Valuation and Accounting of Intellectual Valuation and Accounting of Intellectual Property (IP) Assets:Property (IP) Assets:

Importance, Methods and ChallengesImportance, Methods and Challenges

Guriqbal Singh JaiyaGuriqbal Singh JaiyaDirectorDirector

SMEs Division ( SMEs Division ( www.www.wipowipo..intint//smesme// ) )World Intellectual Property Organization World Intellectual Property Organization

(WIPO)(WIPO)

Value of Companies1978: Book Value (95 % tangibles)

and Market Value (5 % IP and Other Intangibles)

1998: Book Value (28 % tangibles) and Market Value (72 % IP and Other Intangibles)

Intangibles Assets as % of S & P Market Capitalization

• 1982: TA=62%; IA= 38%

• 1992: TA=38%; IA= 62%

• 2002: TA=13%; IA= 87%Tangible Assets (TA)

Intangible Assets (IA)

Source: Brookings Institute

IP and Business Plan• Patents Vs. Trade secrets

• Ease or difficulty in detecting patent infringement (>hidden processes, e.g., petroleum, pharma) (<Products with serial numbers, e.g., automobiles, software)

• Intensity of rivalry within the industry

• Many patents or a few multi-claim patents

• Strength of patent; blocking patents

• Patent clusters: Horizontal or vertical

Financing Options

• Grant

• Loan (Portfolio of IP)

• Equity

• Bonds

• Securitization

Source of Financing Prudent Investors look before they commit

• Family, Friends, and Fool (Idea)

• Government (Grants, soft loans)

• Banks/Financial Institutions

• Angel Investors (Pre-venture or ‘seed type’)

• Venture Capitalists (Proven Idea)

Motivations For IP Valuation (1)

• Traditional Bank Financing

• Angel/Venture Capital Investing

• Licensing

• Sale, Merger, Acquisition

• Gift

• Bankruptcy/Liquidation

• IP Investment Holding Company

Motivations For IP Valuation (2)

• Taxation/Transfer Pricing

• Insurance

• Joint Ventures

• Estate Duty

• Capital Markets/Securitization

• Enforcement/Litigation

• Off-balance sheet financing

Who Cares?• Employees

• Investors

• Shareholders

• Investment Bankers

• IPO Specialists

• Wall Street analysts

• Merger & Acquisition Interests

• Licensees, Franchisees• Internal asset

Managers• International affiliates• The Media• Other Stakeholders

Standards of Value• Fair Market Value/Market Value• Insurable Value• Fair Value• Collateral Value• Ad Valorem Value• Acquisition Value• Use Value• Investment Value

Valuation • Of a Company

• Of its IP Assets

• Due Diligence (Evaluate, Valuation)

• Accounting of Intangibles (Balance sheet)

Valuation Steps

A. Data Collection and Analysis (Due Diligence)

B. Valuation Methods

C. Economic Life Analysis

D. Value Conclusion

E. Reporting

Due Diligence

• Expensive: To be amortized over the life o the loan as a higher rate of interest

Grants

• Government Schemes (e.g., Singapore, Canada)

• University

• Municipal/Local Bodies

• Foundations

Loans

Acceptable Collateral should be:

• Readily Identifiable

• Durable

• Marketable

• Value reasonable ascertainable

• Securable

Collateral: Priority in Interest

• ‘Perfecting’ a security Interest; due diligence

• Recording requirement: IP register

• IP as ‘hostage’ for good behavior (‘Moral Hazard’)

• Contingency Plan for repossessed collateral (‘Market for Lemons’: Information asymmetry)

IP Valuation Methods

•Market Approach

•Cost Approach

•Income Approach

•Judicial Approach

Market Approach

• Expected sale price at a specific time, in a particular market, based on comparable arm’s length market transactions

• Extensive knowledge of comparable data required

Cost Approach

• Economic principle of substitution

• Reproduction cost (Exact replica)

• Replacement cost (Different form or appearance)

Cost Approach

COMPONENTS

• Materials

• Labor

• Overheads

• Intangible Asset Developer’s profit/reward

• Entrepreneurial Incentive

Cost Approach

OBSOLESCENCE:

• Physical

• Functional

• Technological

• Economic

Income ApproachPresent Value of Future Income Stream• Future Income Stream (Economic Income)

• Duration (Life: Legal, contractual, judicial, physical, technological, functional, analytical, economic)

• Risk (Uncertainty of receiving expected income; interest rates and investment climate)

Methods to Determine Income Stream

• Residual Earnings Approach

• Excess Earnings Approach

• Loss of Income Approach

• Relief From Royalty Approach

• Stock Options (Black-Scholes/Merton Approach)

Residual Earnings Approach

• Business Unit Scale

• Technology Scale

• Product Scale

• Trademark or Patent Scale

Residual Earnings Approach Methods

• Monte Carlo

• Knowledge Capital Score Card

• Tech Factor Method

• Crystal Ball

• Technology Risk and Reward Unit Metrics

• Technology Review Patent Scorecard

• @Risk

Judicial Approach

• Hypothetical Negotiation Between Willing Seller and Buyer

• Georgia Pacific Factors (15)

Georgia Pacific Factors (Patent)

1. Commercial success, current popularity, and profitability of Patented Product (PP);

2. Advantages of PP over old products;

3. Nature of patented invention, character of products embodying invention, benefits to those using the invention;

4. Likely profit margin on PP;

5. Portion of profit credited to patented invention;

Georgia Pacific Factors (Patent)

6. Benefit to non-patented items by sale of PP;

7. Duration and other terms and conditions of patent license;

8. Extent to which infringer has made use of the patented invention;

9. Prior and existing licenses under the patent;

10. Terms for licensing other technologies by licensee;

Georgia Pacific Factors (Patent)11. Patent owner’s licensing and marketing policy;

12. Commercial relationship between the licensor and licensee;

13. Nature and scope of license: territories, field of use, exclusivity, etc;

14. Industry specific practices for comparable patents (established royalty agreements); and

15. Opinion of Experts

Trademark/Brand-related Bundle

• Logo and Logotype• Sub-brands• Domain Names• Trade dress• related Copyrights• Secondary

trademarks• Advertising Concepts

• Graphics• Labeling and

Packaging design• Product shapes• Web-based assets

Attributes Affecting TM Value 1

• Age

• Use

• Potential for Expansion

• Potential for Exploitation

• Associations

• Connotations

• Timeliness

• Quality

Attributes Affecting TM Value 2

• Profitability

• Expenses of promoting

• Means of promoting

• Market share

• Market potential

• Name recognition

Accounting of IP

Patentsprotect

inventions (products, processes)

Mark/ Geographical Indications protects distinctive words, logo,

names, slogans, symbols

Industrial Designprotects

appearance of products,packaging

Trade Secrets protect business plans,

know how, client portfolio,

tacit knowledge, processes

Only IP that generates

direct cash flows in a commercial

transaction is considered

Copyright/Related Rightsprotects literary and artistic works; performers, phonograms,broadcasters; software

Protection against Unfair Competition

As an intangible asset, IP is...

RiskySuccessful IP creation requires creativity and inventive abilities; commercialization

Non-Rivalrous in ConsumptionIP can be used simultaneously by different people without diminishing in its worth

TransferableIP is transferable to a newor similar business context

Context sensitiveBackground of users & context determine relevance of IP to business

Useful for ExcludingIP guarantees right to exclude others and ‘freedom to operate’ in the market

Natureof IP

PerishableOver time IP may become outdated,e.g. technology cycles

… which accountants finds difficult to grasp

Impact on Type of Language developed for IP

• Silence about a lot of a firm’s IP due to inherent definitions and assumptions in accounting

• Internally and externallygenerated IP is treated differently

• Goodwill

• Historically evolved to report tangible assets/liabilities

• Quantitative stock of performance

• Documentation of past financial position

• Factual, precise, objective, comparable information

• Determines perception of a firm’s management and other market participants

Rationale behind Accounting

Accountants recognize the challenge...

• FASB & SEC recommend Voluntary IP Reports“Companies are encouraged to continue improving their business reporting & to experiment with types of information

disclosed & the manner by which it is disclosed.”

• US GAAP allows to account IP explicitly in M&AFAS 141 & 142 require to identify each single asset & determine its fair valueThe amortization of Goodwill is replaced by an annual impairment tests

• Basel Committee on Banking Supervision recognizes the inadequacy of “fair value” for financial assets“In the absence of active markets it will be difficult to obtain or calculate a reliable fair value for certain non-marketable financial instruments held at cost.”

Explicit IP Accounting Gains Momentum— Comparison of different Accounting Standards —

Recognition of IP

US-GAAP German HGB

• Forbidden: § 248/2 HGB

• Exception: acquired IP

IAS/IFRS

• Recognition of IP if IAS criteria are met: IAS 38

• Recognition of IP: Novel approach under FAS 141 &142

Trend towards the explicit recognition of IP increases

InternallyGenerated

IP

• Immediately expensed • Immediately expensed • Immediately expensed

• Recognition of acquired IP:

§ 255/4 HGBAcquired IP

• Recognition of acquired IP if IAS criteria are met: IAS 38

• Purchase Price distributed across all items: FAS 141

• Impairment Test of Goodwill: FAS 142

Advantages of Reporting IP

• Communicates the value of IP to investors • Shows what IP the company owns• Puts a value to the IP• Explains how the IP relates to business segments

INVESTORS

MANAGERS

• Get information on how IP drives growth • Receive adequate inputs for earnings/sales forecasts• Can better estimate risks/revenues of an investment• Can better understand the nature of a business• Increases predictability while decreasing volatility

The IP Reporting Process

•Align IP portfolio to overall business strategy

•Explain to all in the firm why IP matters

•IP Audit

•Set ownership in correlation to expected results

• Understand legal and business scope of IP assets

• Use a reporting system for demonstrating

the value of IP in business

Create IP ownership Understand

IP Ownership

ReportIP

GenerateSuperiorResults

Create IPOwnership

Build IPBusinessCulture

•Ensure market position through IP ownership

•Establish an enabling IP policy and environment

$$$or

¥¥¥or

£££

Elements of an IP Report• Executive Summary How does IP relate to the bottom line of your business? How do you make money and what role does the IP play in it?

• Relate your income streams to IP What were the returns from IP protected business segments? Does the IP help you to gain market share and/or improve profitability?

• Relate IP to your position in the Market How did IP give you an advantage over your competitors? Do you have “freedom to operate” & exclusivity in the market place?

• Demonstrate your managerial skills How determined are you to extract revenue from IP? What experience do you have in managing IP?

• Understand the legal scope of the IP rights What level of protection does your IP guarantee you? What is the risk that you infringe the IP of others and/or that others (legally) free-ride/steal your IP?

The Key Message

!Till there is an adequate accounting standard for IP, SMEs are best advised to develop a voluntary IP report to enhance their position in the market, facilitates access to funding & improves its overall management