Valuation of Intellectual Property: Approaches

We have moved into an information age characterized by increasing competition and

shorter product life cycles; companies are more dependent on their intellectual
properties (IP), as it has being recognized as a Valuable Business Asset. The alue of
IP is much different ! aluation is much difficult than the value of any other assets. IP is
creation of "uman mind but to #no$ the value or to trade that property $e have to
%value& them. The three main approaches are 'ar#et (pproach, Income (pproach !
)ost (pproach.
Introduction
Business enterprise is comprised of Working Capital, Fixed Assets, Intangible Assets and
Intellectual Property. Te increasing callenges of corporate !orld e"eryone !ants to
earn competiti"e ad"antages o"er oters resulting into more dependence on Intellectual
Property .
Intangible assets
Working Business Fixed
Capital Enterprise Assets
Intellectual Property
According to economic teory, te "alue of an asset is best determined by te market, in
te form of a transaction bet!een t!o unrelated entities dealing at arm#s lengt.
$nfortunately, intangible assets and IP tat !ill e"entually support products seldom
benefit from open market conditions, eiter due to no"elty or secrecy factors. In
consideration of te gro!ing in"estments re%uired to de"elop and market products, tere
is a gro!ing need for assessing te economic "alue of suc IP as early as possible in te
product de"elopment cycle.
&uci 'ain, (BA )Finance*, (B+, ,ational +a! $ni"ersity, 'odpur -
.alue assessment is not an accounting operation but rater an attempt to reconcile
information pertaining to a gi"en IP or business pro/ect, suc as de"elopment costs,
expectation of income, comparati"e ad"antages and market data, for te purpose of
making better strategic decisions.
Tere are tree main approaces used for .aluation of Intellectual Property0
-. Cost1based Approac
2. Income1based Approac
3. (arket1based Approac
Cost Based Approach
Tis approac is based upon on te principle of substitution, i.e., "alue of an asset is
estimated on te basis of cost to construct a similar asset at current prices. Te
assumption underlying tis approac is tat te cost to purcase or de"elop ne! property
is commensurate !it economic "alue of te ser"ice tat te property can pro"ide during
life. It considers te cost of te inputs spent on making particular intellectual property is
e%ui"alent to te "alue deri"ed from te same. If te creation is not useful ten also it as
"alue because certain amount of inputs ad been spent on it !ic carries value.
ethods for !aluation under this approach:
-. 4istorical cost trending or &eplacement Cost (etod
2. &eproduction or &ecreation Cost (etod
"i#itations
-. $nder tis metod te "alue of IP is not te real "alue, as it does not does not
directly consider te amount of te economic benefits tat can not be acie"ed
nor te time period o"er !ic tey migt continue.
2. It is difficult to 5etermine all istorical de"elopment costs
3. Tis approac consider cost e%ui"alent to "alue !ic can not be true.
6. Tis approac doesn#t consider risk in"ol"ed in future.
&uci 'ain, (BA )Finance*, (B+, ,ational +a! $ni"ersity, 'odpur 2
Tus, a failure of te cost approac as pre"iously mentioned is tat direct consideration
of te economic benefits and te period o"er !ic tey migt be en/oyed is not
accurately captured in te "alue. A patented product may a"e been inexpensi"e to create
but still a"e significant "alue because of te uge demand for product regardless of te
selling price. Terefore, cost approac fails on te ground tat economic benefits !ill be
en/oyed are not directly considered tat as significant affect on "alue.
Inco#e Based Approach
It is also called as 7conomic Benefits .aluation and Discounted Cash Flow Analysis.
$nder tis metod te "alue of an intangible asset is estimated !ic is based on te
expected income attributable to te intangible asset during its remaining economic life.
Te fair "alue of asset can be expressed as te present "alue of te future stream of te
economic benefits tat are deri"ed from te o!nersip of te property.
Te primary factors !ic represent value are as follo!s0
-. Te 7conomic Benefit
2. Capitali8ation or 5iscount &ate
3. 7conomic +ife
Te future stream of economic benefits is often measured by te amount of net cas flo!
to be deri"ed from employment of te property.
Valuation process:
Forecast income and costs associated !it using te property o"er te life of te
property.
Compute Present .alue of future cas flo!s )use appropriate discount rate
reflecting risk of in"estment* by follo!ing formulae0
Present .alue of future cas flo!s 9
C
-
: C
2

;;;;;;;;;;;;;;;;;...
: C
n
)-: r* )-: r*
2


)-: r*
n

&uci 'ain, (BA )Finance*, (B+, ,ational +a! $ni"ersity, 'odpur 3
Compute te net present "alue by subtracting Present .alue of Cas <utflo!s
from Present .alue of Cas Inflo!s.
"i#itations
It is "ery difficult to estimate income attributable to intangibles, its economic life,
appropriate discount rate= cost of capital and discount rate.
arket Based Approach
$nder tis approac te "alue of intellectual property can determine by considering te
market prices paid for similar properties as a part of tird party transactions. It estimates
te "alue of an intangible asset based on market prices of comparable intangible assets
tat a"e been bougt = sold or licensed bet!een independent parties. In oter !ords, it
Pro"ides indications of "alue by studying transactions of property similar to te property
for !ic a "alue conclusion is sougt.
Also referred to as te Comparable $ncontrolled Transaction )C$T* metod, and is
similar to te Comparable $ncontrolled Price )C$P* metod.
ethods for !aluation under this approach
(arket capitali8ation metod
Comparable "aluation metod or market transaction metod
&oyalty rates metod
$% arket Capitali&ation ethod
Tis approac is used for companies !ic are listed in te stock excanges.
From te balance seet of te company te book "alue of all te total
tangible assets are subtracted from te total liabilities and net tangible
assets are calculated i.e.
,et Tangible Assets ),* 9 Total Tangible Assets > Total +iabilities
Te market capitali8ation of te listed company is te price per sare
multiplied by no. of sare issued. Te estimate of unidentifiable intangible
&uci 'ain, (BA )Finance*, (B+, ,ational +a! $ni"ersity, 'odpur 6
assets)good!ill* can be estimated ? -@A of te total capitali8ation .i.e.
$9 -@A of C !ere C 9 ,: $ : IP
Te market "aluation is gi"en by IP "aluation 9 C > )$:,* or BC= -@ > ,
Te main !eakness of tis metod is tat IP "aluation is not "alued indi"idually and
"aluation of company !ill fluctuate !it te "aluation of sares.
'% Co#parable Valuation ethod (r arket )ransaction ethod
Tis metod pro"ides an indication by comparing te price at !ic similar property
as excanged bet!een buyers and sellers. But for intellectual property it is often
difficult to implement tis approac because information about tird party transaction
in"ol"ing similar property is scarce. Te follo!ing are te re*uirements for valuation
of intellectual property0
Acti"e market in"ol"ing comparable property
Past transactions of comparable property
Access to transaction price information
ArmCs1lengt transactions bet!een unconnected parties
In practice difficult to find sufficiently comparable transactions
*% +oyalty +ates ethod
5efining royalty rate for licensing agreements is anoter intellectual property
"aluation. Te primary forces for dri"ing te "alue of intellectual property and
royalty rates are listed belo!0
Profit margins
(arket penetration potential
Capital in"estment re%uirements
Commerciali8ation costs
&uci 'ain, (BA )Finance*, (B+, ,ational +a! $ni"ersity, 'odpur D
Conclusion
Tus, from all of abo"e approaces it is "ery clear tat te "arious "aluation approaces
and metods pro"ide te "aluer !it a %tool#it.E As !e kno! tat eac coin a"e 2 sides,
toug "aluers a"e a number of tools in teir toolkits !ic a"e teir positi"e as !ell
as negati"e points ,but te most fa"ourable tool from all te oter is income approac as
!e take inflated "alue of IP. Te proper "aluation of Intellectual Property and intangible
Assets in today#s economy is critical to te "alue creation process. Te effecti"eness of
tis extremely complex and /udgmental process depends upon "aluer independence and
competence
&uci 'ain, (BA )Finance*, (B+, ,ational +a! $ni"ersity, 'odpur F