EXECUTIVE
SUMMARY | Intangible assets are
a big part of contemporary business,
and many executives think
innovation and related intangible assets
now represent the principal basis for
growth. CPA/ABVs and CFOs need to be able
to value intangible assets for reasons
that include the sale of a business,
financial reporting, litigation,
licensing, bankruptcy, taxation, financing
and strategic planning.
Most guidance
relating to the recognition and
valuation of intangible assets comes
from accounting and tax regulation.
Congress and FASB have pushed
for greater disclosure and clarity in
recent legislation.
CPA/ABVs and other
valuation analysts engaged to
identify and value intangible assets
must possess a broad base of knowledge
on valuation, knowledge of the relevant
industry and sound judgment to support
their decision making.
Criteria for the
identification of intangible assets
include the following: legal
existence and protection (that is, it
may be identified apart from goodwill if
it arises from contractual or other
legal rights), private ownership,
transferability, and evidence of its
existence such as a contract, license,
registration, listing or documentation.
Most intangible assets fall into one of
five categories: marketing-related,
customer-related, artistic-related,
contract-related or technology-related.
One popular
methodology used to value intangible
assets is the discounted cash
flow methodology, which typically is
used to value assets such as technology,
software, customer relationships,
covenants not-to-compete, strategic
agreements, franchises and distribution
channels. Under this methodology, the
value of an asset reflects the present
value of the projected earnings the
asset will generate. Other methodologies
can be used, too.
It’s a good idea to
value an intangible asset using
multiple approaches, as
applicable, for example to capture the
historical development cost, the future
economic benefit and any other
components that may have a material
effect on the final value such as
capital charges, functional and economic
obsolescence, product sales cycles,
synergistic opportunities and tax
issues, to name a few.
Marc G. Olsen,
M.S. economics, and
Michael Halliwell
, MBA, are director and managing
director, respectively, of valuation
services for the Taylor Consulting
Group, Inc., Atlanta. They have
extensive experience in valuing
intangible assets for a variety of
clients. Their e-mail addresses are
molsen@taylorconsultinggroup.com
and
mhalliwell@taylorconsultinggroup.com
.
|
Intangible assets play a critical role in
business today. Many executives believe they have
replaced fixed assets, the historical
business-growth benchmark, as the key to a
company’s competitive sustainability. Many even
think innovation and related intangible assets
represent the principal basis for growth. While it
is easy to argue that intangible assets are
valuable, it is not so easy for CPA/ABVs and other
valuation analysts to accurately capture a value
for them. So how do you quantify something you
can’t feel, see or weigh? In this article, we
attempt to answer the question of how CPA/ABVs can
best identify and value these types of assets.
MEASUREMENT METHODS COUNT
Businesses need a systematic method for
analyzing the value of intangible (nonphysical)
assets for reasons that include financial
reporting, litigation, licensing, bankruptcy,
taxation, financing and strategic planning, among
others. Such assets include franchises,
trademarks, patents, copyrights, goodwill,
equities, mineral rights, securities and contracts
granting rights and privileges of value to the
owner. So far, most guidance and literature
relating to the recognition and valuation of
intangible assets come from accounting and tax
regulations. For instance, FASB requires
purchasers of a business to allocate the total
consideration paid in a business combination or
net asset transfer to the acquired assets and
liabilities according to their fair values.
Congress and FASB have pushed for greater
disclosure and clarity in recent legislation such
as the Sarbanes-Oxley Act, FASB Statement no. 141,
Business Combinations, and FASB Statement no. 142,
Goodwill and Other Intangible Assets.
In particular, statements no. 141 and no. 142
give specific guidance on defining and measuring
intangible assets. Here we will focus on some of
the methods and approaches these standards suggest
as well as explore other professional practices.
GRADATIONS
Client companies and their valuation
analysts sometimes have difficulty simply
identifying the intangible assets companies
possess or have acquired in a recent business
combination, let alone assigning a reasonable
value to those assets. Often management will avoid
the entire exercise of valuing intangibles because
it involves so much subjectivity. Some managers
argue that, while intangible assets may be an
essential component in their businesses and
necessary to sustain a competitive advantage,
there is little incentive to identify such assets
because once they are recognized they will have to
be amortized over their useful lives and,
subsequently, will have a negative effect on
earnings. Nor does the financial community
have a large body of clear guidance on how best to
recognize and value intangible assets. The
available guidance offers many viewpoints and
methodologies, which are informed by the
background of the writer, the type of intangible
asset being valued and the purpose of the
valuation. CPA/ABVs and other valuation analysts
engaged to identify and value intangible assets
must necessarily possess a broad base of knowledge
on the topic, knowledge of the relevant industry
and sound judgment to support their assumptions
and methodologies.
IDENTIFY INTANGIBLE ASSETS
Most identifiable intangible assets fall
into one of five categories: marketing-related,
customer-related, artistic-related,
contract-related or technology-related. There are
numerous accounting, legal and tax-related
definitions of an intangible asset. However, most
of these definitions identify intangibles using
several similar criteria. Regulatory and
accounting literature in particular specifies that
an intangible asset possesses the following
characteristics: legal existence and protection,
private ownership, transferability, and evidence
of its existence (such as a contract, license,
registration, listing or other documentation).
Under Statement no. 141, to recognize an
acquired intangible asset apart from goodwill, one
of two criteria needs to be met (either or both
criteria can meet the requirements). The first
test, which is known as the contractual/legal
test, states that an intangible asset may be
identified apart from goodwill if it arises from
contractual or other legal rights. The second
criterion is the separability test, which states
that if an intangible asset is capable of being
separated or divided from the acquired entity
(that is, it can be sold, transferred, licensed,
rented or exchanged regardless of whether there is
an intent to do so) it should be identified as an
intangible asset. For example, technology is
typically developed in-house and thus does not
meet the contractual test; however, it can be
separated from the acquired entity and is
frequently licensed, rented or sold from one
entity to another in the course of general
operations.
WHAT IS THE VALUE? Once an
intangible asset has been identified, it needs to
be valued. Despite intangible assets’ lack of
physical substance and relationship to other
assets, which makes them difficult to isolate and
measure, there are several methodologies to value
an identified intangible asset. We will briefly
highlight four of the most common methodologies
(see sidebar “Valuing Intangible Assets—a
Fast-Growing, Demanding Niche”).
Discounted cash flow. One
of the most popular means to value intangible
assets is the discounted cash flow methodology.
This method typically is used to value some of the
more widely known intangible assets such as
technology, software, customer relationships,
covenants not-to-compete, strategic agreements,
franchises and distribution channels. Under this
methodology, the value of an asset reflects the
present value of the projected earnings that will
be generated by the asset after taking into
account the revenues and expenses of the asset,
the relative risk of the asset, the contribution
of other assets, and a discount rate that reflects
the time value of invested capital.
Relief-from-royalty.
Another commonly used methodology is
the relief-from-royalty approach. This methodology
often is used to value trade names and trademarks.
Under this method, the value of an asset is equal
to all future royalties that would have to be paid
for the right to use the asset if it were not
acquired. A royalty rate is selected based on
discussions with management regarding, among other
factors, the importance of the asset,
effectiveness of constraints imposed by competing
assets, ability of competitors to produce similar
assets, and market licensing rates for similar
assets. The royalty rate is applied to the
expected revenues generated or associated with the
asset. The hypothetical royalties are then
discounted to their present value. For
example, our firm recently relied on this method
to value a portfolio of trade names and trademarks
of a health services provider that was acquired by
a major publicly traded company specializing in
health care and wellness services. The most
difficult and time-consuming component of this
approach typically involves determining what to
record as the appropriate royalty rate for the
right to use the asset. Royalty rates for
trade names and trademarks vary widely among
industries depending on the nature of the
proprietary property, its role in the business,
the specific industry and the marketplace. Relying
on benchmarks from health services journals,
royalty rate studies and discussions with
licensing professionals, we observed rates for
health-service trademarks ranged from 0% to 5%. We
selected a rate on the low end of this range after
considering a number of factors, including the
trademarks’ newness (brief track record), intense
market competition, certain technology risks,
profitability and limited name recognition. Guided
by these factors we calculated future expected
cash flows and, thus, the value of this portfolio
(see “20
Steps for Pricing a Patent,” JofA ,
Nov. 04, page 31, and “Damages
Aren’t Always Patently Obvious,” JofA
, Nov. 04, page 36).
Comparable (Guideline) Transactions.
A comparable transactions approach
is typically employed to value marketing-related
intangible assets. The value of an asset is based
on actual prices paid for assets with functional
or technical attributes similar to the subject
asset. Using this data, relevant market multiples
or ratios of the total purchase price paid are
developed and applied to the subject asset. Since
no two assets are perfectly comparable, premiums
or discounts may be applied to the subject asset
given its attributes, earnings power or other
factors. Internet domain names and newspaper
mastheads sometimes are valued with a comparable
transactions approach. The CPA/ABV or other
valuation analyst can gather data from various
industry sources and use them to create
information relating to key sale characteristics.
For example, in the valuation of Internet domain
names, purchasers look for brand recognition,
e-commerce value, recall value, frequency of
name-related searches, letter count and
pay-per-click popularity.
Avoided cost. The last
approach we will mention is the avoided-cost
approach. This method is popular as it is based on
historical data, which is usually available and
does not rely on the subjective assumptions
employed under the other, previously mentioned
methodologies. Under the avoided-cost method, the
value of an asset is based on calculating the
costs avoided by the acquiring company when
obtaining a pre-existing, fully functional asset
rather than incurring the costs to build or
assemble the asset. The savings realized may
include actual and opportunity costs associated
with avoided productivity losses. The
avoided-cost approach can be a useful method to
value technology. Using the economic principle of
substitution, whereby an informed purchaser would
pay no more for an asset than the cost of
purchasing or producing a substitute asset with
the same utility as a company’s current
technology, CPA/ABVs and other valuation analysts
will collect estimates from company management on
the number of employees and salaries associated
with developing the technology, potential benefits
associated with those employees/programmers, and
ancillary expenses such as overhead,
administrative, travel and meal costs associated
with the technology. In addition, the
CPA/ABV needs to consider replacement costs,
reproduction costs, depreciation and obsolescence
when utilizing this approach. Lastly, it is
necessary to calculate tax effects on expected
cash flows, while accounting for any amortization
tax benefit, to ascertain the final value of
technology for the avoided-cost approach.
When valuing any single intangible asset, two
final points are important. First, an intangible
asset should be valued using multiple approaches,
as applicable. As noted, the process of valuing
intangible assets is prone to subjectivity and the
use of several approaches will help to zero in on
a credible value. For example, while the
avoided-cost methodology may capture the
historical development cost as well as the
individual facts and circumstances surrounding the
creation of an asset, it will not capture the
future economic benefit of an asset that a
discounted cash flow methodology would address.
Second, depending on the asset under review,
it will be necessary to address and consider other
components that may have a material effect on the
final intangible asset value such as capital
charges, functional and economic obsolescence,
product sales cycles, synergistic opportunities
and tax issues, to name a few. Valuation analysts
often are very helpful in sorting through these
complex matters.
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Valuing
Intangible
Assets— a Fast-Growing,
Demanding Niche
Valuing intangible
assets is a tough professional
services arena, but skilled
valuation analysts such as
CPA/ABVs are up to the
challenge. The success of an
intangible assets valuation
depends on a “meeting of the
minds” that the client, its
representative attorney and
the appraiser clearly
understand. To achieve this,
the engagement framework
should specify:
The purpose of
the engagement.
The standard of
value to be used (fair value
for financial reporting
purposes, fair market value or
investment value, for
example).
Identification of
assets/property to be valued.
Date of
valuation.
Premise of value.
Timing of the
report.
Details affecting
the engagement’s planning and
acceptance. Indeed,
the beginning of the
assignment or “the
pre-beginning of the
assignment, is the most
important part of the
valuation process,” says Gary
R. Trugman, CPA/ABV.
Credible valuations of
intangible assets (including
intellectual properties) are
grounded in consistent
application of approaches and
methodologies accepted by the
business valuation community
at large. Three common
approaches for appraising
intangible assets are: income,
market, and asset-replacement
cost, for example. A CPA/ABV
or other valuation analyst
needs to know the strengths
and weaknesses of each
approach (and the related
methodologies) specific to the
property/asset being valued.
The accompanying text
discusses four methodologies:
discounted cash flows,
relief-from-royalty,
comparable transactions and
avoided-cost. The first two
methods are the income
approach, and the other two
are the market and
asset-replacement approach,
respectively. The income
approach—commonly used to
value intangible assets—calls
for methods that include
direct capitalization, profit
split, excess earnings and
loss of income. An
asset-replacement cost
approach also should consider
the reproduction and
replacement cost as well as
the cost avoidance method.
Success is in the details.
—Robert P. Gray
Robert P. Gray
, CPA/ABV, CFE, FACFEI, of
Parente Randolph, Dallas,
has an extensive background
in financial/accounting
analyses, business
valuation, economic damages,
forensic investigation and
litigation. He is a member
of the AICPA’s Forensic and
Litigation Services
Committee, which provides
professional guidance to
CPAs who perform fraud
investigations and determine
economic damages. His e-mail
address is
rgray@parentenet.com
.
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RECENT DEVELOPMENTS While
the standards statements that guide current
practice took effect about five years ago,
accounting and financial pronouncements are
ever-changing. Through recent pronouncements such
as Statement of Financial Accounting Standards no.
157, Fair Value Measurement, and the
pending replacement of Statement no. 141 with the
proposed Statement no. 141(R), FASB is making
substantial revisions to required GAAP to increase
the use and impact of the fair value standard. As
a result, the manner to identify and measure
intangible assets is also changing.
Currently, intangibles are identified from a
buyer’s perspective. For example, in a business
combination, an acquirer will only recognize the
assets it seeks from the acquisition (that is, a
buyer will not recognize a seller’s trade name,
even if that asset possesses value in the market,
if it knows at the time of the acquisition that it
will drop the name). The recent pronouncements,
however, shift the perspective from that of a
buyer to that of a market participant, which will
require the buyer to recognize all assets that
possess a value, whether or not the buyer will
retain or utilize the intangible assets it
acquires. Consequently, this shift in
perspective is having a significant impact on how
items are reported, specifically in two principal
areas. First, from the eyes of a market
participant, a greater number of intangible assets
may need to be identified. No longer will buyers
be at liberty to exclude intangible assets that
management teams view as valueless to their
particular organizations. Correspondingly,
goodwill on a buyer’s balance sheet will decrease.
Second, as a result of having more intangible
assets recorded on their balance sheets, buyers
will be forced to amortize those previously
unidentified intangible assets according to their
useful lives. Thus, under this new perspective,
buyers may see more identified intangible assets
on their balance sheets and less earnings on their
income statements as a result of higher noncash
charges. How interested parties view these
changes will vary widely. For instance, auditors
and regulatory agencies may support the recent
FASB pronouncements and general espousal of the
revised fair value standard, which can be viewed
as more conservative than current practice and are
more likely to prevent an earnings overstatement.
A chief financial officer or other senior
executive, on the other hand, likely would resist
those changes, due to their potential negative
effect on earnings. Technology or biotechnology
firms might be less concerned with earnings and
more concerned with the possibility of goodwill
impairment, and therefore seek to identify as many
intangible assets as possible. Market observers
and financial analysts might be indifferent to
these changes, as they will not have an expected
impact on cash flows and not affect operations
prior to EBITDA. The identification and
measurement of intangible assets are not simple
tasks, and as the proposed statements take effect
they will arguably make the process more
complicated for management and their advisers.
However, as the approaches and methods used to
both identify and value intangible assets are more
frequently practiced and refined, the process
likely will become easier—less a matter of
delineating between shades of gray and more one of
dotting the i’s and crossing the t’s. |