valuation of taxpayer ip assets (2012 willamette)

8/13/2019 Valuation of Taxpayer IP Assets (2012 Willamette)

1/23


2/23

38 INSIGHTS WINTER 2012 www.willamette.com

Accordingly, valuation analysts who practice inthe state and local property tax discipline should befamiliar with the following:

1. Intellectual property identification and duediligence procedures

2. Generally accepted valuation approachesand methods

3. Valuation synthesis and conclusion proce-dures

4. Valuation report writing practices5. Related valuation professional standards

First, this discussion considers many of the dif-ferent reasons why intellectual property owner/ operatorsand/or their legal counselwork withvaluation analysts to conclude the value of the tax-payer intellectual property.

Second, this discussion summarizes the gener-ally accepted approaches, methods, and proceduresrelated to intellectual property valuation. This dis-cussion outlines the valuation attributes that areparticular to each of the four types of intellectualproperty. And, this discussion describes the role ofthe due diligence process in the intellectual prop-erty valuation.

Finally, this discussion presents several illus-trative examples of the application of the three

generally accepted intellectual property valuationapproaches.

IDENTIFICATION OF T AXPAYER INTELLECTUAL P ROPERTY

An intellectual property is an intangible asset thatenjoys special legal recognition and protection. The

special legal status of an intellectual property is usu-ally the result of specific statutory authority, eitherfederal or state. General commercial intangible assetsare typically created in the normal course of the tax-payer (or owner/operator) business operations.

Common examples of general intangible assetsinclude customer contracts and relationships, sup-plier contracts and relationships, employee relations(as represented by a trained and assembled work-

force), licenses and permits, operating systems andprocedures, company books and records, and so on.Such general commercial intangible assets are

typically created over time in almost every success-ful going-concern taxpayer corporation. Taxpayerexecutives typically do not have to make a specialeffort to create such general commercial intangibleassets. Such general commercial intangible assetsnaturally develop as the taxpayer executives man-age the day-to-day operations of the going concerntaxpayer corporation.

On the other hand, an intellectual propertyis typically created by the specific and consciousintellectual activity of the developer. The creativityinvolved in developing an intellectual property cantypically be identified and attributed to a specificindividual. When created, an intellectual propertyis a new and unique invention that can be either(1) artistic, like a book or photographic image, or(2) technological, like a chemical process or com-puter software code.

This discussion applies to the valuation of allfour types of intellectual property: (1) patents, (2)trademarks, (3) copyrights, and (4) trade secrets. Asummary discussion of the four intellectual propertytypes is presented below.

Intellectual property is a subset of intangibleassets. Therefore, all intellectual property assets areintangible assets. Of course, all intangible assets arenot intellectual property assets. And, for purposesof this discussion, the terms intangible asset andintangible personal property are considered syn-onymous.

P ATENTS A patent grants an inventor the right to excludeothers from making, using, or selling the patented

invention for a statutorily determined period oftime. A patent represents a property interest for thepatent holder. There are three kinds of patents: util-ity, design, and plant patents.

A utility patent may be issued with regard to aninvention that has some type of usefulness or utility.

An example would be a new pharmaceutical productto control high blood pressure.


3/23

www.willamette.com INSIGHTS WINTER 2012 39

A design patent may be issued for any new, orig-inal, and ornamental design for an article of manu-facture 1 and does not need to meet the usefulnessstandard in order to qualify as a design patent. Inorder to qualify for a design patent (instead of for autility patent), the design must be purely ornamen-tal and nonfunctional. However, two patents may beissued for the same device:

1. A design patent for the product design

2. A utility patent for the product useful char-acteristics

A plant patent may be issued for an asexuallyreproduced distinct and new variety of plant. 2 Aplant also does not need to meet a usefulness stan-dard in order to qualify as a plant patent.

In order to qualify, an invention must meet spe-cific requirements. For example, an invention musthave utility and novelty.

Utility refers to usefulness, and this criterion isonly required for utility patents. Novelty, required forall three patents, means the invention, design, or plantmust be unique from all prior inventions, designs, orplants. An idea, however, cannot be patented.

T RADEMARKS A trademark is used to identify a brand or a com-pany and lets a consumer know that a good isproduced by a specific producer. A service mark isa closely related intangible asset to the trademarkintellectual property. A service mark lets the con-sumer know that a service is coming from a specificservice provider.

A taxpayer company that has developed a brandedproduct and invested in its production wants consum-ers to identify the product trademark with quality. Thetrademark associated with the subject product allowsthe taxpayer company to achieve that objective.

A trade name is different from a trademark. Atrade name is a business entitys name. A trademarkidentifies products and a service mark identifies ser-vices that are produced by that entity. Trade dressrefers to the way a product or service is displayedand promoted. For a product, the trade dress couldbe represented by the product packaging. For aservice, the trade dress may be the dcor that theservice is provided in.

C OPYRIGHTSCopyright law protects original works of author-ship. 3 To qualify for copyright protection, an origi-nal work must display at least some creativity andbe fixed in a tangible medium of expression.

Several types of original works of authorshipmay qualify for copyright protection: (1) literaryworks; (2) musical works, including any accom-panying words; (3) dramatic works, including anyaccompany music; (4) pantomimes and choreo-graphic works; (5) pictorial, graphic, and sculptur-al works; (6) motion pictures and other audiovisualworks; (7) sound recordings; and (8) architecturalworks. 4

An author is the person who created the work, ataxpayer company that pays someone to create thework in an employment context, or a business thatcommissions the work under contract. The authoris the owner of the copyright except in two cases:(1) the author assigns away the rights before com-pleting the work or (2) the author is an employeewho made the work as part of his or her employment.

T RADE S ECRETS A trade secret is any information that has economicvalue and is not generally known by the public. 5 Thetrade secret owner (i.e., taxpayer) can ensure thatthe information is generally unknown to the publicby taking reasonable measures to maintain the con-fidentiality of the information.

An example of such reasonable measures wouldbe to have a nondisclosure agreement signed by alltaxpayer company employees, consultants, and visi-tors with access to the secret business information.

The term trade secret covers a wide spectrumof information. The type of business informationthat is typically considered to be a trade secretincludes the following:

1. Information about customers, such as cus-tomer order and credit characteristics, cus-tomer lists, and mailing lists


4/23


2. Information about personnel, suppliers, ordistributors, such as supply sources

3. Information on the costs and pricing ofgoods, as well as books and records of thebusiness

4. Information concerning new business oppor-tunities and current business methods

5. Some databases and know-how

T HE I NTELLECTUAL P ROPERTY C OMMERCIALIZATION P ROCESS

A taxpayer intellectual property often enjoys com-mercialization opportunities that general commer-cial intangible assets typically do not. Goodwill, atrained and assembled workforce, or favorable sup-plier contracts typically cannot be commercializedoutside of the taxpayer company that owns/operatesthese intangible assets.

In contrast, intellectual property has transfer-able legal rights that can be more easily sold orlicensed. In addition, intellectual property legalrights can be easily divided, while intangible assetlegal rights cannot be easily divided.

For general commercial intangible assets, eitherthe taxpayer owner uses the intangible asset ora third-party operator uses the intangible asset.However, both the taxpayer owner and a third-partyoperator cannot use the same general intangibleassetfor example, the same assembled workforce.

Therefore, either the intangible asset is used toproduce (1) operating income (from the ownersuse of the intangible asset) or (2) owner income

(from the operators payment of a license fee tothe intangible asset owner). However, a generalintangible asset typically cannot produce both oper-ating income and owner (i.e., license) income at thesame time.

In contrast, for an intellectual property, thetaxpayer can use the intellectual property, and athird-party operator can also use the intellectualproperty. This occurs through the process of anintellectual property license. In addition, a second(and a third, and a fourth . . .) operator can use thetaxpayer intellectual property through the processof an intellectual property sublicense.

Accordingly, an intellectual property (such as apatent) can be used to produce operating incometo the taxpayer/owners business enterprise. And,it can also be used to produce owner (i.e., a licensefee from a third-party operator) income to the intel-lectual property taxpayer/owner.

Patents, trademarks, copyrights and trade secretscan be either sold outright or they can be licensed.

A license allows the intellectual property ownerto permit others to use the intellectual propertywithout the taxpayer giving up all of the ownershiprights to the intellectual property.

In general, this license procedure is similar tohow a franchise works. By way of analogy, the fran-chisor is the owner of the patent, trademark, copy-right, or trade secret, and the franchisee is able touse the franchisors intellectual property subject to

certain restrictions. An intellectual property owner does not have

to license its intellectual property. That is, thetaxpayer company may operate its own intellectualproperty by directly entering the relevant market-place. The taxpayer company can feel confident indistributing its work. This is because the intellectualproperty rights are protected either by statute or bycommon law.

C OMMON T ERMS OF I NTELLECTUAL P ROPERTY L ICENSE A GREEMENTS

One of the benefits of owning an intellectual prop-erty is the ability to license (or effectively lease) itto a third-party operator. In order to operate theintellectual property, a licensee may agree contrac-tually to pay such form of royalty fee to the licensor.The license of intellectual property can be a veryprofitable business line for the taxpayer company.

Typically, the terms of the intellectual propertylicense agreement will set out the royalty rate (orother royalty payment arrangement) that the opera-tor/licensee will pay to the owner/licensor. Thisroyalty rate is sometimes expressed as a percentage

of the income that is generated by the operation ofthe licensed intellectual property. When the intellectual property royalty rate is

expressed as such a profit split formula, 25 percentof the licensee/operator income is a common profitsplit royalty rate for the licensee/operator to payto the licensor/owner. For purposes of such a profitsplit formula, the licensee income is often defined asearnings before interest and taxes (or EBIT).

An intellectual property license agreementwill typically set out the terms by which thelicensee/operator can use the intellectual property.Obviously, the taxpayer company has a continuedinterest in the value of the intellectual property.

The taxpayer company does not want the subject intellectual property to be devalued in anyway because of misuse by the intellectual propertylicensee. Therefore, the intellectual property licenseagreement will typically set out standards or prac-tices that the licensee/operator must follow in orderto maintain the quality of the intellectual property.


5/23


C OMMON T ERMS OF O THER INTELLECTUAL P ROPERTY C ONTRACTS

The owner of the intellectual property rights is freeto grant to another party the full ownership of theintellectual property by selling it. In an intellectualproperty sale contract, the ownership of the intel-lectual property is fully transferred with the own-ership rights. After the intellectual property sale,no royalties will be paid to the original intellectualproperty owner.

T YPICAL P ARTIES TO THE INTELLECTUAL P ROPERTY C OMMERCIALIZATION P ROCESS

There are usually three parties to the intellectualproperty commercialization process:

1. The intellectual property developer

2. The intellectual property owner3. The intellectual property operator

One party may operate in all three roles. Thatwould be the case if the taxpayer company cre-ated the intellectual property, continues to own it,and uses it to generate or protect some measure ofincome.

Frequently, the intellectual property develop-er may also be the intellectual property owner.Typically, a person receives the legal rights to anintellectual property the moment it is created.

Those rights are then transferred to the taxpayercompany. However, who the intellectual propertyowner is, and what those ownership rights are, is notalways self-evident.

For example, if the work was a work of authorshipcreated for hire on commission, then the intellectu-al property developer would not be the intellectualproperty owner, but rather the taxpayer companythat commissioned the work for hire. If a taxpayeremployee in the scope of his or her employmentcreates the work, then the intellectual propertyrights would be owned by the taxpayer employer,also under the work made for hire doctrine. In the

case of inventions, generally speaking, a taxpayeremployer owns the rights to inventions created byemployees within the scope of their employment.

Alternatively, the taxpayer company may have animplied license known as a shop right to use theinvention royalty-free.

It is noteworthy that there is a distinctionbetween copyrights and patents. A copyright arises

immediately upon creation of the work of author-ship. In contrast, an invention, in terms of a pat-ent right, does not arise unless a patent authoritygrants a patent. Rather, in the case of unpatentedinventions, the right that would arise immediatelyupon creation may be a trade secret, depending iftrade secret conditions have been met.

If an intellectual property operator is not theintellectual property owner, then there typically

would be some form of a use license agreementbetween the two parties. The intellectual propertyoperator will typically pay a royalty fee to the intel-lectual property owner in exchange for the ability touse the intellectual property.

F ACTORS THAT THE V ALUATION A NALYST S HOULD C ONSIDER

Typically, the first procedure inthe intellectual property valua-tion analysis is for the valuationanalyst to identify the valuationsubject.

A typical dictionary definitionof intellectual property is:

Property that derives fromthe work of the mind or intel-lect; specifically: an idea,invention, trade secret, pro-cess, program, data, formula, patent, copy-right, or trademark or application, right, orregistration relating thereto. 6

As mentioned above, there are four types ofintellectual property: (1) patents, (2) copyrights, (3)trademarks, and (4) trade secrets. The intellectualproperty is the patent or the copyright itself. Theintellectual property is not the product that is pat-ented or the manuscript that is copyrighted.

F ACTORS R ELATED TO W HETHER THE T AXPAYER I NTELLECTUAL P ROPERTY I S V ALUABLE

The value of an intellectual property is influencedby its exclusivity. For example, once a patent orcopyright has expired and it can be used by anyparty, it will have far less value.

A patent or a copyright is typically more valuableat the beginning of its legal protection life. When a pat-ent is first granted, the intellectual property taxpayer/

A patent ora copyright istypically morevaluable at thebeginning of itslegal protectionlife.


6/23


owner can be assured of years of the exclusive abilityto prohibit anyone else from using, making, and sellingthe related property.

The intellectual property taxpayer/owner maylook forward to royalty income and/or operatingincome (however defined) from the intellectualproperty. As the legal protection expiration dateapproaches, the amount of future royalty and/oroperating income typically decreases. Therefore, the

value of an intellectual property typically decreasesover its life cycle.

G ENERAL R EASONS TO V ALUE INTELLECTUAL P ROPERTY

There are numerous general reasons why the tax-payer company (or its legal counsel) may ask thevaluation analyst to value a commercial intellectualproperty.

These various reasons may be grouped into thefollowing categories of taxpayer company motivations:

1. Transaction pricing and structuring2. Intercompany use and ownership transfers3. Financial accounting and fair value reporting4. State and local ad valorem property taxa-

tion planning and compliance5. Financing collateralization and securitization6. Litigation claims and dispute resolution7. Management information and strategic

planning8. Corporate governance and regulatory/con-

tractual compliance

9. Bankruptcy and reorganization analysis10. License, joint venture, and other develop-

ment/commercialization opportunities

The following discussion presents a nonexhaus-tive list of many of the specific reasons why thetaxpayer company (or its legal counsel) may ask thevaluation analyst to value intellectual property.

S PECIFIC R EASONS TO V ALUE INTELLECTUAL P ROPERTY

There are many specific reasons why the taxpayercompany (or its legal counsel) may require a valua-tion of intellectual property rights.

1. Transaction pricing or structuringn Pricing the sale of a taxpayer intellec-

tual property or a portfolio of two ormore intellectual property assets.

n Pricing the license of a taxpayer intel-lectual property or a portfolio of two ormore intellectual property assets.

n Equity allocation in a taxpayer businessenterprise or joint venture formationwhen the different investors contributedifferent tangible assets, general intan-gible assets, and intellectual property tothe start-up business.

n Asset allocation to the equity ownersin a liquidation of a taxpayer businessenterprise or joint venture when differentinvestors receive tangible assets, generalintangible assets, or intellectual propertyin exchange for their equity interests.

2. Intercompany use and ownership transfersn The transfers of intellectual property

between the wholly-owned subsidiaries(or other business units) of a consoli-dated taxpayer business enterprise.

n The transfer of intellectual property

between less than wholly-owned sub-sidiaries (with different minority share-holders) of a consolidated taxpayerbusiness enterprise.

n Product inventory cost accounting forin-process goods transferred betweenbusiness units with varying intellectualproperty ownerships in a consolidatedtaxpayer business enterprise.

3. Financial reporting and fair value accountingn Business acquisition purchase price

allocations among all acquired tangibleassets and intangible assets.

n Goodwill and intellectual propertyannual impairment testing.

n Post-bankruptcy fresh start accountingfor all taxpayer business entity tangibleassets and intangible assets.

4. Taxation planning and compliancen Purchase price allocations among all

acquired tangible assets and intangibleassets in a taxable business acquisition.

n Depreciation and amortization account-ing for purchased tangible assets and

intangible assets.n Charitable contribution deductions of

donated intellectual property.n Intercompany transfer pricing of intel-

lectual property owned by controlledforeign subsidiaries of a multinationaltaxpayer corporation.


7/23


n State and local ad valorem propertytax compliance and appeals related toexempt (or taxable) intellectual property.

5. Financing collateralization and securitiza-tionn Use of intellectual property as collateral

on cash flow-based or asset-based cor-porate debt financings.

n Sale/leaseback or sale/licenseback financ-ing of taxpayer intellectual property.

6. Bankruptcy and reorganizationn Use of intellectual property as collateral

on taxpayer secured debt.n Use of intellectual property as collateral

or debtor in possession (DIP) secureddebt.

n Intellectual property sale or license asa DIP cash generation spinoff opportu-nity.

n Use of taxpayer intellectual property in

the assessment of a debtor corporationsolvency or insolvency.n License or operating use of debtor

intellectual property as part of plan ofreorganization.

7. Litigation claims and dispute resolutionn Intellectual property royalty rate analy-

sis in infringement claims.n Intellectual property breach of contract

or noncompete/nondisclosure agree-ment economic damages claims.

n Intellectual property condemnation,

expropriation, eminent domain, or dis-sipation of taxpayer corporation claims.

n Intellectual property lost profits ininterference with business opportunityor lender liability claims.

8. Management information and strategicplanningn Formation of intellectual property joint

venture, joint development, or jointcommercialization agreements.

n Negotiation of inbound or outboundintellectual property use, development,

commercialization, or exploitationagreements.

n Analysis of intellectual propertybasedcapital formation alternatives.

n Analysis of intellectual propertybased(license, sale, use, etc.) wealth creationalternatives.

9. Corporate governance and regulatory com-pliancen Custodial inventory of all the taxpayer

owned and licensed intellectual property.n Assessment of insurance coverage

needed on the taxpayer intellectualproperty.

n Development of defense strategiesagainst infringement, torts, breach of

contract, and other wrongful acts.n Development of defense against dis-

sipation of taxpayer corporation assetsallegation.

10. Commercialization and development oppor-tunitiesn Identification of intellectual proper-

ty license, spin-off, joint venture, andother commercialization opportunities.

n Negotiation of intellectual propertylicense, spin-off, joint venture, andother commercialization opportunities.

Each of the above-listed motivations indicates areason why the taxpayer company or legal counselmay ask the valuation analyst to analyze intellectualproperty.

For each of these assignments, the valuationanalyst may consider one or more of the followingrelated (but subtly different) quantitative analysisobjectives:

1. To estimate a defined value for a specifiedownership interest in the intellectual prop-erty

2. To measure an appropriate royalty rate orlicense fee associated with the third-partylicense of the intellectual property

3. To calculate the arms-length price (ALP)for the intercompany transfer of intellectualproperty between controlled foreign entitiesof a multinational corporation.

4. To quantify the expected remaining usefullife (RUL) of the ownership or operation (orassociated rate of change in the value) ofthe intellectual property.

5. To determine the amount of lost profits or

other economic damages associated with adamages event suffered by the intellectualproperty.

6. To opine on the fairness (or solvency, ade-quate consideration, excess benefits, etc.)of an intellectual property sale or licensetransaction.


8/23


The following discussion focuses on the first cat-egory of these intellectual property analysesthatis, to estimate a defined value for the taxpayer intel-lectual property.

Nonetheless, there are numerous similarities inthe generally accepted approaches, methods, andprocedures that the valuation analyst may use inthe performance of all types of intellectual propertyvaluation, forensic analysis, and financial opinion

engagements.

G ENERALLY A CCEPTED INTELLECTUAL P ROPERTY V ALUATION A PPROACHES AND M ETHODS

There are numerous methods and procedures thatmay be used in the valuation of intellectual prop-erty. Due to the fundamental similarities and differ-ences of these valuation methods and procedures,they are categorized into three generally acceptedvaluation approaches. These three generally accept-ed intellectual property valuation approaches arebased on fundamental economic principles.

The three generally accepted intellectual proper-ty valuation approaches are: (1) the cost approach,(2) the market approach, and (3) the incomeapproach.

The generally accepted valuation approachesencompass a broad spectrum of microeconomicsprinciples and property investment dynamics. Eachof the three generally accepted valuation approach-es has the same objective: to arrive at a reasonable

indication of a defined value for the taxpayer intel-lectual property.

Accordingly, analytical methods and proceduresthat are based on the same economics principles aregrouped into the three valuation approaches.

A valuation analyst will typically attempt tovalue the taxpayer intellectual property using allthree generally accepted valuation approachesinorder to obtain a multi-dimensional perspective onthe intellectual property. However, the individualmethods and procedures that are associated withthe three valuation approaches may or may not beapplicable to the valuation of a particular intellec-tual property.

Consequently, the valuation analysts selectionof the valuation methods and procedures used tovalue a particular intellectual property will dependon the following factors:

1. The unique characteristics of the intellec-tual property

2. The purpose and objective of the subjectanalysis

3. The quantity and quality of available data

4. The ability of the valuation analyst to con-duct adequate due diligence related to thosedata

5. The transactional practices in the subjecttaxpayer industry

6. The experience and judgment of the valua-tion analyst

The objective of using more than one valua-tion approach is to develop mutually supportingevidence for the value conclusion. The valuationanalysts value conclusion is typically based on asynthesis of the value indications derived from eachapplicable valuation approach and method.

M ARKET A PPROACH V ALUATION

M ETHODSThe market approach is based on the economicsprinciples of competition and equilibrium. Theseeconomics principles indicate that, in a free andunrestricted market, supply and demand factorswill drive the intellectual property price to a pointof equilibrium.

The principle of substitution also influences themarket approach. This is because the identificationand analysis of the equilibrium price for a substituteintellectual property will provide pricing evidencewith regard to the intellectual property value.

Market Approach Valuation PrinciplesThe valuation analyst will often attempt to applymarket approach methods first in the valuation pro-cess. This is because the marketthat is, the eco-nomic environment where arms-length transactionsbetween unrelated parties occuroften providesthe best indication of value.

However, the market approach may not beappropriate for the valuation of certain taxpayerintellectual property. This is particularly the case ifthe condition of the taxpayer intellectual propertyis not sufficiently similar to the intellectual proper-ties that are transacting (by sale or license) in themarketplace.

In that case, the guideline intellectual propertytransactional prices may not indicate the expectedprice for the intellectual property.

The price of an intellectual property is not nec-essarily equal to its value. Value is often defined as


9/23


an expected price. That is, value is the price that theintellectual property owner would expect to fetch inthe appropriate marketplace.

In contrast, price represents what one particularbuyer paid to one particular seller for one particularintellectual property.

In any particular intellectual property sale (orlicense) transaction, either participant may havebeen influenced by nonmarket, participant-specific

influences. If such influences did occur, and if suchinfluences are not general to the marketplace, thenthat particular intellectual property transactionalprice may not be indicative of the expected price forthe intellectual property.

Even if the intellectual property was itself boughtor licensed, that transactional price should not benaively relied upon to indicate an expected futureprice. This is because this transactional price mayhave been influenced by nonmarket, participant-specific influences.

The Market Approach ValuationProcess Within the market approach, there are generallyrecognized valuation methods. The practical appli-cation of these market approach methods involves acomplex and rigorous analytical process. There is ageneral systematic processor frameworkto theapplication of intellectual property market approachmethods.

The basic procedures of this systematic processare summarized as follows:

1. Research the appropriate exchange market

to obtain information about sale or licensetransactions, involving either guideline(i.e., generally similar) or comparable(i.e., almost identical) intellectual propertythat may be compared to the intellectualpropertyin terms of characteristics suchas intellectual property type, intellectualproperty use, taxpayer industry in whichthe intellectual property operates, date ofthe sale/license, etc.

2. Verify the information by confirming (a)that the data obtained are factually accurateand (b) that the sale or license exchangetransactions reflect arms-length marketconsiderations. If the guideline sale orlicense transaction was not at arms-lengthmarket conditions, then adjustments tothe transactional data may be necessary.This verification procedure may also elicitadditional information about the currentmarket conditions for the sale or license

of the intellectualproperty.

3. Select relevant unitsof comparison (e.g.,income multipliers,dollars per unit, orother metricsunitssuch as per draw-ing, per customer,

per line of code)and develop a com-parative analysis foreach selected unit ofcomparison.

4. Compare the select-ed guideline orcomparable intel-lectual property saleor license transactions with the taxpayerintellectual property using the selected ele-ments of comparison; and adjust the sale orlicense price of each guideline transaction

appropriately to the taxpayer intellectualproperty. If such adjustments cannot bemeasured, then the valuation analyst mayeliminate the sale or license transactionas a guideline for future valuation analysisconsideration.

5. Calculate the various pricing metrics (foreach unit of comparison) derived fromthe guideline or comparable transactions.Quantify the mean, median, high, and lowpricing metrics from the sample of selectedguideline or comparable transactions.

6. Select the various pricing metrics (e.g.,revenue multiples, income multiples, priceper drawings, price per line of code, etc.)that is appropriate to the intellectual prop-erty. The selected pricing metrics may beat the low end of the range, middle of therange, or high end of the range providedby the guideline or comparable transactiondata. The valuation analyst should selecttaxpayer-specific pricing metrics based onthe analysts comparisons of the intellectualproperty to the guideline/comparable intel-lectual property.

7. Apply the selected taxpayer-specific pric-ing metrics to the intellectual propertyfinancial or operational fundamentals (e.g.,revenue, income, etc.) in order to concludeone or more value indications.

8. Reconcile the various value indicationsproduced from the analysis of the guide-line/comparable sale or license transaction

Even if the intel-lectual propertywas itself boughtor licensed, thattransactional

price should notbe naively reliedupon to indicatean expected futureprice.


10/23


pricing metrics into either (a) a single valueindication or (b) a range of values.

The reconciliation procedure is the last proce-dure of any market approach valuation analysis inwhich two or more value indications are derivedfrom market-derived transactional data.

In the reconciliation procedure, the valuationanalyst summarizes and reviews (1) the transac-tional data relied upon and (2) the analyses thatresulted in each value indication. The valuation ana-lyst then resolves these value indications into eithera range of values or into a single value indication.

It is important for a valuation analyst to considerthe strengths and weaknesses of each value indica-tion derived, examining the reliability and appropri-ateness of (1) of the market data compiled and (2)the analytical procedures performed.

C OST A PPROACH V ALUATION

M ETHODS The cost approach is based on the economics prin-ciples of substitution and price equilibrium. Theseeconomics principles indicate that a willing buyerwill pay no more for a fungible intellectual propertythan the cost to obtain (i.e., either to purchase orto construct) an alternative intellectual property ofequal utility.

In other words, a willing buyer will pay no morefor a fungible intellectual property than the price ofan intellectual property of comparable utility. Forpurposes of this economics principle, utility can be

measured in many ways, including functionality,desirability, and so on. Accordingly, an efficient market will adjust the

price of all assets (including intellectual property)in equilibrium so that the price the market will payis a function of the comparative utility of each intel-lectual property.

The cost approach often has application limita-tions with regard to a taxpayer intellectual propertyvaluation. This is because most intellectual proper-ties are not fungible. Instead, most intellectual prop-erties are unique. That is, the intellectual propertycannot be substituted for a comparable intellectualproperty.

When the intellectual property is unique (func-tionally, technologically, or legally), then the valu-ation analyst should carefully consider the appli-cation of the cost approach to the property taxvaluation.

Within the cost approach, cost is influenced bythe marketplace. That is, the relevant cost is often

the greatest amount that the marketplace is willingto pay for the fungible intellectual property.

This value is not necessarily the actual historicalcost of creating the intellectual property, and it isnot necessarily the sum of the historical costs forwhich the willing seller would like to be compen-sated. This is because value is not equal to cost,at least not to cost as measured in the historicalaccounting sense.

The conceptual foundation of all cost approachvaluation methods relates to the following econom-ics principles:

n The substitution principleThis principleconcludes that no prudent buyer would paymore for a fungible intellectual propertythan the total cost to develop a new intel-lectual property of equal desirability andutility.

n The supply and demand principleThisprinciple indicates that shifts in supply anddemand (1) cause costs to increase anddecrease and (2) cause changes in the sup-ply of different types of intellectual prop-erty.

n The externalities principleThis principleindicates that gains or losses from externalfactors may affect the value of an intel-lectual property. For this reason, externalconditions may cause a newly created intel-lectual property to be worth more or lessthan its cost.

Definition of Intellectual Property Cost There are several generally accepted cost approachvaluation methods. Each of these valuation methodsuses a particular definition of cost. Two commoncost definitions are as follows:

1. Reproduction cost new 2. Replacement cost new

Reproduction cost new is the total cost, at cur-rent prices, to develop an exact duplicate or replicaof the taxpayer intellectual property. This duplicateintellectual property would be developed using thesame materials, standards, design, layout, and qual-

ity of workmanship used to create the original intel-lectual property.Replacement cost new is the total cost to devel-

op, at current prices, an asset having equal function-ality or utility of the intellectual property.

Functionality is an engineering concept thatmeans the ability of the intellectual property to per-form the task for which it was designed.


11/23


Utility is an economics concept that means theability of the intellectual property to provide anequivalent amount of satisfaction.

The replacement intellectual property would be(1) developed with modern methods and (2) devel-oped according to current standards, state-of-the-artdesign and layout, and the highest available qualityof workmanship.

Accordingly, the replacement intellectual prop-

erty may have greater utility than the taxpayerintellectual property. If this is the case, the valu-ation analyst should adjust for this factor in theobsolescence analysis of the replacement cost newless depreciation method.

Moreover, while the replacement intellectualproperty performs the same task as the taxpayerintellectual property, the replacement asset is oftenbetter (in some way) than the taxpayer intellec-tual property. The replacementasset may yield more satisfac-tion than the taxpayer intellec-tual property. If this is the case,

the valuation analyst shouldadjust for this factor in thereplacement cost obsolescenceestimation.

There are several other costdefinitions that may be applica-ble to a cost approach analysis.For example, some valuation analysts consider ameasure of cost avoidance as a cost approach meth-od. This method quantifies either historical or pro-spective costs that are avoided (i.e., not incurred)by the taxpayer company due to the intellectualproperty ownership.

In addition, some valuation analysts considertrended historical costs as a value indication. Inthis method, actual historical intellectual propertydevelopment costs are identified and quantified and,then, trended to the valuation date by an appro-priate inflation-based index factor. Regardless of thespecific definition of cost used in the analysis, allcost approach valuation methods typically includea comprehensive and all-inclusive cost definition.

Intellectual Property Cost ComponentsThe intellectual property development cost mea-surement (whether replacement cost, reproductioncost, or some other cost measure) should includenot only direct costs (e.g., materials) and indirectcosts (e.g., engineering and design labor). The costmeasurement should also include the following:

1. An intellectual property developers profit(on the direct cost and indirect cost invest-ment)

2. An opportunity cost/entrepreneurial incen-tive (to economically motivate the intellec-tual property development process)

The developers profit is a cost component thatis sometimes overlooked in the cost approach analy-sis. From the perspective of the intellectual propertydeveloper, first, the developer expects a return of allof the material, labor, and overhead costs related to

the development process.For example, a building contractor expects to

earn a reasonable profit on the construction ofany residential, commercial, or industrial building.Likewise, an intellectual property developer expectsto earn a reasonable profit on the development ofthe intellectual property.

The developers profit can be estimated by usingseveral procedures. It can be estimated as a percent-

age return on the developersinvestment in material, labor,and overhead. It can be estimat-ed as a percentage markuporas a fixed dollar markuptothe amount of cost and timeinvolved in the developmentprocess. It can also be estimatedas a fixed dollar amount.

The valuation analyst maysometimes disaggregate the developers investmentinto two subcomponents:

1. The amount financed by external financ-ing sources (e.g., banks and other financialinstitutions)

2. The amount financed by the owner/opera-tors capital

The developers profit associated with the costsfinanced by external sources is analogous to con-struction period interest accrued in the construc-tion of a tangible asset.

Some valuation analysts include this construc-tion period interest in the developers profit costcategory, and some valuation analysts include thisinterest as overhead in the indirect cost category.Usually, a higher rate of return is assigned to thecost amount financed by the owner/operators capi-

tal, as compared to the cost amount financed byexternal financing sources.

The opportunity cost is another cost compo-nent that is sometimes overlooked in the costapproach valuation analysis. Nonetheless, oppor-tunity cost is an important consideration of thecost approach analysis. The opportunity costis the amount of economic benefit required to

Robert F. Reilly. IntellectualProperty Assets in the TaxpayerCorporation. Journal of PropertyTax Administration 6, no. 2 (2009).

Further Reading


12/23


motivate the owner/ operator to enter intothe development pro-cess.

The opportunity costis often measured by ref-erence to the intellectualproperty replacement/ reproduction time peri-

odthat is, the amountof time required forthe owner/operator toreplace or reproduce theintellectual property denovo.

The valuation ana-lyst will estimate theamount of the differencebetween

1. the amount of economic income that theowner/operator will earn by operating thetaxpayer intellectual property during thereplacement time period and

2. the amount of economic income that theowner/operator will earn (without operat-ing the subject intellectual property) duringthe intellectual property replacement timeperiod.

Typically, the intellectual property developerwill earn zero or negative economic income dur-ing the replacement/reproduction time period. Thedifference between these two economic incomeestimates (i.e. (1) positive for ownership/operationof the intellectual property and (2) zero or negativefor development of replacement/reproduction intel-lectual property) is one procedure for measuring theopportunity cost component of the cost approachanalysis.

With regard to the cost approach, intellectualproperty developers may be compared to real estatedevelopers (e.g., the developer of a shopping mallor a residential apartment complex). There is anopportunity cost associated with the developmentprocess for both the intellectual property developerand the real estate developer. The time (and the

financial resources) that they devote to the subjectproject is time (and resources) they are divertingfrom another development project.

Alternatively, the time (and the financialresources) that they devote to the subject project istime (and resources) they are diverting from owningthe subject (operational) intellectual property orresidential/commercial real estate complex.

Likewise, both the intellectual property devel-oper and the real estate developer expect to becompensated for the conceptual, planning, andadministrative efforts associated with putting theentire project together. They both expect to be com-pensated for the full period of time between

1. when they initially begin the developmentof the subject project and

2. when they realize the full commercial

potential of the subject developmentproject.

This opportunity cost concept may be easier tounderstand with regard to the real estate developer.From the time the real estate developer first beginsto construct the shopping mall until the time all ofthe retail stores are leased and occupied, the devel-oper is likely to experience negative cash flow dur-ing this development period. Lets assume that thistime period is two years.

A real estate developer who purchased an opera-

tional (i.e., fully leased) shopping mall two yearsearlier would experience positive cash flow duringthat same two-year period. The foregone cash flowduring the two-year development period is one indi-cation of the opportunity cost required to motivatethe real estate developer to build a new shoppingmall (instead of buying an existing shopping mall).

Accordingly, this opportunity cost measure maybe considered as one of the cost components in thereal estate valuation cost approach analysis.

The same type of opportunity cost is necessaryto motivate the intellectual property developer toproduce a new patent, trademark, computer pro-gram copyright, chemical formulation trade secret,food recipe trade secret, or other taxpayer intellec-tual property.

The taxpayer company should be compensatedfor the risk of the new development process com-pared to the relatively low risk of using the last gen-eration of technology, consumer brands, computersoftware, and so on.

The intellectual property developer should becompensated for the forgone economic income(however measured) during the development peri-od. This forgone economic income is one indica-tion of the opportunity cost required to motivatethe developer to create a new intellectual property(instead of buying an existing intellectual property).

Accordingly, this opportunity cost measureshould be considered as one of the cost componentsin the cost approach analysis.

All four cost componentsthat is, direct costs,indirect costs, developers profit, and opportunity

. . . both the intel-lectual propertydeveloper and thereal estate developerexpect to be compen-sated for the concep-tual, planning, andadministrative effortsassociated withputting the entireproject together.


13/23


costshould be considered as part of a cost approachanalysis. So, while the cost approach is a fundamen-tally different set of valuation analyses from theincome approach, there are necessary economicanalyses involved in the cost approach.

These economic analyses (which may involvesome analysis of the intellectual property income)provide indications of both

1. the appropriate levels of opportunity cost (ifany) and

2. the appropriate amount of economic obso-lescence (if any).

Cost New Less DepreciationThe replacement cost new is the total cost to cre-ate, at current prices, an intellectual propertyhaving equal utility to the taxpayer intellectualproperty. However, the replace-ment asset would be (1) devel-oped with modern methods and(2) developed according to cur-rent standards, state-of-the-artdesign and layout, and the high-est available quality of work-manship.

Accordingly, the replace-ment intellectual property mayhave greater utility than thetaxpayer intellectual property.

Reproduction cost new is the total cost, at cur-rent price, to construct an exact duplicate or replicaof the intellectual property. This duplicate intel-lectual property would be created using the samematerials, standards, design, layout, and quality ofworkmanship used to create the original intellectualproperty.

The intellectual property cost new (howevermeasured) should be adjusted for losses in valuedue to

1. physical deterioration,2. functional obsolescence, and3. economic obsolescence.

Physical deterioration is the reduction in the

intellectual property value due to physical wearand tear resulting from continued use. It is unlikelythat intellectual property will experience physicaldeterioration.

Functional obsolescence is the reduction in theintellectual property value due to its inability toperform the function (or yield the periodic utility)for which it was originally designed. Technological

obsolescence is a decrease in the intellectual prop-erty value due to improvements in technology thatmake an intellectual property less than the idealreplacement for itself.

The technological component of functional obso-lescence occurs when, due to improvements indesign or engineering technology, a replacementintellectual property produces a greater standard-ized measure of utility production than the taxpayer

intellectual property.Economic obsolescence (i.e., a component of

external obsolescence) is a reduction in the intel-lectual property value due to the effects, events, orconditions that are external toand not controlledbythe intellectual property current use or condi-tion.

The impact of economic obsolescence is typi-cally beyond the control of the owner/operator. For

that reason, economic obsoles-cence is typically consideredincurable.

In any cost approach analy-sis, the valuation analyst willestimate the amounts (if any)of physical deterioration, func-tional obsolescence, and eco-nomic obsolescence related tothe intellectual property. In thisestimation, the valuation ana-lyst often considers the intel-

lectual property actual ageand its expected RUL.Such an age/RUL consideration is a common com-ponent of the cost approach.

In the cost approach, the typical formula forquantifying the intellectual property replacementcost new is: reproduction cost new curable func-tional obsolescence = replacement cost new.

To estimate the intellectual property value, thefollowing formula is often used: replacement costnew physical deterioration economic obsoles-cence incurable functional obsolescence = value.

INCOME A PPROACH V ALUATION M ETHODS

The income approach is based on the economics

principle of anticipation (also called the principleof expectation). In this approach, the intellectualproperty value is the present value of the expectedeconomic income to be earned from the ownership/ operation of the intellectual property.

As the name of this economics principle implies,the willing buyer anticipates the expectedincome to be earned from the intellectual property.

C. Ryan Stewart. FunctionalObsolescence Considerationsin the Cost Approach Valuationof Industrial and CommercialProperty. Willamette ManagementAssociates Insights (Summer 2008).

Further Reading


14/23


This expectation of prospective income is con-verted to a present worththat is, the intellectualproperty indicated value. This conversion requiresthe valuation analyst to estimate the investorsrequired rate of return on the intellectual propertygenerating the prospective economic income.

This required rate of return will be a functionof many economic variables, including the riskorthe uncertaintyof the expected economic income.

Measures of Commercial IntellectualProperty Income

There are numerous alternative income measuresthat may be relevant to a taxpayer intellectualproperty valuation. If properly applied, these differ-ent income measures can all be used in the incomeapproach to provide a reasonable value indication.

Some of the alternative income measures includethe following:

1. Gross or net revenues

2. Gross income (or gross profit)3. Net operating income4. Net income before tax5. Net income after tax6. Operating cash flow 7. Net cash flow 8. Incremental income9. Differential income10. Royalty income11. Excess earnings income12. Several others (such as incremental income)

There are different income measures that maybe used in the income approach. Therefore, animportant procedure in this valuation approach isfor the valuation analyst to ensure that the discountrate or the direct capitalization rate used is derivedon a basis consistent with the income measure used.

There are at least as many income approachvaluation methods as there are alternative incomemeasures.

In addition, all of the different income approach

valuation methods use two categories of mathemati-cal procedures:

1. Direct capitalization procedures2. Yield capitalization procedures

However, most income approach valuation meth-ods may be grouped into the following categories

of valuation methods. These categories of incomeapproach valuation methods have similar practicaland conceptual considerations.

Income Approach Valuation MethodsThese common categories of intellectual propertyincome approach valuation methods are summa-rized below:

1. Valuation methods that quantify theincremental level of intellectual propertyincomethat is, the taxpayer companywill earn greater revenue (however mea-sured) by owning/operating the intellec-tual property as compared to not own-ing/operating the intellectual property.

Alternatively, the taxpayer company willincur lower costssuch as investmentcosts, capital costs, or operating costsby owning/operating the intellectual prop-erty as compared to not owning/operatingthe intellectual property.

2. Valuation methods that estimate a relieffrom a hypothetical royalty paymentthatis, the amount of a royalty payment thata hypothetical third-party licensee wouldbe willing to pay to a hypothetical third-party licensor in order to obtain the rightuse of the intellectual property. The tax-payer company does not have to pay (i.e.,is relieved from paying) this hypotheticallicense royalty payment. This is becausethe taxpayer company actually owns theintellectual property. Therefore, the tax-payer company does not have to inbound

license the intellectual property from ahypothetical third-party licensor.

3. Valuation methods that measure a differen-tial level of incomethat is, these methodscompare the income that the taxpayercompany actually earns with the intellec-tual property in place to some benchmarkincome measure. The benchmark incomemeasure can be an industry average levelof income, a measure of income earned byselected guideline companies, the incomeearned by the taxpayer company beforethe intellectual property was developed,

etc.4. Valuation methods that consider com-

parable companiesthat is, these meth-ods compare the taxpayer company toselected comparable publicly traded com-panies. These companies typically operatein the same industry as the taxpayer com-pany, and they may be competitors to the


15/23


taxpayer company. The difference is thatthe selected companies dont operate thetaxpayer intellectual property. These meth-ods compare the taxpayer profit margin(typically the earnings before interest andtaxesor EBITmargin) to the compa-rable companies. These methods assign anyexcess profit margin (above the profit mar-gins earned by the comparable companies)to the taxpayer intellectual property. Thesemethods are often called comparable profitmargin (CPM) methods.

5. Valuation methods that quantify a profitsplitthat is, these methods start with thetaxpayer total operating profit margin, typi-cally measured as the EBIT margin. Thesemethods split or allocate the taxpayerprofit margin between (a) the intellectu-al property and (b) all other contributoryassets. Contributory assets are all of the tax-payer other working capital assets, tangibleassets, and other (routine) intangible assets

that are used to produce the total operatingincome. The profit split percent (e.g., 20percent, 25 percent, 30 percent) allocatedto the intellectual property is typically basedon the valuation analysts functional analysisof the taxpayer business operations.

6. Valuation methods that requantify residualor excess profitsthat is, these methodsalso start with the taxpayer total operatingincome, typically measured as the net cashflow. Next, the valuation analyst identifiesall of the taxpayer contributory assets.Third, the valuation analyst assigns a fair

rate of return to each of the contributoryassets. The fair rate of return multipliedby the value of the taxpayer contributoryassets results in the capital charge, or thecontributory asset charge. Last, the totalnet cash flow minus the contributory assetcharge equals the taxpayer residual orexcess profits. These residual or excessprofits are then associated with the tax-payer intellectual property.

Direct Capitalization Procedures

In a direct capitalization analysis, the valuation ana-lyst (1) estimates a normalized income measure forone future period and (2) divides that income mea-sure by an appropriate investment rate of return.The appropriate investment rate of return is calledthe direct capitalization rate.

The direct capitalization procedure can be usedany time the intellectual property income is expect-

ed to change by a constant rate (whether that rateis positive, negative, or zero percent) over a multi-year period.

The direct capitalization rate may be derivedfor (1) a perpetuity period of time or (2) a speci-fied finite period of time. This decision will dependon the valuation analysts expectation of the intel-lectual property income flow duration. And, theexpected income flow duration is typically equal to

the intellectual property RUL.Few intellectual property assets have an infinite

RUL. Therefore, it is a more common procedure touse the direct capitalization procedure on a limitedRUL basis. That is, the analyst will calculate a directcapitalization rate for a finite RUL, such as 10 yearsor 20 years.

If the valuation analyst projects an infinite RULfor the taxpayer intellectual property, then the ana-lyst will typically also project that the taxpayer willincur some amount of annual maintenance expendi-tures (e.g., R&D expense, advertising expense, pub-lishing expense) in order to continually maintainthe intellectual property life.

In the limited life direct capitalization proce-dure, the appropriate direct capitalization multipleis typically the present value annuity factor (PVAF)for the selected capitalization rate for the intellec-tual property expected RUL.

Yield Capitalization MethodsIn a yield capitalization analysis, the valuation ana-lyst projects the intellectual property income mea-sure (however defined) for a discrete time period

into the future. This income projection is convertedinto a present value by the application of a presentvalue discount rate.

The present value discount rate is the inves-tors required rate or returnor yield capitalizationrateover the expected duration of the intellectualproperty income flow.

The duration of the income projection periodand whether or not a residual value or terminalvalue should be considered at the conclusion ofthe projection perioddepends on the valuationanalysts estimate of the income duration. And, thatestimate of the income duration is typically basedon the intellectual property RUL.

The yield capitalization procedure is typi-cally used when the taxpayer intellectual prop-erty income flow (however defined) is expectedto change on a nonconstant growth rate over theincome projection period. In such an instance, thedirect capitalization procedure is not applicable,


16/23


and the yield capitalization procedure is perfectlyapplicable.

The result of either the direct capitalizationanalysis or the yield capitalization analysis is theincome approach value indication. Either capi-talization procedure can be used with any of theintellectual property income measurement methodsdescribed above.

Income Tax Amortization Adjustment Regardless of whether the yield capitalization proce-dure or the direct capitalization procedure is used,there is one additional income approach procedurethat the valuation analyst should consider.

That procedure relates to the cash flow effect ofthe income tax amortization deduction related to anintellectual property that is purchased as part of ataxable business combination.

More often than not, the valuation analyst doesnot need to make this income tax amortization

adjustment to the preadjusted income approachvalue indication. However, the valuation analystshould consider whether such an adjustment isappropriate in each intellectual property incomeapproach valuation analysis.

When an intellectual property is purchased aspart of the taxable acquisition of a going-concernbusiness, the price of that purchased asset may beamortizable to the acquirer for federal income taxpurposes.

This amortization deduction is allowed underInternal Revenue Code Section 197. That is whysuch intellectual property assets are referred to asSection 197 intangible assets.

However, the valuation analyst should realize thefollowing:

1. Not all taxpayer intellectual property quali-fy as Section 197 intangible assets.

2. A Section 197 intangible asset has to bepurchased as part of a going-concern busi-ness acquisition (and not on a stand-alonebasis).

3. The business acquisition has to be a tax-able transaction, such as a cash for assets

transaction under Section 1060 (and not,for example, a Section 368 stock for stockmerger).

4. The intellectual property owner/operatorcontemplated in the defined standard ofvalue should be a taxpayer company thatis able to use the amortization-relatedincome tax deductionthat is, the owner/

operator must be a taxpayer (and not taxexempt) entity.

Therefore, before applying an income tax amor-tization adjustment, the valuation analyst shouldconsider the following questions:

1. Is the intellectual property a Section 197intangible asset?

2. Would the intellectual property normallysell as a Section 197 intangible asset?

If the answer to either question is yes, then thevaluation analyst may consider applying an incometax amortization adjustment. Section 197 allows thebusiness acquirer to amortize the fair market value(presumably, the price paid) of the purchased intel-lectual property over a statutory 15-year amortiza-tion period. This annual amortization is a deductionthat reduces the acquirers taxable income and,therefore, income tax expense.

The value of this amortization deduction is thepresent value of the income tax expense savingsover 15 years, present valued at the same dis-count rate used in the intellectual property incomeapproach valuation analysis.

When applicable, this present value of incometax expense savings is added to the preadjustedincome approach value indication for the intellectu-al property. The sum of (1) the present value of theincome tax savings and (2) the preadjusted valueindication equals (3) the final intellectual propertyincome approach value indication.

Alternatively, some valuation analysts use anincome tax amortization factor as a shortcut to the15-period tax expense savings calculation.

The common income tax amortization factorformula is:

1

1

In this formula, the income tax rate should bethe same tax rate that was used in the unadjustedincome approach analysis. The present value annu-ity factor is the present value of an annuity of $1 for15 years at the present value discount rate that wasused in the unadjusted income approach analysis.The amortization period is always 15 years for aSection 197 intangible asset.

For example, lets consider a business acquirerwith a 40 percent effective income tax rate and a 20percent present value discount rate.


17/23


Using the amortization value adjustment factorformula, the intellectual property income approachvalue indication amortization adjustment would becalculated as follows:

1

1 1

amortization value adjustment factor = 14%

Assuming that the unadjusted income approachvalue indication for the taxpayer intellectual prop-erty is $1,000, the amount of the amortization valueadjustment is $140 rounded (i.e., $1,000 14%).

When using the amortization value adjustment fac-tor formula, the total income approach value indica-tion for the taxpayer intellectual property is $1,140(i.e., $1,000 unadjusted value + $140 income taxamortization value adjustment).

This income tax amortization value adjustment(however calculated) is intended to reflect the incre-ment in net cash flow related to the amortization-

related income tax expense savings. This net cashflow increment is not reflected in the unadjustedincome approach analysis.

This adjustment, then, properly reflects theamount of income tax expense that should beincluded in the income approach valuation analysis.

Since it is an adjustment to income tax expensein the income approach, this adjustment is notapplicable to either the cost approach or the marketapproach. In other words, the income tax amortiza-tion adjustment should not be considered in intel-lectual property valuation analyses based on eitherthe cost approach or the market approach.

R EMAINING U SEFUL L IFE A NALYSIS After the valuation analyst has identified the appro-priate intellectual property valuation approachesand methods, the typical next procedure is the RULanalysis. The estimation of the intellectual propertyRUL (i.e., a lifing analysis) is a common compo-nent of each of the generally accepted valuationapproaches.

In the income approach, a lifing analysis may beperformed to estimate the projection period for theintellectual property income subject to either yieldcapitalization or direct capitalization.

In the cost approach, a lifing analysis may beperformed in order to estimate the total amount ofobsolescence, if any, from the estimated measure ofcostthat is, the intellectual property reproduc-tion cost or replacement cost.

In the market approach, a lifing analysis may beperformed to select, reject, and/or adjust compa-rable or guideline intellectual property sale orlicense transactional data.

For each valuation approach, the RUL analysishas a direct and predictable effect on the intellec-tual property value indication. The likely expectedeffect on the taxpayer intellectual property valueindication is summarized below.

E XPECTED E FFECT ON THE I NCOME A PPROACH V ALUE I NDICATION

Normally, in the income approach, a longer RULestimate results in a greater intellectual propertyvalue. The income approach value is particularlysensitive to the RUL estimate when the RUL is lessthan 10 years.

The income approach value is not particularlysensitive to the RUL estimate when the RUL is morethan 20 years.

E XPECTED E FFECT ON THE C OST A PPROACH V ALUE I NDICATION

Normally, in the cost approach, a longer RUL esti-mate results in a greater intellectual property value.That is because a longer RUL generally indicatesless obsolescence in the intellectual property.

Normally, a shorter RUL estimate results in alower intellectual property value. This is becausea shorter RUL generally indicates greater obsoles-

cence in the intellectual property.

E XPECTED E FFECT ON THE M ARKET A PPROACH V ALUE I NDICATION

The market should indicate an acceptance for thetaxpayer intellectual property RUL. If the taxpayerintellectual property RUL is materially differentfrom the guideline sale or license transaction intel-lectual property RUL, then adjustments to themarket-derived transactional pricing multiples (orother metrics) should be considered.

If the taxpayer intellectual property RUL is morethan materially different from the guideline sale orlicense transaction intellectual property RULs, thenthis fact may indicate a lack of marketability forthe taxpayer intellectual property. This fact mayindicate a lack of market demand for an intellectualproperty with the taxpayer intellectual property age/ life characteristics.


18/23


C OMMON F ACTORS I NFLUENCING INTELLECTUAL P ROPERTY E XPECTED RUL

The following list presents some of the factors thatthe valuation analyst may consider in the taxpayerintellectual property RUL analysis:

n Legal factorsn Contractual factorsn Functional factorsn Technological factorsn Economic factorsn Analytical factors

The valuation analyst will typically considereach of these categories of life influence factors inthe intellectual property RUL estimation. Typically,for ad valorem property tax intellectual propertyvaluation purposes, the life factor that indicates theshortest RUL deserves primary consideration in theintellectual property RUL estimate.

V ALUATION I LLUSTRATIVE E XAMPLES

As explained above, the taxpayer intellectual prop-erty values indicated by all three generally acceptedvaluation approaches should be considered in thefinal value synthesis and conclusion. This is dueto the fact that the valuation variables usedandthe value indications concludedin each approachprovide a different perspective on the intellectualproperty value.

The following discussion presents simplifiedillustrative examples with regard to an intellec-tual property valuation for a hypothetical TaxpayerCorporation. Each simplified example illustrates

one of the three generally accepted valuationapproaches.

Taxpayer Corporation is a centrally assessedtaxpayer. The current assessment date is January1, 2011. Lets assume that all intangible per-sonal property (including intellectual property)is exempt from property tax in the subject taxing

jurisdiction.

Exhibit 1Taxpayer CorporationCopyrights on Computer SoftwareFair Market ValueAs of January 1, 2011

Cost Approach Valuation Analysis

Software Systems

Person-Hours toReplace

theComputerSoftware

AverageBase Cost

perPerson-

Hour($)

EmployeeBenefits and

OverheadCost

AllocationFactor

FullAbsorption

Cost perPerson-Hour

($)

ReplacementCost New

LessDepreciationComponents

($)Facility scheduling 150,000 75 1.85 139 20,850,000Facility processing 80,000 75 1.85 139 11,120,000Inventory control 100,000 85 1.85 157 15,700,000Administration and

accounting85,000 90 1.85 167 14,200,000

Total direct and indirect costs 61,870,000Plus: Developers profit at 15% [a] 9,280,000Plus: Entrepreneurial incentive [b] 3,558,000Replacement cost new (RCN) 74,708,000Less: Functional obsolescence (at 15% of RCN) [c] 11,206,000Equals: Replacement cost new less depreciation 63,502,000Equals: Software copyrights fair market value(rounded) 64,000,000

Footnotes:[a] estimated software developers typical profit margin[b] 10% rate of return on the average RCN investment[c] based on all of the taxpayer computer programs that are scheduled for replacement as of 1/1/11


19/23


The taxpayerslegal counsel retainedthe valuation analystwith the instruction toidentify and value allTaxpayer Corporationintellectual property asof the assessment date.

First, the valuation

identified and valuedthe copyrights associ-ated with the taxpayersinternally developedcomputer software. Theanalyst decided to usethe cost approach andthe replacement costnew less depreciationmethod to value thisintellectual property.

A summary of thiscost approach valuationis presented on Exhibit1.

Second, the analystidentified and valuedthe utility patent asso-ciated with a taxpayerproprietary process.The analyst learnedthat the taxpayer uses the patent, in part, for defen-sive purposes. That is, Taxpayer Corporation man-agement believes that its competitors could easilyreverse engineer the proprietary process within twoyears, without the patent protection.

However, the patent allows the taxpayer to main-tain its process superiority (and operating cost)advantage in the industry.

The analyst decided to rely on the incomeapproach and a discounted cash flow method. Theanalyst considered the economic advantage relatedto the patent over a two-year period; the expectedperiod over which the patent protects the taxpayerstechnological market advantage.

Therefore, the analyst considered the revenueand profitability of the product produced by thepatented process over the next two-year period.This patent valuation analysis is summarized onExhibit 2.

Third, the analyst identified and valued thetrade secret related to the taxpayers (unpatented)proprietary technology and its related documents.Such documents include engineering drawings, pro-cedural and operational manuals, and related tech-

nical documentation. These trade secrets are usedto generate a substantial amount of the taxpayerstotal production.

The valuation analyst worked with TaxpayerCorporation management to (1) develop a projec-tion of the economic benefits associated with thetrade secrets (unpatented) technology and (2) esti-mate the appropriate intellectual property RUL (andassociated economic benefits).

Based on the results of those analyses, the valu-ation analyst decided to use the income approachand the multi-period excess earnings method (or

MEEM).

The summary of this intellectual property valua-tion analysis is presented on Exhibit 3.

Finally, the valuation analyst identified and val-ued the Taxpayer Corporation trademarks and tradenames. The analyst decided to rely on the marketapproach and the relief from royalty method.

The analyst searched for and selected severalcomparable uncontrolled transaction (CUT) arms-length licenses of similar trademarks.

The valuation analyst worked with TaxpayerCorporation management to (1) develop a revenue

Exhibit 2Taxpayer CorporationPatentsFair Market ValueAs of January 1, 2011

Income Approach Valuation AnalysisPatented Process Projection Variables ($ in 000s) Year 1 Year 2

Net sales [a] $146,912 $161,603Gross margin 38,197 42,017Operating expenses (16,160) (17,776)Earnings before interest and taxes 22,037 24,240Income tax expense (7,933) (8,727)Operating income 14,104 15,514Depreciation expense 1,469 1,616Capital expenditures (1,469) (1,616)Capital charge on contributory assets [b] (2,200) (2,200)Incremental net working capital investment (696) (735)

Net cash flow related to patents 11,208 12,579Present value factor at 10% discount rate .9524 .8658Present value of net cash flow 10,674 10,891Equals: Patent fair market value (rounded) 22,000

Footnotes:[a] Assumes a two year patent protection period, a period that protects the taxpayer

from a competitors reverse engineering of the patented process.[b] Contributory assets include other taxpayer tangible assets and routine intangible

assets that are used to generate this income projection.


20/23


21/23


projection for the trademarkedproducts and an estimate of thetrademark RUL.

A summary of the marketapproach intellectual propertyvaluation analysis is presented inthe Exhibit 4 series.

S UMMARY AND C ONCLUSION

This discussion summarized thevaluation analyst considerationsrelated to the valuation of thetaxpayer intellectual propertyfor ad valorem taxation pur-poses.

Such taxpayer intellectualproperty includes the following:

1. Patents

2. Copyrights3. Trademarks4. Trade secrets

An intellectual propertyenjoys special legal recognition (compared to gen-eral intangible assets). In addition, intellectualproperty can generate income to the taxpayer com-pany owner in the form of either (1) license royaltyincome and/or (2) use operating income.

The taxpayer company (or its legal counsel)may ask a valuation analyst to value the intellectualproperty for a variety of reasons. These reasonsinclude transaction (sale or license), financing,commercialization, taxation, accounting, strategicplanning, and forensic analysis purposes.

In particular, valuation analysts are often askedto value the intellectual property (and other intan-gible personal property) of taxpayer companies thatare assessed using the unit valuation principle forstate and local property tax purposes.

Such taxpayer companies typically operate inthe following industries:

n Telecommunicationsn Electric utilitiesn Oil and gas refiningn Pipelinesn Water and wastewater utilitiesn Cable televisionn Airlines

n Railroadsn Mining and mineral extractionn Other operationally integrated industries

The intellectual property valuation processbegins with the definition of the valuation assign-ment. This assignment definition includes: (1)the purpose and objective of the analysis, (2) thedescription of the taxpayer intellectual property andthe related bundle of rights, and (3) the statement ofthe valuation as of date.

Often the first procedure in the valuation analy-sis is the identification of the subject intellectualproperty ownership rights. The taxpayer intellectualproperty value is often a function of its potential toearn and/or protect income for the taxpayer owner/ operator.

The next procedure in the intellectual propertyvaluation is the consideration of the three generally

accepted valuation approachesthe cost approach,the market approach, and the income approach.

Each valuation approach has the same objective:to arrive at a reasonable value indication for the tax-payer intellectual property. Within each valuationapproach, there are numerous methods and proce-dures that may be appropriate for the intellectualproperty valuation.

Exhibit 4ATaxpayer CorporationTrademarksFair Market ValueAs of January 1, 2011

Selected Comparable Uncontrolled TransactionsThird Party Trademark License Royalty Rates

GuidelineLicense

GuidelineLicensee

GuidelineLicensor

StartDate

TermYears

RoyaltyRate %

Other LicenseConsideration

1 Licensee A Licensor A 2009 15 6 $4m [a]2 Licensee B Licensor B 2009 10 5 $10m [b]3 Licensee C Licensor C 2008 12 10 [c]4 Licensee D Licensor D 2008 10 4.5 [d]5 Licensee E Licensor E 208 15 5.5 [e]6 Licensee F Licensor F 2009 20 8-10 [f] [d]

Footnotes:[a] represents Licensor upfront payment[b] represents Licensor payment after 5 th year

[c] this license also settles a pending $50 million litigation[d] the trademark owner also receives other payments from the licensee[e] there are numerous relationships between licensor/licensee parties[f] rate varies based on annual sales volume


22/23


Exhibit 4BTaxpayer CorporationTrademarksFair Market ValueAs of January 1, 2011

Analysis of CUT Trademark License AgreementsRoyalty Rate Adjustment Grid

GuidelineLicense [a]

LicenseRoyaltyRate %

HowComparable

to Subject? [b]

ComparativeSize of

Market [c]

ComparativeGrowth ofMarket [c]

RelativeMarket

Share [c]

OtherLicense

Consideration

AdjustedLicense

Royalty Rate1 6 3 0 0 +.5% [d] 6%2 5 2 ++ ++ 0 +1% [d] 7%3 10 2 0 0 0 -2% [d] 8%4 4.5 3 0 0 [d] 4%5 5.5 2 + + 0 [d] 6%6 8-10 3 -2% [e] 7%

Royalty Rate Mean 6.3%Royalty Rate Trimmed Mean 6.5%Royalty Rate Median 6.5%Royalty Rate Mode 6.5%Royalty Rate Conclusion 6.5%

Footnotes:[a] from Exhibit 4A.[b] on a scale of 0 to 3; where 0 is less comparable to the subject taxpayer trademark and where 3 is most comparable to the subject

taxpayer trademark[c] on a scale of , -, 0, +, ++; where is the smallest and where ++ is the largest[d] valuation analyst adjustment based on an assessment of other factors (1) in the license agreement or (2) between the licensor and the

licensee[e] valuation analyst adjustment due to differences in the subject taxpayer trademark vs. the selected guideline trademark

The analysts selection of the appropriate valu-ation methods and procedures is based on several

factors, including the following:1. The characteristics of the taxpayer intel-

lectual property2. The quantity and quality of available data3. The analysts ability to conduct a sufficient

due diligence analysis4. The purpose and objective of the valuation

assignment5. The experience and judgment of the valua-

tion analyst.

The final intellectual property value conclu-sion is typically based on a synthesis of the valueindications derived from each applicable valuationapproach and method.

These generally accepted valuation approaches,methods, and procedures are relevant to the taxpay-er intellectual property analysis during the entire

ad valorem tax return filing, assessment negotiationand appeal, and taxpayer litigation process.

Notes:1. What Is a Patent? U.S. Patent and Trademark

Office, www.uspto.gov.2. Ibid.3. Copyright Basics, U.S. Copyright Office, www.

copyright.org: 14. Ibid.: 3.5. Uniform Trade Secret Act, Section 1.6. Merriam-Websters Dictionary of Law .

Robert Reilly, CPA is a managing direc-tor of the firm and is resident in ourChicago office. Robert often writes,lectures, and testifies with regard to the valuation of intel lectual p roperty for ad valorem taxat ion (and other ) purposes. Robert can be reached at (773) 399-4318 or at r freil ly@willamet te.com.


23/23

E x h i b i t 4 C

T a x p a y e r

C o r p o r a

t i o n

T r a

d e m a r

k s

F a i r M a r

k e t V a l u e

A s o

f J a n u a r y

1 ,

2 0 1 1

R e l i e f f r o m R o y a l t y V a l u a t i o n M e t h o d

A p p l i c a t i o n o f S e l e c t e d R o y a l t y R a t e

M a r k e t A p p r o a c h V a l u a t i o n A n a l y s i s

T r a d e m a r k R o y a l t y I n c o m e P r o j e c t i o n P e r i o d [ a ]

T r a d e m a r k V a l u a t i o n V a r i a b l e s ( i n $ m i l l i o n )

Y e a r 1 Y e a r 2 Y e a r 3 Y e a r 4 Y e a r 5 Y e a r 6 Y e a r 7 Y e a r 8 Y e a r 9

R e v e n u e g r o w

t h r a t e [ b ]

1 0 %

1 0 %

1 0 %

0 %

0 %

0 %

- 1 2 %

- 1 2 %

- 1 2 %

T r a d e m a r k p r o d u c t r e v e n u e ( y e a r 0 = 4 0 0 ) [ b ]

4 4 0

4 8 4

5 3 2

5 3 2

5 3 2

5 3 2

3 6 9

4 1 2

3 6 3

S e l e c t e d p a t e n t l i c e n s e r o y a l t y r a t e

6 . 5 %

6 . 5 %

6 . 5

%

6 . 5 %

6 . 5 %

6 . 5 %

6 . 5

%

6 . 5 %

6 . 5 %

P r o j e c t e d r e l i e f f r o m r o y a l t y l i c e n s e e x p e n s e ( r o u n d e d )

2 9

3 1

3 5

3 5

3 5

3 5

3 0

2 7

2 4

P r o j e c t e d l e g a l a n d m a i n t e n a n c e e x p e n s e ( y e a r 0 e x p e n s e = 1 0 )

1 0

1 1

1 1

1 1

1 2

1 2

1 2

1 3

1 3

P r o j e c t e d l i c e n s e n e t e x p e n s e r e l i e f ( r o u n d e d )

1 9

2 0

2 4

2 4

2 3

2 3

1 8

1 4

1 1

P r e s e n t v a l u e d i s c o u n t f a c t o r ( a t 2 0 % , m

i d - y e a r c o n v e n t i o n )

0 . 9 1

0 . 7 6

0 . 6

3

0 . 5 3

0 . 4 4

0 . 3 7 0 . 3

0

0 . 2 5

0 . 2 1

P r e s e n t v a l u e o f l i c e n s e n e t e x p e n s e r e l i e f

1 7

1 5

1 5

1 3

1 0

9

5

4

2

T o t a l p r e s e n t v a l u e o f l i c e n s e n e t e x p e n s e r e l i e f

9 0

E q u a l s : T r a d e m a r k f a i r m a r k e t v a l u e ( r o u n d e d )

9 0

F o o t n o t e s :

[ a ] b a s e d o n t h e e s t i m a t e d t r a d e m a r k R U L .

[ b ] b a s e d o n t a x p a y e r m a n a g e m e n t p r o j e c t i o n s r e l a t e d t o t h e t r a d e m a r k e d p r o d u c t s .

valuation of taxpayer ip assets (2012 willamette)

Documents