IP strategist: Serious business for serious people
The work of the IP valuation professional is often subject to intense third-party scrutiny; it must be of the highest professional standard
IP valuation is not an exact science, but this is not a caveat for lack of process or failure to utilise effective methodologies. Many disciplines are not exact sciences – including law and auditing – but are just as reliable, provided that they are performed by experienced professionals who adopt rigorous professional standards.
The methodologies typically used to value IP assets (ie, income, cost and market) are not new, but are widely acknowledged as being appropriate and relevant. The skill is not in adopting a methodology, but in selecting the most appropriate for the specific IP asset being valued.
To do this effectively, you need detailed knowledge of intellectual property and, more importantly, a process for identifying a company’s critical IP assets – those that secure competitive advantage. Formal intellectual property is easy to identify and the associated costs often appear in a company’s financial statements. However, less formal intellectual property, including brands, are hidden from users of accounts. For this reason, companies tend to report the expense in creating and maintaining brands only, without reflecting their real value.
Accounting standards require that all IP assets acquired in a business combination be classified separately and recognised in the acquirer’s group financial statements. The process of classifying and valuing each IP asset is crucial for two reasons:
- It can significantly affect potential write-offs to the acquirer’s future profit; and
- Different classes of acquired intellectual property are treated differently for tax purposes.
Identifying acquired intellectual property
Recent changes to both accounting and tax rules have significantly altered the IP valuation landscape. Companies making acquisitions must now fully assess the assets and liabilities acquired – not just those on the target’s balance sheet. Listed entities applying International Financial Reporting Standard 3 and now UK entities applying Financial Reporting Standard (FRS) 102 must identify all the assets acquired. These standards refer to existing and potential customers, contractual and non-contractual relationships, and registered and unregistered trademarks. Companies know that these assets exist – they commit resources to them, protect and monetise them – but have neither the need nor the opportunity to recognise them.
Economic useful life of intellectual property
Classifying each IP asset means estimating the economic useful life (EUL) of each, in order to:
- determine the forecast calendar period to be used for the valuation calculation; and
- help the acquirer to assess the period of amortisation for each IP asset – rather than adopting FRS 102’s default EUL of five years.
Not an easy task – but it can have a significant impact the valuation and consequently future write-offs for amortisation. Professional IP valuers must assess the potential risk of obsolescence from functional, economic, technological and cultural factors which could affect the EUL and value of each IP asset. Valuers must gather relevant information on products or services that the intellectual property underpins and the market in which they are sold.
“Professional IP valuers must assess the potential risk of obsolescence from functional, economic, technological and cultural factors which could affect the economic useful life and value of each IP asset”
Adjustments for risk and uncertainty
Future cash flows will be discounted to reflect the risk that a company’s forecast revenues – on which the valuation is based – may not be achieved. Risk can result from products, markets and sectors in which the intellectual property is being monetised, the ability of management to fully exploit the intellectual property, the financial resources available or the investment required to enable a scale-up to achieve forecasts.
Benchmarking is an essential part of the process – the valuation range must make economic sense. Questions to consider include the following:
- Does the valuation demonstrate that the intellectual property is instrumental in driving the company’s revenues?
- Is the return on the intellectual property in line with expectations and how does it compare to returns from other company resources?
- Is the EUL of each IP asset in line with sector norms (eg, the EUL of customer relationships can differ significantly across sectors)?
Comparability and consistency
Access to a database of both previous IP valuations or sales and sector comparables makes benchmarking considerably less laborious and more consistent. The skill is not in adopting a methodology, but in knowing IP assets, correctly classifying them, rating their quality and selecting the most relevant valuation methodology.
IP valuation is a relatively new professional discipline, which inevitably attracts new entrants. Despite little regulation or formal guidance, there are two bulldogs guarding public and corporate interests: auditor and tax collector. As a self-regulating profession, we must feel the full weight of this responsibility.
IP valuation processes should be comprehensive, key assumptions must be justified, valuation ranges should be commercially viable and our work must be documented to provide the clearest of audit trails. Why? IP valuations now form an integral part of commercial transactions and corporate reporting, impacting on the tax allowances to which companies are entitled and directly affecting the reported future profits of our clients.