to utilities, accommodation and support staff

The concept behind the cost method of valuation is that a business purchaser would not have to incur these costs if they buy the IPR. Furthermore, in doing so they would not have to suffer the financial and/or operational consequences of failing to successfully develop their own IPR, or deal with the potential difficulties in protecting it if they did develop their own.

One of the downsides of this method of valuation is that potential future profits are not incorporated into the calculation – it is based solely on the costs incurred, which does not take account of possible future success in the marketplace.

Income-Based or Economic Benefit Valuation Method

The income method of IP valuation, also known as the economic benefit method, aims to identify the income that a company’s intellectual property rights could generate in the future, and the costs of generating that income – in other words, the economic benefit to the business over the IP’s useful economic life.

Figures for risk and the financial cost are also calculated and included in the overall calculation, the result is what is known as the Net Present Value, or NPV. A prospective buyer can use this figure to help them make their purchase decision, which would depend on whether the NPV is positive or negative.

In contrast to the cost method, the income method uses potential future scenarios as the basis for the valuation, rather than past events. This in itself can cause issues given the difficulty in forecasting over a period of several years, and also in calculating the useful economic life of IP assets.

Factors which may be taken into account include:

• State of the economy
• The extent of the IPR’s market
• The type of competition
• Costs such as registering and defending the intellectual property

A secondary form of the income/economic benefit method is relief from royalties, whereby a value can be assessed based on how much money in royalties the company would have to pay if they didn’t own their intellectual property assets outright.

Market-Based Valuation Method

The market value method uses a product’s performance in the market to arrive at a valuation. Transactions involving similar products are also used for comparison purposes. Again, this method of valuation has pros and cons.

Market value offers a relatively reliable valuation basis, is based on supply and demand in the marketplace, but when it comes to comparison with other products there is not a great deal of information publicly available.

This type of data often remains confidential, and any that is readily available tends to be general in nature. If suitable transactions are found, a further difficulty can arise if the context of the transaction is something other than a business sale – insolvency, for example, or litigation. In this case, an adjustment would need to be made in order to allow for more accurate comparison of IPRs.

If appropriate data is available, however, the market approach is generally considered to be a fair method of valuing IP assets as it takes into account consumer behavior.

The ownership of intellectual property rights can considerably enhance the value of a business, but the most appropriate method of valuing IPRs will vary between companies. An understanding of the economy, the industry in which the business operates, and the business itself, are all required to arrive at a fair value figure.