Intellectual Property Valuation July 2018...Agenda DUFF& PHELPS 2 James Palmer Managing Director,...

Intellectual Property Valuation

James Palmer, Managing Director, Duff & Phelps

July 2018

Agenda

2DUFF & PHELPS

James PalmerManaging Director, Valuation Advisory Services t +44 (0) 20 7089 4827e [email protected]

I. IntroductionI. What is intellectual property?II. Why value intellectual property?III. Unique challenges in valuing intellectual propertyIV. Basis of value

II. How to value intellectual property?i. Income approachii. Market approachiii. Cost approach

III. Other considerationsIV. Conclusion

IntroductionI.

What is Intellectual Property?• Intellectual property (“IP”) refers to a category of assets which covers intangible creations of the mind. Different types of intellectual property

include copyrights, patents, and trademarks as well as trade secrets, publicity rights, artistic works like music and literature, as well as some discoveries, inventions, words, phrases, symbols, and designs.

• Intellectual Property Rights (“IPRs”) provide protection over the assets and can enable their owner to take action to try and stop others from replicating, using, importing or selling their creation. Means to protect IPR’s include:

– Patents: Protect new inventions and cover how products work, what they do, how they do it, what they are made of and how they are made.

– Trademarks: Protect brands and can be used for a name, a product or a service.

– Design rights: Protects the visual appearance of a product.

– Copyright: Protects literature, artistic works, photographs, music, dramatic works, software, databases, films, radio and television broadcasts, sound recordings and published editions.

– Law of Confidentiality: Protects trade secrets. To keep trade secrets protected, you must establish that the information is confidential, and ensure that anyone you tell about it signs a non-disclosure agreement (NDA).

• IPRs also provide a licensee with the opportunity to invest in and commercialise the underlying IP in a new market or market segments. The IP system aims to foster an environment in which creativity and innovation can flourish.

• Like other forms of property, you can buy, sell and license IP. However, unlike the products they protect, IP assets cannot be seen or touched and measuring their value can be challenging due to their unique nature.

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Financial ReportingPurchase price allocationImpairment review

TaxTax planningTax investigation supportMoving assets between jurisdictions

Merger & AcquisitionDue diligenceSupporting acquisition pricingMake or buy decisionsSupport for loan collateralSubstantiate potential disposal value

Transfer PricingEstablishing transfer pricing policiesSetting internal licensing agreements


Strategic Planning and ManagementSupporting IP maintenance decisionsAssessing and prioritising development activitiesMaking informed strategic decisionsIdentifying value driversPricing negotiations

Legal SupportQuantifying damagesNegotiating external licensing agreementsIntellectual property investigationsExpert witness testimony

Why Value Intellectual Property?

Unique Challenges to Valuing IP

Valuing IP presents a number of unique challenges as compared to valuing more standard assets of a company. These can include:

• Does the patent protect the product or is it redundant?• Is the solution unique or are there other solutions available? • How much is your brand worth after years of marketing spend?• Measuring how well recognised the brand or IP is within and outside of the industry?• Determining who might be a Market Participant or potential buyer for the IP?• What is the rate of adoption of new product?• Can an emerging competing technology erode or render the IP obsolete?

Over time the responses to these questions will change and the value of the IP will be impacted accordingly.

From a measurement perspective, challenges include:

• It can be difficult to separate IP from the business • The IP may not yet, or may not directly, generate income• The value of the IP may vary widely depending on the perspective of the holder

As a result of the above, it can take considerable effort and analysis to narrow down the conclusion of value with the range.



Basis of Value• The definition of value, and the resulting value of the IP, may vary depending on the circumstances under which the valuation is being

performed. For example, the value of IP to one specific party may be different to another due to each parties unique perspective and needs.

• Many different value concepts and definitions exist including:– Fair Market Value– Liquidation Value– Orderly Liquidation Value– Forced Liquidation Value– Going Concern Value– Intrinsic ValueSome commonly used definitions are highlighted on the following page.

• Typically when considering Fair Value or Fair Market Value the perspective of a market participant is applied and the projections driving the analysis should reflect those of the identified market participant, in theory those cash flows which might be paid for, rather than be specific to the owner.

• Key attributes of a market participant include;– Independent of each other– Knowledgeable and well informed– Able to enter into a transaction– Willing (not forced) to enter into a transaction

Common definitions of value include:

• The International Valuation Standards Committee (“IVSC”), in its Glossary of key terms, defines Fair Value as “The estimated price for the transfer of an asset or liability between identified knowledgeable and willing parties that reflects the respective interests of those parties.”

• International Financial Reporting Standards (IFRS 13) defines the Fair Value of an asset or liability as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” The concept of an orderly transaction assumes it is not a forced liquidation or distressed sale, that the transaction occurs under current market conditions and that proper marketing has already occurred prior to the valuation date.

• The International Glossary of Business Valuation Terms (definitions adopted by a number of societies and organisations, including the American Institute of Certified Accountants, the American Society of Appraisers, the Canadian Institute of Chartered Business Valuators, the National Association of Certified Business Analysts and The Institute of Business Appraisers) defines Fair Market Value as “the price, expressed in terms of cash equivalent, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms-length, in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”


Basis of Value (cont.)

How to Value IPII.

How to Value Intellectual Property?Acceptable methods for the valuation of identifiable intangible assets and intellectual property fall into three broad categories. They are market based, cost based, or income based.

In determining the most appropriate method to apply, consider how the asset creates value for its owner:• Does it generate additional revenues? • Does it save costs? • Does it give a competitive advantage without directly generating additional revenues or saving costs?

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Income Approache.g. DCF, relief from royalty

Market Approache.g. Comparable Asset Pricing

Cost Approache.g. Replacement Cost

Fair Value

Estimate

Income ApproachII.i.

How to Value Intellectual Property?Income Approach

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• The Income Approach is a valuation technique that provides an estimation of the Fair Value of the subject asset based on the cash flows that the asset can be expected to generate in the future over its economic life, the period of time over which property might generate economic benefits.

• Different Income Approach methodologies, and examples of IP assets they are typically used on, include:• Relief-from-Royalty Method: Trade names, brands and technology assets• Multi-Period Excess Earnings Method (MPEEM): Brands and technology assets• Cost Savings Method: Database, know-how, process IP• Greenfield: Long lived licenses• With-and-without Method or Premium profits: Technology assets

• In order to perform a valuation using an income approach, a set of financial forecasts is required as of the date of value and the cash flow related to the intangible asset needs to be separated. A discount rate will then need to be estimated to discount these cash flows back to the valuation date.

The following slides provide further detail on these methodologies.

Depending on the method of income approach applied and the tax jurisdiction applicable to the subject asset, it may be appropriate to add a Tax Amortisation Benefit (“TAB”). This reflects the potential benefit that an IP acquirer may enjoy by amortising the value of the acquired IP for tax purposes, should the local tax jurisdiction allow it.


• The Relief from Royalty method considers what the purchaser would be willing to pay for a license of similar IP or what costs they are saving through owning, rather than licensing, the IP. It is important to distinguish between the nature and contributions of the trade name/ asset and the commercial value created by investing in and exploiting that trade name/ asset i.e. no-one would license IP for a rate that captures all of the excess profit.

• This approach is typically used in the valuation of technology, trade names and similar assets.• It measures the hypothetical amount of future payments, over the life of the asset, that would need to be made to license the intangible

asset if it were owned by a separate third party and then discounts these after tax cash flows to present value.• As an IP moves through its commercialization stages then the applicable royalty rate may increase i.e. the royalty rate for a trade

name in a new territory would likely be lower than in a more established market where the trade name already has market recognition.• Because after tax cash flows are utilized, a tax amortization benefit may be appropriate depending on the tax regulations in the

jurisdiction that the asset is held.• The critical stages in performing a relief from royalty valuation are:

– Identify parameter (revenue) and life– Estimate hypothetical royalty rate– Consider marketing or other costs– Present Value after tax cash flows– Add a TAB (depending on the tax jurisdiction)– Evaluate the reasonableness

• A number of means can be used to estimate the appropriate royalty rates:– Market Comparable Method: Looking at the rates agreed in comparable licensing deals.– Return On Assets Method: An estimate based on an allocation of profit between the different assets in the business.– Excess Operating Profit Method: Looking at “normal” margins of comparable companies and any excess margin generated by the

holder of the IP.

How to Value Intellectual Property?Income Approach – Relief from Royalty

Yr ending 31 Dec,in € thousands 2018 2019 2020 2021 2022

Total Revenue 1,000 900 750 500 200

Royalty Avoided @ 10.0% 100 90 75 50 20

Less: Maintenance R&D (5) (5) (5) (5) (5) EBIT 95 85 70 45 15 After-tax cost savings (tax @ 25.0%) 71 64 53 34 11 Mid period 0.5 1.5 2.5 3.5 4.5 PV Factor @ 12.0% 0.945 0.844 0.753 0.673 0.601 PV of savings 67 54 40 23 7 Sum of Present Values 190 Plus: Tax amortisation benefit 40

Fair Value of technology (rounded) 230


How to Value Intellectual Property?Income Approach – Relief from Royalty

An example of a Technology valuation is presented below.

Royalty rate based on comparable licensing agreements.

Depending on who’s responsible

Reflecting only those revenues utilising the technology

What is the life of the technology?

Appropriate discount rate

Tax jurisdiction where asset resides

Depends on tax rules in jurisdiction. Example assumes a 5 yr life and 25% tax rate.


• The Multi-period Excess Earnings method focuses on the future benefits generated by the subject asset and is one method of measuring the value of an income producing asset.

• This method considers the use of other assets in the generation of the projected cash flows of a specific asset to isolate the economic benefit generated by the subject intangible asset.

• The Multi-period Excess Earnings method is typically used to value the key intangible asset, which may be an IP asset but may also be identified to be a customer based intangible, which is hard to separate from the business. It is often used for the valuation oftechnology.

• The contribution of other assets, such as fixed assets, working capital, workforce, and other intangible assets, to overall cash flows is estimated through contributory asset “capital charges.”

• The value of the IP asset is the present value of the after-tax cash flows attributable to it, net of the return on fair value attributable to tangible and other intangible assets.

How to Value Intellectual Property?Income Approach – Multi-period Excess Earnings


How to Value Intellectual Property?Income Approach – Multi-Period Excess EarningsAn example of a Technology valuation, using an Excess Earnings Approach, is presented below. We note some simplification in the line items for demonstration purposes. Reflects the pattern of replacement

of the existing technology

May be different to the overall business margin i.e. remove future R&D efforts

Applicable royalty rate

Charge based on FV of asset an applicable return

Depends on tax rules in jurisdiction. Example assumes a 5 yr life and 25% tax rate.


Product revenue 1,000 900 750 500 200

Obsolescence factor 0% 10% 25% 50% 75%

Revenue applicable to existing technology 1,000 810 563 250 50

EBIT margin 20% 21% 22% 23% 24%

EBIT 200 170 124 58 12

Less: capital asset charge for trade name (1% of revenue) (10) (8) (6) (3) (1)

Adjusted EBIT 190 162 118 55 12 Less: Tax (@25%) (48) (41) (30) (14) (3) Less: Post tax contributory asset charges

Fixed Assets (5) (4) (3) (1) (0) Working Capital (3) (2) (2) (1) (0) Workforce (2) (2) (1) (1) (0) Other intangibles (5) (4) (3) (1) (0)

Post Tax Excess Earnings 128 109 80 38 8 Mid period 0.5 1.5 2.5 3.5 4.5 PV Factor @ 12.0% 0.945 0.844 0.753 0.673 0.601 PV of savings 120 92 60 25 5 Sum of Present Values 303 Plus: Tax amortisation benefit 64

Fair Value of technology 367


Cost Savings Method:• Used when owning the asset avoids or reduces expenditure or improves efficiency• Savings are measured after tax with a TAB (some exceptions)• Often confused with the replacement cost approach

With and Without Method or Premium Profit Methods:• Measures the impact on the projections of not having or having to replace the subject asset• The two methods are similar but approach the valuation from different perspectives

• With and without: What happens if you lose the asset?• Premium profits: How much the intangible adds?

• Calculated as:

Present value of business with IPLess: Present value of business without IP

DifferencePlus: Tax amortisation benefit

Fair Value

How to Value Intellectual Property?Income Approach – Other Approaches


Savings due to process know-how (improved efficiency) 1,000 900 800 700 600 After-tax cost savings (tax @ 25.0%) 750 675 600 525 450 Mid period 0.5 1.5 2.5 3.5 4.5PV Factor @ 12.0% 0.9449 0.8437 0.7533 0.6726 0.6005PV of savings 709 569 452 353 270 Sum of Present Values 2,353 Plus: Tax amortisation benefit 500

Fair Value of process know-how (rounded) 2,853

• When applying the Income Approach, the cash flows expected to be generated by an asset are discounted to their present value equivalents using a rate of return that reflects the relative risk of the investment, as well as the time value of money.

• When valuing an intangible asset, such as IP, a starting point for estimating the appropriate discount rate may be the weighted average cost of capital (“WACC”).• The WACC is an overall rate based upon the individual rates of return for invested capital components (equity and interest-bearing debt)

and is calculated by weighting the required returns on interest-bearing debt, and common equity capital in proportion to their estimated percentages in an expected capital structure.

• Depending on the premise of value, the WACC may be estimated with reference to a set of publicly listed comparable companies from which data regarding the cost of the debt and equity capital can be measured. However the credit worthiness of the subject company or investment may also be appropriate.

• Critical inputs and steps in the discount rate assessment include the selection of the comparable company set, the determination of the target capital structure and an assessment of the appropriate cost of debt.

• The means by which the asset could be financed should be considered and that may indicate that an equity rate of return is more appropriate.

Weighted Average Rate of Return on Assets:• The Weighted Average Rate of Return on Assets (“WARRA”) reflects required rates of return for all assets of a company, including both less

risky assets (e.g., working capital and fixed assets) and riskier assets (e.g. intangible assets such as technology, customer relationships, and goodwill).

• The “less risky” assets typically have an implied rate of return less than the overall IRR of the subject company. Required rates of return for tangible assets such as working capital and fixed assets are readily observable in agreements between borrowers/lenders of working capital and lessees/lessors of fixed assets.

• Required rates of return for intangible assets are not directly observable but are typically considered to be higher than those of fixed assets. Given the Fair Values and required rates of return for the tangible assets and the business overall, the required rate of return assumed for the intangible assets can be corroborated.


How to Value Intellectual Property?Income Approach – Discount Rate

Market ApproachII.ii.

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How to Value Intellectual Property?Market Approach

• The Market Approach uses comparisons to similar assets for which pricing information is available as the basis for the valuationassessment.

• It is often used for the valuation of portfolio’s of assets such as consumer brands or pharma products and may be used for the valuation of mining assets (mineral development and exploration interests).

• Key inputs into the Market Approach valuation include:• Prices and/or valuation multiples• Adjustments for differences between the subject and the benchmark asset• Geographical coverage and market share• Functionality• Markets accessed (e.g. business-to-business)• Date of the benchmark transaction

• The Market Approach is not adjusted for taxes and therefore it is typically not appropriate to add a TAB.• Potential areas of difficulty in performing the Market Approach include identifying availability of information and adjusting for related

parties, forced sales or specific synergies. A lack of comparable assets, due to the unique nature of many IP assets, may be a reason not to use the Market Approach.

• Sources of information include:• Disclosures in public filings (i.e. Annual Report, 10K)• Press releases• Comparable transactions• News articles/ press releases• Third party databases


How to Value Intellectual Property?Market Approach - example

Target Country Development StageTransaction Value (€m)

Reserves & Resources (000's oz.) Grade (g/t)

Price paid per oz. (€/oz.)

Company A Africa Exploration 18.4 1300.0 2.1 14.2xCompany B Europe Reserves Development 25.0 1150.0 3.1 21.7xCompany C Europe Feasibility 34.0 3000.0 1.1 11.3xCompany D Europe Reserves Development 35.0 800.0 4.2 43.8xCompany E Africa Exploration 5.0 730.0 2.3 6.8x

High 4.2 43.8xLow 1.1 6.8xAverage 2.6 19.6xMedian 2.3 14.2x

Selected Multiple 14.2x

Deposits ( oz.) 1,000,000

Fair Value (€) 14,200,000.0

An example of a mining reserves valuation, using an Market Approach, is presented below.

Cost ApproachII.iii.

• The Cost Approach uses the concept of replacement as an indicator of value. The rationale being that a market participant would not receive more for an asset than the cost to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence.

• The key inputs into a Cost Approach valuation are:• Base Costs: A Cost Approach is applied on a pre-tax basis and therefore development costs are viewed on a pre-tax basis. Costs

should reflect the cost to recreate today (current price trends) rather than the historical costs incurred, although historical costs may provide a reference point.

• Time to recreate• Developer’s Profit: Operating profit on development cost incurred. Based on the routine operating profit margin (or mark-up) that a

third party would earn to incur the development costs. • Opportunity Cost: Captures the foregone return on investment during the development period. Can be viewed as the accumulated

return on developers efforts or “entrepreneurial incentive” (amount required for incentive relative to another project).• Obsolescence Adjustment: This captures functional obsolescence (reduction in value due to the inability to perform the function for

which it was originally designed), physical obsolescence (physical wear and tear from continued use), technological obsolescence (decrease in value due to improvements in technology) and external obsolescence which covers both location (typically only relevant for real estate assets) and economic obsolescence (when operating profits of a business or asset do not support the underlying value of the asset under an in—use premise).

• It is not applicable to add a tax amortization benefit as this is inherently included in the pre-tax costs.

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How to Value Intellectual Property?Cost Approach

How to Value Intellectual Property?Cost Approach - Example: Software

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Employee Classification Software Engineers Average Total Compensation

Months to Develop Technology

Estimated Cost to Replace

IT Employee 25 70 36 5,250

Total Estimated Cost to Replace (£'000) 5,250

Estimated Total Cost to Replace 5,250 Obsolescence Factor 20%

Estimated Total Cost to Replace after Obsolescence 4,200

Plus: Developer's Profit @10% 420

Total Cost to Replace incl. Developer's Profit 4,620

Opportunity Cost

Time to develop the technology (years) 3

Year 1 Year 2 Year 3Annual Costs 1,540 1,540 1,540 Average Annual Cumulative Costs 770 2,310 3,850 Total Opportunity Costs @ WACC of 12% 92 277 462

Total Opportunity Costs 832

Total Value of Technology 5,452

Estimated Remaining Useful Life (years) 5

ConclusionIII.

• IP and intellectual capital are often the key value drivers and most important assets within a business, providing the foundation for market share and profitability growth. IP is often the focus of mergers and acquisitions and companies are increasingly using licensing routes for transfer price planning and to maximise value.

• The valuation of IP can become very technical but it is important to keep sight of the commercial reality. • The three principle approaches each have their benefits and limitations as noted below.

• Determining the applicable approach and obtaining as much support as possible is critical and supporting or cross checking the outcome with alternative approaches should be done where possible.

Conclusion

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Approach

Income Approach

Market Approach

Cost Approach

Advantages

• Captures unique economic features of the asset• Captures estimated future value

• Provides compelling empirical evidence of value• Relatively easy to apply if good comparables are

available• Conceptually pleasing

• Doesn’t need comparable market data• Appropriate when asset isn’t producing income• Can be appropriate for internally developed

intangibles or in liquidation scenarios

Disadvantages

• Relies on ability to accurately forecast future• Ensuring consistency of measure of economic

income and cost of capital

• IP transactions are often unique• Much of the information required to make

meaningful comparisons is not publicly available

• Data may not be readily available• May require numerous adjustments to financial

data

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