In today’s increasingly technology-driven economy, CPA/ABVs face an arduous task in putting a price on technology-based intellectual property. Even with examples like Google’s search engine, Apple’s iPod, or Microsoft’s Windows platform, where established markets exist and discrete revenue streams can be tied to a specific technology, determining value apart from other intangible assets can prove extremely challenging.
Yet, as technology-driven companies continue to emerge and their innovations become increasingly interwoven with the economy, CPAs, valuation specialists and company management will be called upon more frequently to value technology for financial reporting, legal and tax purposes. This article examines technology-based assets and explores the methods and challenges in identifying and valuing them.
Technology is a broad term that can encapsulate a variety of meanings in accounting and valuation contexts. Valuation professionals define technology-based intangibles as possessing value that is attributable to proprietary knowledge and processes, whether developed or purchased, that provide or have the opportunity to provide significant competitive advantages and/or product differentiation (see the book Valuing Intangible Assets, by Robert F. Reilly and Robert P. Schweihs, page 435). In our experience working with numerous technology companies as financial consultants specializing in valuation, we find that current technology is often the primary intangible asset identified and valued, apart from other customer-related intangibles, trade names and trademarks.
Numerous reasons exist for valuing technology- based intangibles, including, but not limited to, financial reporting, tax, strategic or litigation purposes. Notably, for financial reporting, according to FASB’s Statement no. 141, Business Combinations, and as reiterated in the revised version, Statement no. 141(R), acquirers in business combinations must allocate the total purchase price to acquire its target to the assets it acquired, including its intangible assets.
Statement no. 141(R), which was issued in December 2007, applies prospectively to business combinations whose acquisition date is on or after the beginning of the first annual reporting period beginning on or after Dec. 15, 2008. The approaches and methodologies described for valuing technology intangibles in this article are valid for both Statement no. 141 and Statement no. 141(R).
CPA/ABVs and other valuation specialists must also keep in mind another recent FASB pronouncement, Statement no. 157, Fair Value Measurements, when measuring the fair value of any asset or liability for financial reporting purposes. Under Statement no. 157, fair value is defined as the exchange price that occurs in an orderly transaction between market participants to sell the asset or transfer the liability in its most advantageous market (for example, recognized as the “highest and best use”). Of particular note, fair value is a marketbased and not an entity-specific measurement— thus, CPA/ABVs must account for all risks and other factors, even those difficult to quantify, that would be considered by a market participant in pricing the asset.
Two valuation approaches are typically used to value technology: the income approach and the cost approach. Our view is that the former approach is preferred and is employed through either the discounted cash flow (DCF) or relief-fromroyalty methods. For the purposes of this article, we will examine the DCF and cost approaches, as they are most often used in the field in our experience.
ASSIGNING REVENUES TO TECHNOLOGY VIA THE INCOME APPROACH
The first, and sometimes most subjective, step in applying the income approach is to identify which company revenues are attributable to technology such as license revenues generated by the company. In our experience, the approach of assigning revenue is widely accepted in cases where the subject company has revenues from licensing, maintenance and consulting. However, if the subject company does not generate licensing revenue or it is not easily identifiable, another methodology involves an examination of research and development (R&D) expenses as a percentage of total expenses, which can be used to determine an estimated percentage of technology revenue to overall company revenue.
It is important to note that there is no one correct or FASB/SEC-mandated methodology to determine which revenues are technology revenues. In the context of a Statement no. 141 financial reporting assignment, it may also be helpful to consider whether the sources of all of a company’s revenues have been identified, or can be assigned to all tangible and intangible assets of the business.
Exhibit 1 shows an example of how to ensure whether the sources of all company revenues have been identified. Future intangibles will account for a certain percentage of the overall future revenues expected to be achieved by the subject company. For most cases, it is expected that, in the first projected period, the sum of the individual revenues attributable to each intangible asset will approximate the overall company revenues. In outer forecast periods, technology or intangibles not currently existing or in-process will account for an increasing percentage of overall company revenues. These future intangibles are captured in the goodwill of the company and are not separately identified and valued as are current technology and in-process research and development (IPR&D).
In the context of Statement no. 141, it is necessary to further partition these revenues into current, in-process, and future technology for each identified technology, as different accounting treatments exist for each (for example, the value of future technology is captured in goodwill). As can be seen in Exhibit 2, current technology in the initial projection period generally represents 100% of the overall technology-derived revenues to be achieved. In the periods following the acquisition date, IPR&D and future technology account for an increasing portion of the overall projected technology-derived revenues, as obsolescence and competition limit the life of current technology. In practice, however, we often find that even in the case of a rapidly evolving industry like we have seen with clients in Internet security, for example, current technology will continue to make up a certain portion of future technology (that is, it serves as the foundation for future releases) and may require management to extend current technology’s economic life.
Determining the economic life of technology assets is an important part of the process. This can be a large point of contention between management, valuation specialists or auditors. To estimate reasonable time horizons for each group of technology assets, several factors should be considered: the adoption cycle in an industry, obsolescence, and the expectations the market may have about innovation and new releases. Market and industry research and viewpoints of management can help in this regard.
Finally, a CPA/ABV should look at the economic runoff streams for current technology as required for the income approach, which takes into account how long a current technology can realize the vast majority (80% to 90%) of its value. In practice, it is rare to see economic lives of technology of less than a year or more than 10 years, as technology tends to evolve fairly rapidly.
ADDRESSING THE OTHER PIECES OF THE DCF PUZZLE
Once forecasted revenue has been sorted out, the next step in the DCF method is to determine an appropriate cost structure to apply to the various identified technology revenue streams—this is necessary to isolate the cash flows or earnings associated with each technology. In general, R&D expenses relating to future development are typically not included in the expenses charged to the cash flows of the current technology. This technology cost adjustment isolates the expenses attributable to the valuation of the current technology. We have seen health care IT firms with technology cost add-backs ranging from 5% to 10% of revenues.
The final step in valuing technology with a DCF method is identifying an appropriate discount rate or weighted average cost of capital (WACC) to calculate the present value of the technology cash flows. Intuitively, since intangible assets are more risky by nature, it is reasoned that investors will require a higher rate of return on intangible assets than tangible assets. Therefore, the discount rate applicable to the subject company as a whole is not necessarily the rate that is applied to the technology when these assets are considered in isolation. As a reasonableness check to verify that the discount rate for an intangible asset is proportionate to the discount rate of the company as a whole (that is, the company-derived discount rate should approximate the weighted average return of both tangible and intangible assets), a weighted average return analysis (WARA) is often used, as shown in Exhibit 3. In most instances, this analysis results in an intangible discount rate that is greater than or equal to the company WACC. However, due to the composition of the tangible and intangible assets and goodwill for any valuation, results may differ.
In our line of work, we are frequently asked to value acquired early-stage technology companies for financial reporting purposes (that is, for purchase price allocations). In these cases, we may observe a startup company being acquired almost entirely for its technology (as it may have minimal customers and minimal revenues). Thus, it is important at the outset of an engagement to talk with company management to identify and understand the key value drivers and their motivations behind any purchase to get an idea of how others in the market may also view the technology. This is necessary in the context of both Statement no. 141 and Statement no. 141(R), as intangible assets should be valued from the perspective of a market participant rather than a specific buyer.
SOME VALUE STILL FOUND IN THE COST APPROACH
Although the income approach is preferred in most cases, the cost approach is easier to apply because its inputs are more objective. However, many CPAs and other valuation specialists do not frequently use the cost approach because it does not take into account the future economic benefit of the technology being valued. The cost approach only measures the development and support expenses already incurred.
A downside of the cost approach is that it fails to capture the future economic benefits associated with current technology. It can be viewed as providing a “floor” for the value of the technology. In addition, the approach can be very useful and is used regularly in practice, notably in cases of early-stage technology companies with no revenues or in situations where there is great difficulty in assigning cash flows to a company’s technology. Ultimately, in being mindful of the new guidance set under Statement no. 157, CPA/ABVs must evaluate their results for reasonableness when valuing an asset or liability.
IPR&D AND ITS OWN RULES
As is often the case, a company will have new technologies continuously under development that have not yet demonstrated their technological or commercial feasibility (for example, IPR&D). Consequently, it is unlikely that the subject company would be able to realize any value from the sale of the technologies to another party. Because of the circumstances surrounding IPR&D, it is treated somewhat differently than when valuing current technology. Specifically, as it relates to financial reporting, it falls under the scope of FASB Statement no. 2, Accounting for Research and Development Costs, and Interpretation no. 4, Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method—an interpretation of FASB Statement No. 2.
While IPR&D is not valued entirely differently than current technology—the same valuation methods as described above for current technology can also be used for IPR&D—one of the key distinctions is that the acquired company’s IPR&D is not recorded as an asset under Statement no. 141. However, pursuant to Statement no. 141(R), IPR&D is recorded as an indefinite- lived intangible asset and subsequently tested annually for impairment under Statement no. 142. Another major difference between IPR&D and current technology relates to the discount rate to value IPR&D, which will probably be higher than existing technology, reflecting the greater risk associated with IPR&D.
PRICE TAG CONCLUSIONS
In the course of our practice of valuing technology companies, we typically observe that identified intangible assets, which exclude goodwill and unidentified intangible assets, generally account for 20% to 50% of a company’s business enterprise value. Yet, in many cases, technology is the most prized possession by an acquiring company, particularly if a company is in its earliest stages. While valuing technology may never be a simple chore, these valuation services will continue to be in demand and keep CPA/ABVs busy.
Put to Practice: A Real-Life Example for Valuing Technology
Taylor Consulting Group was hired in the fall of 2007 to perform a valuation analysis of certain assets acquired in connection with the purchase of a large electronic commerce software firm. We were able to identify distinct intangible assets.
To value these individual technologies, we categorized them by functionality into five groups. We then utilized the income approach. We thought it would do the best job of capturing the value of each technology because the company had a long history of operations and its technologies were well-established in the market. Company management provided overall company revenue and operating expense forecasts, and we made adjustments to the forecasts to isolate the earnings from the underlying technology. The company’s 20% operating margin was determined to be appropriate for the margins of the individual technologies. In deriving these revenues and expenses, we considered relevant market sizes and growth factors, expected industry trends, individual product sales cycles, estimated life of each product’s underlying technology, and historical expense ratios to support our assumptions.
To determine revenue attributable to each technology, we analyzed the company’s revenue streams along the following categories: licensing, professional services and maintenance revenue. For this work, we determined that 100% of licensing, 50% of professional services, and 25% of maintenance revenue was attributable to technology. These determinations were based on an analysis of technology development costs as a percentage of revenues and total expenses. In addition, we considered the amount of revenues supporting the other identified intangible assets, namely the customer relationships. This is to ensure that all revenues have been accounted for and also to confirm that the same revenues have not been attributed to more than one intangible asset.
As required in any income approach, an appropriate discount rate for the current technology was determined, where we considered both the implied WACC of the transaction and, more importantly, market-derived discount rates that can be retrieved from literature like Morningstar Inc.’s SBBI Yearbooks. In this case, the discount rate for the entire company was 16% and current technology was 18%. This difference is not abnormal—many view current technology as having more risk than that of the whole company due to its limited life and higher likelihood of becoming obsolete due to market competition.
Our WARA analysis verified these assumptions were reasonable, as the company’s discount rate approximated the weighted average return of both tangible and intangible assets. In the end, our analysis resulted in a current technology valuation accounting for approximately 80% of intangible value and 20% of the total purchase price.
The last step required us to determine the useful life of the technologies. In this case, we selected an estimated useful life of five to seven years. This was based on the economic contribution margin of each technology, where approximately 95% or more of the economic contribution of the technologies was achieved in five to seven years. In further support, adoption and obsolescence cycles seen in the e-commerce software market showed a similar time horizon, as confirmed by company management.
“Professional Guidance in Business Valuation: Applying SSVS1,” Sept. 07, page 33
“Intangible Value: Delineating Between Shades of Gray,” May 07, page 66
AICPA/ASA National Business Valuation Conference 2008, Nov. 10–12, Las Vegas
FVS Section and ABV credential
Membership in the Forensic and Valuation Services (FVS) Section provides access to numerous specialized resources in the forensic and valuation services discipline areas, including practice guides, and exclusive member discounts for products and events. Visit the FVS Center at www.aicpa.org/FVS. Members with a specialization in business valuation may be interested in applying for the Accredited in Business Valuation (ABV) credential. Information about the ABV credential program is available at www.aicpa.org/ABV.
Valuing Goodwill and Intangible Assets, a CPE self-study course (#731265)
SSVS1: Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset (#055003)
For more information or to place an order or register, go to http://www.cpa2biz.com/ or call the Institute at 888-777-7077.
Apart from customer-related intangibles, trade names or trademarks, current technology is often the primary intangible asset identified and valued. Determining a technology’s value apart from other business intangible assets is extremely challenging.
The income approach is typically the preferred method for valuing technology and is used through either the discounted cash flow (DCF) or relief-from-royalty methods.
The first, and sometimes most subjective, step in applying the income approach is to identify which company revenues are attributable to technology such as license revenues generated by the company. However, if licensing revenue is not generated or is not easily identifiable, another method often applied is examining R&D expenses as a percentage of total expenses.
Determine an appropriate cost structure to apply to the various identified technology revenue streams. This is necessary to isolate the cash flows or earnings associated with each individual technology. R&D expenses relating to future development are typically eliminated from the expenses charged to the cash flows of the current technology.
Identify an appropriate discount rate to calculate the present value of the technology cash flows. Since intangible assets are more risky by nature, it is reasoned that investors will require a higher rate of return on identifiable intangible assets than tangible assets. Therefore, the discount rate applicable to the subject company as a whole is not necessarily the rate that applies to the technology when these assets are considered in isolation.
New technologies that are still under development and have not demonstrated technological or commercial feasibility are referred to as IPR&D and are treated differently from current technology.
Bryan M. Katz, Esq., is a senior director in the Financial Advisory Services Practice of Taylor Consulting Group Inc. Marc G. Olsen, performs financial analysis and business modeling services at Taylor Consulting Group Inc. Their e-mail addresses, respectively, are, firstname.lastname@example.org, and email@example.com.