The predominant amount of S&P 500 value comes from intangible assets and goodwill (“Intangibles”) of the underlying companies. It is no surprise that patents and brands are more valuable than desks. Understanding the components of intangible value is of great relevance to tax authorities and financial stakeholders.
Intangibles can be broken down into three categories: intellectual property (IP), relationship-based assets, and goodwill. Let’s talk about each.
Intellectual property, as a term, needs clarification. It is not uncommon to think about IP as something that one can’t touch. Either knowledge or intelligence or both, it may seem as a metaphysical entity. As a result, IP terminology is often misused.
A quick google definition of IP is:
a work or invention that is the result of creativity, such as a manuscript or a design, to which one has rights and for which one may apply for a patent, copyright, trademark, etc.
IP assets are concrete beings. In fact, you can see them, touch them, classify them, sell them, steal them, transport them, and so on. We know that Google is great because it has great software, Pfizer because it has great patents, and Disney because it has great copyright content. Coca-Cola may sell a recipe but retain a trade name.
Simply asking for an “IP valuation” is not sufficient to understand what needs to be done. The request does exclude other intangibles, such as relationship-based assets and goodwill. In the context of a business acquisition, “IP valuations” may not cover the entire scope of work required.
IP valuations can be performed using income-based, cost-based, and sometimes market-based approaches. The income-based approach relies on financial projections attributable to a specific IP asset or a group of assets; it is the most theoretically sound method whilst most difficult to implement. The cost-based approach equates IP value to the cost of developing the asset; it has the potential to be rather accurate. The market-based approach is not common, though does have its place in certain situations.
The IP covers assets that are proprietary by nature (one can have a title to it); they are easier to separate from the business entity physically. Relationship-based assets are closely associated with business operations. They may dissipate quickly without the support of the product or service. Relationship-based assets include customer relationships, backlog, servicing contracts, and non-compete agreements.
The value of the relationship-based assets can also be measured quantitatively. Supported by specific contractual terms, historical customer behavior, and observable financial performance, such assets are often valued with greater confidence than their IP cousins.
Goodwill represents the residual value of the company after attributions are made to all tangible assets as well as IP-based and relationship-based assets (a.k.a. identifiable intangible assets). Goodwill represents future technology, future customers, business processes, and infrastructure that unites individual assets in a greater value-producing organization.
To value goodwill, one will have to value the entire business and subtract the values of the individual identifiable intangible and tangible assets. We don’t believe any effort should be put into the income approach style of goodwill valuation.
IP valuation is required in both tax compliance and financial reporting. It is often valued for strategic and litigation purposes as well. In transfer pricing (IRC Sec. 482), IP valuations are necessary to establish asset values in transactions between related parties.
Purchase price allocations (PPA) is another valuation study where all identifiable intangible assets and goodwill values are determined. PPAs are performed when the entire entity is acquired. IRC Sec. 1060 and FASB Accounting Standard Codification Topic 805 govern PPAs. Each provides its own classifications of intangible assets.
The first step in any valuation study is to define the property being valued. The property to be valued is determined by tax, legal, or accounting considerations. In PPA, a valuation specialist will assist in determining which discrete intangible assets must be valued. However, it is up to the client to determine if the PPA is needed (i.e., the entire entity changed hands) or if an individual and specific IP asset (or a group of assets) have to be valued.