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VALUING INTANGIBLE ASSETS & INTELLECTUAL PROPERTIES

By Stephen J. Kerr

One of the more vexing problems in business valuation is the issue of valuing intangible assets. Intangible assets come in many forms and probably do not appear anywhere on the company's balance sheet. These intangibles may include, patents and trademarks, copyrights, mailing lists, exclusive contracts, royalty agreements, work-in-progress, proprietary designs and many others.

These assets and intellectual properties have a real value that can be estimated through investigation and objective calculation. The actual value of anything, tangible or not, is based on what someone else is willing to pay for it. The price paid for an asset has a great deal to do with who can put it to its highest and best use. If you are holding a license or copyright on a film or book that is not presently being distributed because you cannot afford to do so, that right may still have great value to a larger company with the resources to market the book or production.

In the mind of the purchaser of intangible assets you can bet that he or she will be trying to calculate whether it is better to purchase the complete asset (take a mailing list for example) or is it less costly to simply duplicate the work that went into making the asset themselves. Therefore, Replacement Cost is one method in which you can estimate the hours and expense of replicating the intangible asset yourself Once you have been able to estimate the replacement cost as new, (often the highest price you could pay) you may then seek to offer the current owner a fair price for their asset to spare you from having to go through the process of recreating it from scratch.

However, there is no equivalent replacement value on many assets such as copyrights and trademarks, and no open market to draw comparisons from. Thus, we are left with a second and more accurate tool for valuing intangible assets:

THE DISCOUNT METHOD OF VALUATION

In the Discount Method of Valuation, the goal is to determine for a specific assets, what the future cash flow would be over its projected economic life, and thereby derive what the net present value of the asset is today.

HYPOTHETICAL EXAMPLE:
"Healthy Body Publishing"

Healthy Body Publishing in our example is a multi-faceted publishing and direct mail company that wants to spin off its direct mail business to someone else. The management has kept internal records on the direct mail business, and now they want to know how much the direct mail business is worth if it were to be sold off. It is easy to imagine that the direct mail business is basically a mailing list of 50,000 names - the company keeps no inventory or other tangible assets on its books specifically relating to the direct mail business -orders are drop shipped by other publishers directly to the customer and that Healthy Body Publishers just does the ordering and invoicing.

The first item that you will need is to confirm how much of the income and profits of the entire company are derived from the intangible asset (mailing list) and its surrounding business (direct mail marketing).

We're going to suppose, for the sake of our sanity, that the owners of Healthy Body Publishers have run the direct mail business as a profit center for the company and have internal profit and loss statements that they can refer to when reviewing the unit's perform ance against that of the whole company.

What they determine through investigation, because they kept careful records, is that the mailing list is responsible for $300,000 in annual revenue and approximately $80,000 of the company's net profits (before taxes).

Every asset tangible or intangible has a given Economic Life over which it provides the vast majority of its income to the owner. For some patents and copyrights the remaining Economic Life can be as long as 20 years. For others it may be as short as six months. In our hypothetical example, Healthy Body Publishers has estimated that the remaining Economic Life of their present mailing list, and the business that is built upon it, is about 4 years before it is substantially worn out and would have to have been almost totally replaced.

If we depreciate the value of the present cash flow ($80,000) over the 4 year given Economic Life of the mailing list we get the following schedule:

Year 1 $80,000
Year 2 $60,000
Year 3 $40,000
Year 4 $20,000
Total $200,000 / 4 years = $50,000 average cash flow

The next step is to divide the projected average $50,000 annual cash flow by the return on investment the next owner will have to make to justify the business risk inherent in purchasing someone else's depreciating intangible asset. Since we are saying that this is a secure business with a consistent track record of profits, let's suppose that the buyer will be satisfied with a return on investment of about 20% over the next four years. This model of valuation is also known as the Capitalization Method and the percentage return on investment is referred to as the "Cap Rate".

Capitalization Method

To achieve the Net Present Value of the investment in today's dollars, you will need to discount the $250,000 for the cost of money (if borrowed) and for inflation. What you will end with will probably be a negotiated price between $200,000 and $250,000.

An intangible asset can be valued in this way if you can accurately project the Economic Life of the asset and isolate the net profit the company earns off of that specific asset. Royalties for example may be easy to calculate net earnings from, but you may not be able to determine how fast those royalty agreements are depreciating.

For the purpose of capitalizing on intangible assets sometime in the future, it is a good idea for entrepreneurs to keep track of the bottom line net profit they receive from the use and application of their intangible assets. And, in the case of companies with multiple income streams from separate but commingled operations, you must keep internal profit and loss statements on these operations if you ever wish to sell one of these ventures off separately.

WHAT IS THE VALUE OF NEW INTANGIBLE ASSETS, NOT YET RELEASED?

To value productions or new works not net produced and marketed, you may follow basically the same rules as presented above, but with some notable exceptions.

First, you must investigate with great care what the projected Economic Life will be on your new asset. That means asking the competition, if you must, how much use they have realized out of similar rights, licenses, lists or other assets. Whatever you do, your estimate of a usable economic life should not just be some "wild guess". If your asset is to have a long Economic Life, be sure to factor in costs to update the asset to keep it valuable.

Since you do not have a track record on this asset, you must make sales projections and cost projections to forecast, as best you can, a conservative net operating income for the asset (or company). This is called a "proforma" in financial circles. Once you have completed a proforma on the new asset, divide the forecasted net income by its proposed economic life and divide by the anticipated capitalization rate -- and you will have the estimated Present Value of that intangible asset.

Again I must stress, any accurate valuation of a single asset or a whole company must include some discussion as to terms under which it might be sold and the market it is being sold to. Supply and demand still rule pricing in our free market and it is a good idea to study the overall market in your industry to find out if your asset is in great supply, high demand or neither.