Many small businesses today have a significant amount of intellectual property as part of their value. Sometimes it can be difficult to actually place a value on this type of property. It can be hard to understand, as it’s often quite technical. Also, there are different types of intellectual property, and each asset is unique. Another reason intellectual property is hard to value is that there isn’t much transaction data on direct sales of it.
In order to overcome these difficulties, valuators use a technique referred to as the relief from royalty method.
Intellectual Property 101
Generally, intellectual property falls into one of four broad categories: patents, copyrights, trademarks, and trade secrets.
Related intangible assets that businesses own may include unpatented proprietary technology, trade names, trade dress, brands, computer software and customer lists. Some reasons for an appraisal of intangible assets may include:
- Financial reporting
- Tax compliance
- Sale or licensing transactions
Accounting Compliance Issues
Companies also may be required to value intangible assets if they follow Generally Accepted Accounting Principles (GAAP).
Alternatively, FASB Accounting Standards Codification Topic 350, Intangible Assets — Goodwill and Other, requires companies to test acquired goodwill and other intangibles annually for impairment and write them down if their fair values drop below their carrying amounts. It is a very complex process to test goodwill, but basically it depends on the value of an organizations tangible and identifiable intangible assets. This includes intellectual property.
Rather than test for impairment, private companies may elect to amortize goodwill straight-line generally over 10 years under FASB Accounting Standard Update 2014-02. However, if a business chooses this method, they must still test for impairment when certain events happen, such as the loss of a key person, or an unanticipated increase in competition.
Relief from Royalty Method
One of the most common techniques for valuing intellectual property is the relief from royalty method, which borrows concepts from the cost, market and income approaches to valuing a business.
The relief from royalty method estimates how much of a company’s earnings come from an intellectual property asset, based on what the company would have paid for the use of that asset if they didn’t own it. In other words, the asset’s value is equal to the value of the royalty payments from which the company is relieved by virtue of owning the asset.
A valuator applies this method by selecting a royalty rate based on available market information about similar assets, industries, territories, and other factors. for licenses involving similar assets, industries, territories and other characteristics. In general, there are 15 appropriate factors that can be used to determine a reasonable royalty. The valuator would then figure out a risk-adjusted discount rate to determine the value of the royalty payments.
A Time-Tested Approach
Professional valuators have been using the relief from royalty method for many years. It is a viable method, whether it’s being used for litigation, sale, or accounting or tax purposes. To find out more about the relief from royalty method, contact Filler & Associates.