Valuation of Intellectual Property Mark Weston, CA, CBV Director, Advisory and Transaction Services

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1 9:30 am 10:15 am Valuation of Intellectual Property Mark Weston, CA, CBV Director, Advisory and Transaction Services

2 Agenda General Valuation Approaches Cost Based Valuation Methods Market Based Valuation Methods Income Based Valuation Methods

3 General Valuation Approaches Cost Approach Uses concept of replacement as an indicator of value Value is based on the amount that would currently be required to reproduce an asset or replace the service capacity of the asset Market Approach Measures value based on market prices of comparable assets Actual transaction prices for similar assets are used as benchmarks for the asset being valued Requires recent transaction prices and sufficient other data on comparable assets Income Approach Measures value based on the future cash flows that an asset can be expected to generate over its remaining useful life The projected cash flows are converted into their present value equivalents through discounting Requires that future cash flows for the assets can be forecasted with reasonable reliability

4 Cost Based Valuation Methods Reproduction Cost Method Measures value by calculating the cost to reproduce the asset (asset is recreated in its current form) Typically based on indirect method whereby actual historical costs incurred to create the asset are trended to the current date Adjustments are made for physical deterioration, functional obsolescence and economic obsolescence as applicable Examples include PP&E, internally developed software Replacement Cost Method Measures value by estimating the cost to replace the asset, i.e the asset is replaced with another of equivalent functional utility Typically based on direct method whereby current prices for substitute assets with similar functionality are used Adjustments made for physical deterioration, functional obsolescence, and economic obsolescence as applicable.

5 IP Valuation - Reproduction/Replacement Cost Advantages Simple to explain and understand Historical costs to create the asset initially are often documented and available Resources and process to recreate the asset are often known or can be reliably estimated Companies often evaluate the value of an asset using a build versus buy analysis Challenges The Subject IP may be copyright or patent protected such that recreating the asset is not a viable alternative The unique nature of some assets makes them difficult or impossible to replicate Does not consider the income generating capacity of the asset There may be considerable opportunity costs associated with the time required to recreate the asset

6 Example IP Valuation Cost Approach Software Module Development Hours Cost per Development Hour ($) Replacement Cost New (000 s) 2 Outdated (000 s) 3 Inactive (000 s) Depreciated Replacement Cost (000 s) Finance 3,500 1,000 3, ,900 Operations 2,800 1,500 4, ,300 Human Resources 1, , ,200 Administration 2, , ,300 10,000 11,100 1,200 1,200 8, Replacement Cost (New) Assumes no inflation from the original costs to develop in 2008 Functional Obsolescence Assumes that certain features would be replaced with more efficient technologies if the asset was replaced 1 3 Economic Obsolescence Assumes that certain features would not generated future returns if the asset was replaced 4 Depreciated Replacement Cost Assumes that any tax benefits and costs would offset Assumes there are no additional opportunity costs ( i.e significant time investment)

7 Market Based Valuation Methods Comparable Transactions Method Measures value by comparing the asset being valued to similar asset for which recent arms-length transaction prices can be observed Adjustments are made for differences in characteristics of the asset being valued compared to the transaction comparables Requires that verifiable recent transaction data is available along with sufficient underlying information on the comparable asset to make a reliable comparison

8 Market Based Valuation Methods Comparable License Method Measures value based on the market price for a license of a similar asset to a third party Appropriate adjustments are made for differences in the characteristics of the assets Often combined with multi-period discounted cash flow method or royalty method where projected license or royalty payments are discounted to their present value Examples include franchise rights, technology, trademarks

9 IP Valuation Market Based Methods Advantages Based on actual transaction prices between market participants Grounded in reality not theory Simple and practical to apply when transaction data for comparable assets is available Challenges Recent transaction data for similar IP often does not exist or is not obtainable Subjective adjustments are often required to compensate for differences between the Subject IP and comparables The Subject IP may not transact separately from the business enterprise utilizing the IP

10 Income Based Valuation Methods Discounted Cash Flow Method Commonly used to value intangible assets that generate predictable cash flows Based on premise that a third party would be willing to pay an up-front sum to receive the expected future cash flows Projected cash flows are converted to their present values through discounting Examples include financial assets, contracts, franchise rights, mineral reserves

11 Income Based Valuation Methods Relief From Royalty Method Commonly used to value intangible assets that could be licensed Based on premise that a third party would be willing to pay a royalty to use the asset Projected royalties are converted into their present value equivalents through discounting Examples include patents, proprietary technology, trade names and trademarks

12 Example IP Valuation Relief from Royalty Method Revenues Royalty Rate 4.0% 4.0% 4.0% 4.0% Royalty Savings Taxes 25% (5.0) (5.5) (5.8) (6.0) After-Tax Savings Discount Factor 17.0% Present Value Total 48.6 Tax Benefit 4.8 Fair Value Tax Benefit Tax benefit derived based on the value of the future deduction of the initial cost of the asset from taxable income Revenues Forecast revenues from all branded products Royalty Rate Comparable market research observed range of 2% to 6% OR Observed net profit premium of 4% on branded products over non-branded products Discount Factor Takes into account: Cost of equity Indefinite Life Forecast risk Brand Recognition, competition and margin WARA analysis

13 Discount Rate Considerations WACC WARA Discount Rate Considerations Enterprise Value Equity Debt Goodwill Intangible assets Fixed assets Working capital WACC Cost of equity Returns on other assets Cost of equity - In between rates for tangible asset backing and goodwill Lease rates Mortgage rates Asset backed lending rates Short-term borrowing rates

14 IP Valuation Relief from Royalty Approach Advantages Sound and practical model for asset types that are typically licensed Implementation is fairly straight forward when license income or revenue and operating margins for products or services utilizing the Subject IP are available Directly incorporates a market based required return through the use of a risk adjusted discount rate Challenges Applicable only to certain types of IP that are licensed or Licensable Forecasting future license income or revenues and operating margins for products and services utilizing the Subject IP can be challenging and subjective License or royalty data for comparable IP may be limited or not available, and thus significant subjective adjustments may be required due to lack of comparability Value indication can be sensitive to subjective input assumptions such as royalty rate, discount rate, revenues growth and useful life assumptions

15 Income Based Valuation Methods Multi-period Excess Earnings Method Measures value by calculating the cash flow attributable to an asset after deducting appropriate returns for contributory assets used to generate the income stream Projected excess earnings are discounted to their present value using an appropriate risk-adjusted discount rate

16 Example IP Valuation Multi-Period Excess Earnings Revenues After-Tax Cash Flows Less: Contributory Asset Charges 7.0% (35.0) (38.5) (40.3) (42.0) (42.8) Excess Earnings Discount Factor 17.0% Present Value Total Tax Benefit 15.4 Fair Value Revenues Forecast revenues related to the IP being valued After-tax cash flows Cash flows after deduction of gross margin, administrative costs, and income tax 3 Rates of Return on Assts 4 Discount Factor Contributory Asset charges are applied based on the required rates of return on working capital, capital assets, brand and the assembled work force used to generate the after-tax cash flows Takes into account: WACC & Cost of equity Indefinite Life Forecast risk Brand recognition, competition and margin WARA analysis

17 IP Valuation Multi-Period Excess Earnings Method Advantages Provides a theoretical model for allocating an income stream earned from a group of assets to the individual assets contributing to the income stream Is widely accepted and utilized method for valuing IP when the economic benefits are difficult to directly identify but clearly have value Challenges Required the identification and valuation of all assets in the group contributing to the income stream using other valuation methodologies Estimating the required returns on the contributory assets is subjective and the valuation of the Subject IP can be sensitive to these inputs Assumes all excess earnings after providing for a return on identifiable contributory assets is attributable to the Subject IP May overvalue the Subject IP by including value attributable to unidentifiable assets or going concern

18 Income Based Valuation Methods With and Without Method Asset value measured by the difference in cash flows generated by the business with the asset in-use versus without the asset Difference in cash flows is attributable to incremental earnings or cost savings associated with the asset Projected cash flow differentials are discounted to their present value Examples include non-compete agreements, defensive intangibles, technologies

19 IP Valuation With and Without Method Advantages Provides a theoretical model for isolating the contribution of a particular asset to an income stream generated by a business or group of assets Applicable when the incremental benefit from utilizing the asset is quantifiable, such as the incremental margin on a branded product or the cost savings associated with a process technology Challenges Quantifying the incremental benefit to the cash flow stream provided by the Subject IP can be difficult and subjective Can be complex to model May require scenario analysis to evaluate multiple alternatives to the Subject IP

20 IP Valuation Greenfield Method Advantages Provides a theoretical model for isolating the value of a particular asset independent of the other assets utilized in the operation of a business Is widely accepted and utilized method for valuing IP when the business operations are dependent on owning the IP Challenges The inputs and assumptions required to develop cash flow forecasts for the hypothetical start-up company are often difficult to quantify and highly subjective May not represent value-in-use (the value of the asset currently in use as part of an ongoing business as opposed to a start-up business)

21 Thank you for coming. Mark Weston, CA, CBV Director, Advisory and Transaction Services

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