Valuation of Intellectual Property Assets

Professor Derek BosworthIntellectual Property Research Institute

of AustraliaMelbourne University

Coverage of the presentation

• IP as a component of IC

• Nature of the management problem

• The Diageo problem

• Nature of the accounting problem

• Accounting issues surrounding intangibles

• Accounting methods for intangible assets

• Options pricing and optimal stopping

• [Other strategic issues]

Not covered in the presentation

• Economic approaches to valuationProduction function and market valuation –

dealt with in a previous presentationPatent valuation analysis – using renewal

data

• Methods of valuing product characteristicsConjoint analysis (marketing)Hedonic analysis (economics)

IP as a component of IC

Intellectual Capital

Human Capital

Relational Capital

Organisational Capital

Intellectual Property

“Sociological” Skills and

Capital

“Technological” Skills and

Competencies

Infrastructure Capital

Organisational (structural) capital: examples of IP/IPRs

• patents

• copyrights

• design rights

• trade secrets

• trade marks

• service marks

• trade dress

• utility models

• plant & seed varieties

Nature of the management problem

Why Value Intellectual Capital

• Measurement of IC - enables a more efficient management of the company - i.e. to:understand where value lies in the companyhave a metric for assessing success and growthprovide a basis for raising finance or loans

• If borrowing can only be secured against tangible assets, then knowledge-based companies will be disadvantaged in investment and growth.

The Diageo problem

Diageo: the company

• Grand Metropolitan - formed as a hotel company in 1962

• by mid-1980s strengths in variety of branded products

• became known as Diageo in 1997, on merger with Guiness

Previous accounting practice

• GrandMet – often bought and sold brands• Acquired Heublein from Nabisco in 1987• Paid £800 million, of which over £500 million

was for the Heublein brands (i.e. intangibles)• Given the accounting procedures at the time,

GrandMet published its next set of accounts in January 1988

the Heublin brands were not valued£565 million of the £800 million paid for the company

was written off as goodwill against reservesas a result, the balance sheet net assets fell, giving

the impression than £565 million had been wasted

Changed accounting practices• Subsequently GrandMet introduced brand

capitalisation• after acquiring Pilsbury in 1989, the balance

sheet showed the importance of brandsbrands £2.7 billionother assets £6.9 billionliabilities (mainly debt) (£6.7 billion)net assets £2.9 billion

• Without brand capitalisation the balance sheet would have shown net assets of only £0.2 billion

• Corbett (1997) argues that this would have been an absurd situation

Further example of brand aquisition

• GrandMet acquired Pet in 1995 at a cost of £1.8 billion

• Again, the acquisition affected GrandMet's balance sheetbrands £3.8 billionother assets £7.3 billionliabilities (7.7 billion)net assets £3.4 billion

Accounting issues surrounding intangibles

Accounting concerns

• Is the intangible asset clearly identifiable

• Does the company hold an unambiguous title to the asset

• Could the intangible asset be sold separately from the business

• Does the intangible give rise to a “premium” not earned by other companies?

Replicated plant and

equipment

Product modification

Innovation

New factory

Staff training

Research and development

Most certain Most uncertain

Source: Webster

Tangibility and uncertainty

Separable Not separable

Wholly tangible (i.e. machine tool)

Highly intangible (i.e. goodwill)

Source: Wild and Secluna

Tangibility and Separability: the Spectrum of Assets

Accounting methods for intangible assets

Accounting approaches to valuation

• Cost based valuationhistorical creation cost - how much did it cost to create?current recreation cost - how much would it cost to

recreate an identical intangible?

• Market based valuation - evidence from sale or purchase of similar assets (i.e. individual brands, branded divisions or whole companies)

• Income based valuation looks at the stream of income attributable to the intangible asset, based on:historical earnings (i.e. multiple of earnings)expected future earnings (i.e. discounted cash flow)

External influences on IC measurement and disclosure

• Writing off expenditures on intangibles against profits or reserves seems wrong

• Thus, there is considerable pressure on accounting bodies devise new accounting codes of practice (SSAPs/GAAPs)

• Examples:SSAP 13, 1989 - covers the treatment of R&D

expenditureDraft SSAP 22, “Accounting for Goodwill”

IC audits

Towards an IC audit• Various authors suggest an IP audit – see

e.g. Brooking 1997• Each company produces a taxonomy and

set of checklists similar to Slide 3 above• Weights are applied to each item on the

checklist – reflecting importance in achieving company goals

• Large “dots” reflect very important and small less important

• Position within the target reflects the perceived strengths (close to “bull”) and weaknesses (far from “bull”) of each asset.

Brooking’s “target”

Conclusions on IC audits• Majority of the 8 large dots (more) and 22 small

dots (less important), in IP quadrant• Brooking argues

target is consistent with an IP dominant company (40% of listed assets are IP assets)

if the company is not intended to be IP dominant, then “severe changes are required”

66% of the IP assets are below average in value, including the significant ones

• Tracking likely changes over time, she argues“The IC of this company looks like its in pretty bad

shape and likely to get worse.”

Options valuation and optimal stopping techniques

Options values• Options pricing methods are potentially the

way forward• Only method that really deals with risk• Applicable to every stage of creative process:

investment in R&Ddecision to patent, etc.decision to commercialise the invention

• But:Need information about wide range variablesInventive process is a multi-stage decision – which

makes the calculation very complex

Underlying principle

• Black-Scholes→Merton→Dixit & Pindyck

• equations that allow for changes in the degree of risk over time

• in the D&P modelthe benefits of waiting one more periodminus costs of waiting= value of the option

• often called optimal waiting models

Value of a real option

The value of real option is determined by:

• present value of project cash flows (+)

• investment cost of project (-)

• time remaining to invest in the project (+)

• standard deviation of the project value (+)

• risk free interest rate (+)Pitkethly (2002)

Optimal stopping rules

• Use the distribution of possible returns to decide:how much to dohow long to go on doing it

• Uses the distribution to calculate a “reservation return” R* which indicates:whether to do any R&Dwhether to accept a given result, R, and

exploit, R>R*or carry on doing research