Intellectual property is often the driver behind business performance and economic growth. Relevant question: How do you determine the value of IP in an acquisition?
Uber, the world's largest cab company, does not own cars and Airbnb, the world's largest accommodation company, does not own real estate. In today's economy, the role of intellectual property (IP) is very important. Especially in knowledge-based economies, IP is the driver behind business performance and economic growth. Thus, IP is also increasingly playing a significant role in acquisitions.
What is intellectual property
Intellectual property commonly refers to rights such as patents, trademark rights, trade name rights, design rights, copyrights, trade secrets and know-how. A company can use intellectual property internally but also make it available externally to third parties through licensing or sale, among other things.
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Intellectual property is often capitalized on the balance sheet under intangible assets or recognized on the income statement. In 2014, the IFRS (International Financial Reporting Standards) established a number of requirements that must be met when capitalizing intangible assets: 1) identifiability must be clear; 2) the asset must be owned by the company; and 3) must result in future economic benefits. If these items cannot be met, the expenditure on the asset should be on the company's income statement at the time the expenditure occurred. For the buying party, it is important to know whether the IP to be acquired will allow you to carry out the business plan, what IP rights and obligations are in the company, and what IP risks, if any, are present in the company.
It is therefore important to value intellectual property correctly. Due to its nature, however, this is less straightforward than valuing tangible goods.
Valuation methods
In general, there are three approaches to valuing IP, each with its own advantages and disadvantages.
#1 Cost approach
The first approach, the cost approach, assumes that the value of an asset is equal to the replacement cost of the asset. Whereas the replacement cost approach looks at the cost of making or buying an exact replica, the reproduction cost approach looks at the cost of making or buying a good with equal economic benefit. Since IP is usually unique in nature, an exact replica cannot be made. When valuing intellectual property, it would be more appropriate to use the reproduction cost method. This approach is relatively easy to implement. However, a weakness is that future economic benefits are not considered. The approach assumes that costs incurred are an indicator of benefits (and thus value), which is often not the case in the case of IP.
#2 Market approach
The second approach, the market approach, values an asset based on prices paid in the market. The market value method looks at known transaction prices of the asset for valuation. This method requires that a good be homogeneous and that an active market exists for it. However, intellectual property generally does not meet this.
#3 Income approach
The third approach, the income approach, measures the value of the asset using the present value of the net economic benefit that will be generated over the life of the asset, discounting the expected cash flows using a weighted average cost of capital to determine the value.
This method uses the cash flows directly associated with the asset, such as licensing revenue, which is not always an issue. As with the market approach, the downside is that data is not always available. Intellectual property often has value only in a given situation.
Thus, the choice of method depends on the type of IP and the purpose of valuation. Proper application requires knowledge of the various methods and experience with the strengths and weaknesses of the methods. It is therefore advisable to hire a professional when your company's intellectual property needs to be valued.
