«Research commissioned by the Intellectual Property Office, and carried out by: Martin Brassell, Kelvin King This is an independent report ...»
Intangible assets are differentiated from one another by characteristics such as ownership, function, market position and image. For example, ladies’ fashion shoe brands may be characterised by use of particular colours and styles, and also price. Also, whilst intangible assets within the same class will inevitably have similar characteristics, there will also be characteristics that differentiate them from other similar ones.
For definitions of many of the terms used in the Guidance Note, the reader is referred to the International Glossary of Valuation Terms produced by the International Valuation Standards Council. The Guidance Note is intended to comply with the requirements of the relevant International Valuation Standard, in this case IVS 210 Intangible Assets. To satisfy the Red Book requirements on knowledge and skills it is important that the valuer is regularly involved in business valuation as practical knowledge of the factors affecting any particular asset, business or share is essential. This Guidance Note is of global application.
200 The role of intellectual property and intangible assets in facilitating business finance
The Market Approach measures the value of an asset through the analysis of recent sales or offerings of similar or substitute property and related market data. However, it has to be recognised that it is rarely possible to find such evidence relating to identical assets.
The Market Multiple Method focuses on comparing the subject asset for example a brand, patent or copyright to guideline data such as industry royalty rates. In applying this method, such royalty rates are evaluated and adjusted based on the strengths and weaknesses of the subject asset relative to similar assets, and applied to the appropriate operating data of the subject asset to arrive at an indication of value. Appropriate adjustments to reflect different properties or characteristics are usually made to the derived data.
The Similar Transactions Method utilises valuation data based on historical transactions that have occurred in the subject asset’s industry or related industries to arrive at an indication of value. The derived data is then adjusted and applied to the appropriate operating data of the subject asset to arrive at an indication of value.
When applied to IP valuation, value indications are developed by discounting expected cash flows to their present value at a rate of return that incorporates the risk-free rate for the use of funds, the expected rate of inflation, and risks associated with the particular investment. The discount rate selected is generally based on rates of return available from alternative investments of similar type and quality as of the date of value.
The Income approach also embraces methods such as the ‘Relief from Royalty’ method, defined by IVS 210 as one that “...estimates the value of an intangible asset by reference to the value of the hypothetical royalty payments that are saved through owning the asset, as compared with the cost of licensing it from a third party.” There is also the Multi Period Excess Earnings method, defined as “…a method of estimating the economic benefits of an intangible asset over multiple time periods by identifying the cash flows associated with the use of the asset and deducting a periodic charge reflecting a fair return for the use of contributory assets.” The Income Approach, as applied using the capitalised earnings basis of valuation is also common in intangible asset valuation. In application a thorough understanding of accounting and economic profits, their historical record and forecasting, is necessary in each case.
The cost approach The Cost Approach measures the value of an asset by the cost to create or replace it with another like asset. When applied to intangible asset valuation, obsolescence, maintenance, and the time value of money are considerations.
The role of appraisal Appraisal in the valuation of intangible assets and IP includes techniques to identify the earnings specifically associated with the subject asset; gross profit differential, excess profits and relief from royalty. Following identification of the profit attributable to the subject asset, capitalisation of earnings and discounted cashflow techniques are adopted.
Issues to consider in relation to the present value techniques (PVT) include:
• the number of years over which the cashflow is applied
• the capitalisation rate or discount rate applied at the end of the term
• the discount rate(s) adopted
• whether inflation is built into the cashflow
• what other variables need to be considered in respect of the cashflow in the future
• the trading profile of the asset
• initial and running yields, IRR (Internal Rate of Return) and the terminal value 202 The role of intellectual property and intangible assets in facilitating business finance Where a valuer decides that a PVT approach is appropriate, it is important that market transactions (comparables) that reflect the same approach to valuation are taken into consideration. The details of market transactions may be more difficult to obtain where a PVT approach is adopted. However, such transactions will assist in assessing, among other things, the discount rate to be adopted, the IRR and the general approach taken by the market.
If the valuation subject is a specific intangible asset, before undertaking the detailed cashflow modelling, quantification of the remaining useful life and decay rate associated specifically with the use of asset(s) is required. Typically this remaining useful life analysis will quantify the shortest
of the following:
Thus economic use valuation will involve key components; a financial forecast, identifying specific intellectual capital and business earnings and discount rate determination and risk (cost of capital). Unsystematic and systematic risk will be considered and discount rate determination in its basic application will require identification and application of the cost of capital to known and projected cashflows.
Discounting appropriately weighted asset cost of capital and more basic discount rate building will be adopted. The two basic ingredients of the cost of capital are the cost of debt and the cost of equity. To assist in the calculation of appropriate rate of return and discount rates valuers utilise a number of different methodologies including the Capital Asset Pricing Model, Arbitrage Pricing Theory, and hybrids depending on the particular circumstances, as well as the preference and judgement of the valuer.
In recent years the IP solution has been used to good effect to address the pension deficit crisis, and companies are looking at creative ways to fill gaps with quality bond-like assets.
(for a specified period of time) to those assets. The trustees can then also receive income from the IP through licencing, franchising and so on.
There is significance in the fact that this most conservative world, with significant fiduciary duties and the need not to accept any risk, has placed the ability to value and use IP assets ahead of the use of traditional assets such as real estate. With sound valuation processes now established for intellectual property actuaries, the Pension Regulator, HMRC, legal and accounting professionals have facilitated and participated in the following case studies that have become public domain (and there are also a growing number of examples that are not yet in the public
• Diageo used whisky and contingent cash in an asset-backed contribution structure; (2million barrels of maturing whisky in a 15-year partnership and annually purchase £25 million of maturing whisky providing cashflow stream to the pension fund
• GKN used trade marks from property in an assets-backed contribution structure of cash (£13m per annum for 20 years which was valued at £331 million), reflecting an internal licencing fee for the GKN trademark, rental income for five UK properties and the ability to use future service costs if in surplus
• Philips made a €350 million cash contribution to the pension plan which was used to purchase Philips’ 17% in NXP Semi-conductors
• John Lewis’ minority stake of 29% in Ocado was valued at £128 million and given to Trustees, who have now sold their stake in two bits with total sale proceeds amounting to £336 million
• Costain’s PFI Investments were valued at £22 million and transferred to the pension fund
• TUI Travel plc in 2011 announced that it was using the brands Thomson and First Choice as collateral to help finance its defined scheme. The partnership received royalty payments from the UK operating subsidiary for the use of the brands and plans to make annual income distributions to the pension schemes totalling around £16.5 million for 15 years until 2026. Pension trustees will own the Thomson and First Choice names for a period of 15-20 years so TUI UK will have to make payment each year into the partnership vehicle.
Taking a hypothetical example to further illustrate these innovative solutions to solve pension deficits; in a £500m pension deficit scenario, the company would have to clear it over perhaps a 15 year period. With a securitised asset structure with IP, it has a commitment to pay £50m over 10 years, but that commitment is provided through a partnership vehicle which is backed by a company asset, in these cases IP such as a trade mark, copyright, software or patents, backed by guarantees collateralised and treated like a bond payment.
The collateralised payments get treated as a £500m asset on day one in the pension scheme.
So rather than eliminating the £500m deficit over 10 years, the deficit is eliminated straight away because of the presence of what is essentially a securitised bond.
A further advantage is that because it is securitised, the commitment is backed by an asset, so the trustees are happier to have a longer period to recover the deficit. So the commitment could 204 The role of intellectual property and intangible assets in facilitating business finance
Valuing IP in such a manner and in such a high profile, risk-averse fiduciary area for employer covenant assessment communicates a significant ability to meet such obligations. It also demonstrates the ability of expert IP valuers to satisfy those fiduciaries and the numerous professional advisors acting for company and pension trustees, Pension Regulator and HMRC, that IP valuation processes and methodology are robust. This is no less than the scrutiny HMRC subjects IP valuation in tax efficient exploitation matters and concerning litigation and infringement actions, the court process of cross examination. However it is the pension sector and IP use that prove that rigorous inspection processes exist and may encourage them to be used more in lending and credit risk situations.
In terms of liquidity, the Current Ratio (current assets/current liabilities) indicates the extent to which the claims of short-term creditors are covered by assets which are expected to be turned into cash within 12 months (also known as the working capital ratio). The Quick Asset Ratio (current assets less stock or work in progress/current liabilities) is a variation of this method, sometimes called the ‘acid-test’ ratio. Cashflow is often assessed considering depreciation plus profit after tax plus increase in deferred tax minus dividends. Capital Gearing (borrowed funds/ total funds less Intangibles) and Income Gearing are considered.
Activity Ratios consider stocks/sales, trade debtor and trade creditors turnover. Profitability Ratios considering profit margins are typically expressed as gross margin/sales, trading profit/ sales and/or net profit before tax/sales.
Methods of business valuation, in the context of intangible asset valuation Lenders may request that IP valuation is placed in the context of a full 100% valuation of a business.
Similar to the methods of intangible asset valuation described above the income approach present value techniques measure the value of an asset by the present value of its future economic benefits. These benefits can include earnings, cost savings, tax deductions, and proceeds from its disposition.
When applied to equity interests in businesses, value indications are developed by discounting expected cash flows to their present value at a rate of return that incorporates the risk-free rate for the use of funds, the expected rate of inflation, and risks associated with the particular investment.
One of the key assumptions underlying present value techniques (often described as discounted cash flow) is the discount rate used to discount the cashflows and residual value. The discount rate would be calculated based on the Company’s Weighted Average Cost of Capital (WACC).
The WACC represents the company’s blended after-tax costs of debt and equity assuming an industry level capital structure. The cost of equity is likely to be estimated using the Capital Asset Pricing Model referred to above.
The market approach measures the value of an asset through the analysis of recent sales or offerings of comparable property. When applied to the valuation of an equity interest, consideration is given to the financial conditions and operating performance of the company being valued relative to those of comparable companies operating in the same or similar lines of business, potentially subject to corresponding economic, environmental, and political factors and considered to be reasonable investment alternatives. The two primary market approach methodologies are (again) the Public Company Market Multiple method and the Similar Transaction Method.
These ratios and multiples so derived reflect the opinion of investors seeking control of target companies. Revenue multiples will be adjusted for differences in profitability as appropriate.
Valuation multiples considered in establishing the enterprise typically include: Enterprise Value (EV) to revenue, EV to Earnings before Interest, Tax, Depreciation and Amortisation (EBITDA) and EV to EBIT.