It is hard to underestimate the importance of technology in modern enterprises. From legacy manufacturing to artificial intelligence and life science breakthroughs, technology plays an ever-increasing role. However, the need to assign a specific value to it may arise only when the enterprise is faced with a strategic transition, such as a merger or an acquisition.
Purchase accounting under FASB Accounting Standard Codification Topic 805 (“ASC 805”) calls for valuations of acquired technology and in-process research and development (“IPR&D”) when any such asset is identified as part of the acquired enterprise. The valuation guidance can be found in ASC 805 as well as in AICPA Accounting and Valuation Guide, Business Combinations, and AICPA Practice Aid entitled Assets Acquired to Be Used in Research and Development Activities, issued 2013, among others.
At the highest level, valuation methodologies are classified as income-based, market-based, or cost-based approaches. The income approach allows an analyst to build the case or tell the story as to what makes the technology valuable. The cost approach is useful in buy-vs-build decisions. The market approach is rarely possible.
The types of technologies that may qualify for the income approach include patented and unpatented technology and IPR&D assets. Typically, a part of the product sold to a customer, such technologies offer value that correlates with the product’s commercial success. Financial projections at the enterprise or product level are a starting point for identifying cash flows, i.e., value attributable to the technology.
- Relief From Royalty Method estimates the present value of future cash flows obtained by a hypothetical licensor who gets to charge a royalty to a third party for its technology. The royalty rate is typically applied to the projected revenue over the useful life of the technology. The hypothetical royalty payments can be reduced by applicable costs, tax affected, and discounted to arrive at the present value of the technology.
- Multi-Period Excess Earnings Method estimates future cash flows by modifying enterprise or product-level financial forecasts. First, it attributes a portion of projected revenue to the existing technology. Second, it unburdens the P&L from new R&D expenditures. Finally, it reduces the profit margin to account for the contributions made by other assets such as net working capital, fixed assets, workforce, and contributing intangibles.
- Greenfield Methods can build a fully integrated business model around the technology, often including periods of negative cash flows to reflect upfront development costs. Risk-adjusted Net Present Value method is a variant used for pharmaceutical products in development. It multiplies future cash flows by the probabilities of achieving them.
- Option Pricing Methods, e.g., real options, are considered to be income-based methods. They are often used when the technology has gone through various development stages. Each stage is viewed as an option to see and participate in its outcome.
Many variations of the income approach exist, including manufacturing cost savings, incremental revenue, or with-without method. The basic idea is the same. The methods isolate future cash flows attributable solely to the specific technology or a bundle of technologies (or patents), providing a comprehensive picture of what makes it valuable.
Market participants may value technology based on the cost savings it can offer, typical in the context of buy-vs-build decisions. Said differently, a market participant won’t value the asset any more than the cost to recreate it. Of course, complexities arise when the technology is patented with no feasible workaround.
In fact, the future value of technology is not expected to correlate with the cost of R&D. However, in situations where the technology does directly contribute to the P&L, the cost can be a good starting point. For example, software with predetermined or routine back-office functionality won’t be valued at more than what it takes to rewrite it.
The cost approach can be helpful when no alternative reliable information is available. Historical costs or even pro-forma budgets are more reliable than financial projections for a non-existent product. Thus, the cost approach may dictate the transaction price, but the true detailed strategic analysis will have to involve other methods.
We like to think of the market approach as a benchmarking exercise. Something else, something similar, was sold for a known price, which we can use to triangulate the value. The market approach does not tell us where the value is coming from; it just tells us what it might be based on other, not very comparable situations. Because technologies are hard to calibrate in terms of their economic potential, such benchmarking rarely works for stand-alone intangibles.
A transaction may include the technology as one of its elements but has other components as well. The process of isolating technology value by valuing other elements of the transaction is referred to as the market approach. The simplest situation is when the technology is purchased for cash, but situations can be a lot more complex. Naturally, this method won’t help determine how much cash there should be in the first place.
The purpose of the valuation is an important factor in selecting the right method. For regulatory purposes, the cost approach can produce reliable documentation. For strategic analysis, a certain variant of the income approach will help understand the source of value and its key drivers. A combination of different methods is often stronger than a single model. No matter the approach, technology value estimates will always be as much about the numbers as the story behind them.