Intellectual Property May be Worth a LOT More than You Expect, Baby
Mood rings were groovy, “Jaws” was playing at the movies and the Vietnam War was ending. It was 1975 and a new television show called Wheel of Fortune debuted its first spin.
That wheel is still spinning and being stuck in 1975 must work for Pat and Vanna since they are still solving those puzzles and recording new shows today.
Are you stuck in 1975, too? When you value your company, how much do you think your Intellectual Property is worth? When I talk to inventors, entrepreneurs, and others, they often cite 15 or 20 percent, roughly the same as in 1975! And I was under the same mistaken impression until I read a new report.
The Numbers Please
Ocean Tomo, a firm providing financial services centered on IP assets, recently completed an Intangible Asset Market Value Study on the composition of equity market values for the companies listed in the Standard and Poor’s 500.
The results were not at all like the 15-20 percent I had expected. Value for Intellectual Property at these companies is closer to 85 percent! My colleagues in the know about valuations say that number can be well over 90 percent in the case of tech startups. [2]
That is a lot of value. Typical Intellectual Property defenses today include IT system safeguards, guards at the front entrance, fences, and the use of NDAs. All are good protection in their own regard but are you unnecessarily putting your IP valuation at risk by not knowing if someone is infringing? How would you know?
Maybe you will get a call from a friend who reads a concerning article in a trade magazine or online. Maybe you will see a reference to your intangible asset on a competitor’s website. While these are real possibilities, they’re not the way to protect such a large proportion of your company’s valuation.
SIDE NOTE: To be fair, some businesses likely have much less than 84 percent IP value. Perhaps smaller commodity-driven businesses such as restaurants, retail, supply stores, etc.? Though, even these businesses will have trademark, trade secret, and copyright concerns. I’m still trying to find data that splits these valuations apart by industry or that detail smaller companies. Please let me know of any research or data in either regard.
So why should you and your company pay closer attention to the value and protection of your IP? Here are my take-aways from this article:
• The value of Intellectual Property is THE critical driver of many business valuations. Regardless of whether you’re a small company or a large one, you need to make sure one or more people is looking for ways to increase these valuations.
• Many companies already have significant value in their Intellectual Property and that poses a potential threat to your business. Why? You may infringe on their rights without realizing the problem and the owners of that property will defend its value by whatever means they have at their disposal (insert “ugly lawsuit” here). This concept is the same one used for building a fence around your building: you want to keep the people or companies that might damage the value of that property as far away as possible. The big takeaway here is that a lot of the people I talk with are not careful about infringing upon existing Intellectual Property (think patents, trademarks, or copyrights). While nothing is perfect, avoiding infringement should be a part of any company’s stage-gate process for implementing new ideas.
• If you are the owner of Intellectual Property, you should establish methods for detecting infringement to protect your company’s value. Some of these methods are extremely inexpensive and near real-time.
• I would wager those larger companies, and their IP attorneys, are much more likely to understand the results of this study. Smaller companies should make sure someone is responsible for keeping track of potential problems and knowing when to bring in counsel.
The study notes that the market values may have peaked and aren’t likely to plummet anytime soon. I suggest you think about what you need to protect the IP you have now and are likely to have in the future.
And please don’t pin your company’s fortune to a 1975 strategy. Contact me for 2015 solutions before you take your next spin.
Picture and graphics credits:
[1] “Mike-Myers-Austin-Powers-1-” by Source. Licensed under Fair use via Wikipedia – 1975, Wikipedia
[2] Ocean Tomo, LLC (2015), reused with permission
This article addresses a valuable topic, but does only a cursory job of doing so. I make the following comments in the context of one who makes his living providing valuation services and purchase-price allocations to corporate clients.
1. Sweeping generalizations about whether the value of intellectual property (IP) in the future will increase, decline, or remain constant have limited utility and are useful only to those who do not understand the valuation issues.
2. The article is silent about how the values of the relative IP components were derived. It is possible that Ocean Tomo–a fine firm, incidentally–simply subtracted the book value of equity for a given company from the market value of its equity on a particular date. If that’s how it was done, then intellectual property that is already on the balance sheet of a given company would have been excluded. The proper way to handle that situation is to add back the carrying value of the IP to the result obtained from subtracting book value from market value of equity.
3. The article is silent on the value of Goodwill, how it is determined, and its impact on market value. In most profitable companies, Goodwill is likely to carry the greatest value of the assets that comprise intellectual property. But Goodwill is also a ‘residual’. It cannot be directly valued because it is what’s left after all of the identifiable assets–tangible and intangible–are valued.
4. Because it’s a residual, Goodwill is also required to be examined for possible impairment at least annually. The guidance from the Accounting Standards Codification (ASC)–which is the name of the body of standards that now make up GAAP (Generally Accepted Accounting Principles)–specifying how this should be done has changed in recent years. A discussion in this forum of those changes would, in my view, make most readers’ eyes glaze over, so I’ll refrain from doing so. But, because of it’s a residual, Goodwill is THE riskiest kind of IP and can be quite volatile, esp. for smaller companies. And, as a general proposition, the smaller and the younger a company is, the lower is the value of its Goodwill because Goodwill is created over long periods of consistent profitability.
5. The article is also silent about how a company should go about choosing an outside firm to assess its IP. That process is a non-trivial undertaking because there are many purveyors of valuation services who don’t have the knowledge to make that assessment; that statement holds even when the individual professional has a valuation ‘designation’. There are five valuation designations–CFA (chartered financial analyst), ASA (Accredited Senior Appraiser), CBA (Certified Business Appraisers), CVA (Certified Valuation Analyst), and ABV (Accredited in Business Valuation). The qualifications for two of those are trivial and appear to be intended primarily to generate annual revenue for the organizations issuing those credentials.
6. It is worth noting that few CPAs–and I am a CPA myself–are competent when it comes to valuing a company or its IP. Don’t misunderstand here: Most CPAs are solid citizens and conscientious professionals. I have taught them in 33 states. But if they are what I call ‘traditional CPAs”–in the sense that they offer accounting and tax services–then, unless they’re part of an accounting firm that is pretty substantial (at least a half-dozen partners), they don’t do enough valuation work to do it well. There’s a simple reason for that: they offer valuation services for defensive purposes (i.e., to keep their clients from looking elsewhere for such services). There are also situations where CPA firms that provide accounting services are conflicted out of doing valuation work for their accounting clients. But the guidance for when a conflict exists is worded in such a way as to be highly subjective; in addition, enforcement is casual, so a firm that ignores a conflict is unlikely to be detected and to face sanctions, loud and public ones, aimed at deterring it from engaging in conflicted work in the future.
7. In addition, valuation is far more about finance, economics, and competitive strategy than it is about accounting. If having the CPA designation conferred knowledge crucial to becoming a good securities analyst, there would be many CPAs working for investment bankers and institutional investors. In fact, there are precious few, something that has remained constant over many decades.
8. Most CPAs would much rather look backwards than forwards. That’s a major reason that they became accountants in the first place—they have a low tolerance for ambiguity, and there is little ambiguity looking in the rear-view mirror. But valuation is PROSPECTIVE (i.e., forward-looking). That makes it completely different from traditional accounting services: valuation services require the use of a set of mental muscles that are completely different from those required to provide accounting servicesValuation uses a set of mental muscles that are completely different from those required to provide accounting services. Like any other set of muscles that are not used frequently, when sudden demands are made on valuation muscles, bad things often happen, and people, esp. clients, can get hurt.
9. Most important, the value of any company or asset is the present value of its EXPECTED future free cash flows. Developing a comfort level for the ambiguity required in estimating what those are and also the riskiness that they will occur both in the magnitude and in the time frames envisioned is something for which few CPAs of my acquaintance can get comfortable. Valuation also requires social skills (asking very tough questions in a friendly and non-threatening way – think Peter Falk in his TV role as Columbo) and writing capabilities (creating a ‘once-upon-a-time’ type of report that explains, in simple English, WHY a company is valued at a certain level) that few CPAs have.
In closing, let me repeat: I am a CPA (who wouldn’t be caught dead doing his own tax returns). I have great respect for the traditional services that CPAs provide. But those services tend to be limited to accounting and tax services in the overwhelming number of cases. Show me a CPA who does two or three valuations a year, and I’ll show you the equivalent of a brain surgeon who does two or three brain surgeries a year. When the latter calls what he does ‘practicing medicine,’ he’s telling everyone the truth. Clients should want both their CPAs and their brain surgeons NOT to practice. They should want them to do the real thing.
Warren, It’s a fair point you make that the blog post was cursory; however, this was intentional as my blog posts are never book length as this is preferable in social media and with my editor.
I won’t address each of your bulleted comments but I’ll address the first two.
Valuation is part science and part art with at least three different valuation methods and entire books being devoted to the subject. As this fell outside the scope and brevity of the post, they intentionally weren’t mentioned. Most licensees have neither the skills or the resources to do this on their own and, fortunately, many recognize that they need the assistance of a professional (while some do not).
Many entrepreneurs and inventors I meet are typically not cognizant about how significant the IP component can be to their valuation. Because of this they do things like trying to cut corners to save money by filing their own provisional applications, not considering their trade secret opportunities as having value, not thinking about obtaining trademarks, and so on which could degrade the value of their IP. Worse, many people and companies I know will try to improve their existing products or start new companies without considering the very real risk of infringement. The point here is that companies with high IP values may defend it as much, or more, than their physical property.
As far as the derivation of values, I do not know Ocean Tomo’s methodology but I do know that their numbers are similar to those generated by other organizations.
Steve
Valuation is neither art nor science, Steve. It is craft, as I note here: [Editor: this link was broken and deleted on 3/26/2018].
Hi Steve,
You note that there are at least three types of valuation methods in your comment to Warren.
While true, I would posit that this leans on the side of misleading, as there are probably over 20 different methods of valuation that will be done and/or accepted depending on the company being evaluated, the people looking at the valuation, and the industry/size/geography of the business.
I enjoyed reading your post and considering the idea that many business people today underestimate the value of IP in (their) business. I will be looking into this idea in a little more detail thanks to your article.
Warren makes some great points as well as is clearly a learned valuation professional who is cognizant of the pitfalls of assuming any bean counter can also count IPR.
Chang, It’s good to know that there are so many more methods to valuation, thanks! Steve
Chang, that’s a very good “catch” of an error that Steve made. I missed it myself, so thank you for bringing it up because I think it bears fleshing out.
Let me say at the beginning that there are not, to my knowledge, “probably over 20 different methods of valuation.” I’ll demonstrate why that is not the case in what follows.
Let’s start with the hierarchy of nomenclature in valuation. Going along a continuum of focus from broader to narrower (from ‘macro’ to ‘micro’, if you will), there are “approaches,” “methods,” and “procedures.” That means that, within approaches, there are methods, and within each method, there are procedures. I’ll confine my comments here to approaches and methods since that’s where the confusion appears to have begun: When Steve referred to “three methods,” I think he meant “three approaches.” (Please correct me if I’m wrong about that, Steve – reading minds is an exercise fraught with error!)
The approaches, and the methods within each one, are:
1. market approach
a. guideline public company (GPC) method
b. merged-and-acquired company method
c. internal stock transactions (valid only it at arm’s length)
2. income approach
a. discounted cash flow (DCF)
b. capitalization of economic income
3. cost approach (a.k.a. asset-based approach)
a. asset accumulation method
Inexperienced valuation analysts often–and wrongly–assume that “book value” is a method under the cost approach. They are incorrect because each of the three approaches assumes that the value of any company includes ALL of its assets and liabilities, whether they’re recognized on the balance sheet or not. To be sure, the asset accumulation method STARTS with the book values on the balance sheet. Then, however, it moves up the food chain and adjusts them. Such adjustments are extremely difficult because, for one thing, they require valuation expertise in machinery and equipment that most of us who appraise equity interests do not have. Adjustments to recognize the value of various intangible assets are likewise demanding. That is undoubtedly why the American Society of Appraisers now has a certification program in valuing such intangibles.
As a practical matter, most businesses are valued based on economic income of one kind or another. That statement implies the use of two approaches: market and income. Knowledgeable valuation professionals usually deploy one of the methods under those two approaches. Those methods are almost always GPC and DCF.
At least one valuation membership organization (which shall remain unnamed here) teaches its members that the GPC method cannot be used to value smaller middle-market companies. It argues that a small private company cannot be compared with a huge public one. Unfortunately, as is often the case when that particular organization is holding forth on sophisticated valuation practices, its argument is false. In fact, the GPC method can and should be used in nearly every kind of valuation (exceptions: professional practices and VfFR [valuation for financial reporting]). In the GPC method, the challenge is knowing how to adjust the valuation multiples to reflect size differences between the client private company and the big public enterprises.
That, in turn, is not an undertaking for the faint of heart. Our GPC template contains nearly 200 columns of data that, when combined, appear in about 50 columns. For ease of readability, we take screenshots of various columns and Copy/Paste them directly into our reports. We use colors, different size fonts, and arrows so that we have ways to draw the reader’s attention to what we’re discussing in the text.
Using DCF requires an in-depth understanding of the client company’s unsystematic risk profile. Researching, analyzing, discussing, and writing about that one aspect of valuation usually takes about 2/3 of our time. That is because it is complex, multidisciplinary, and multifaceted. Few valuation professionals in the middle-market space know or understand that. As just one example, most use off-the-shelf industry risk premiums from the wonderful Duff & Phelps annual handbook. Others Copy/Paste narratives from IBISWorld and other suppliers to discuss an industry.
The problem with both of those practices is that most of the data in the D&P handbooks and all of the narratives from IBISWorld comes from companies that usually compete industry-wide. Few middle-market companies do that. Instead, they compete in ‘strategic groups’ (a term originating in Michael Hunt’s 1972 Harvard dissertation on his ten-year study of the U.S. small-appliance industry). Strategic groups are segments of industries. Those segments are defined by two constraints; what they are depends on the group in question, but in our line of work, one is almost always geographical. The sine qua non here is that studies done by the U.S. Federal Trade Commission have found that, in most industries, the various underlying structures of the strategic groups in a given industry tend to differ significantly from that of the industry as a hold. In particular, market shares in strategic groups tend to be more concentrated. That has implications for both competitive behavior and risk.
Based on my observations for nearly 25 years, I infer that a huge proportion of the valuation professionals who do BV on a part-time basis (and who constitute the vast majority of the members of the unnamed valuation organization above) use, not the DCF method, but the “capitalization of economic income” method. They argue that the client company either doesn’t have the time, or refuses, to prepare five-year projections of free cash flow. As CPAs usually do–and I am a CPA, so I can say this (even though we do NOT, NEVER HAVE, and NEVER WILL offer ‘traditional CPA services’–those part-timers roll over and just accept that from the client. In so doing, they fail to recognize two crucial responsibilities of being a valuation professional:
1. doing the requisite due diligence before accepting an engagement in the fist place
AND
2. failing to understand that helping clients–educating them, if you will–is a key aspect of what we do.
Those part-timers also don’t understand capitalization of economic income well enough to know that capitalization is simply a unique form of DCF: it assumes constant annual growth in free cash flow. Constant growth requires a stable and mature industry and management that is sophisticated enough to recognize and deal with that. In nearly 500 valuation and advisory engagements, I’ve encountered exactly one (1) middle-market company whose circumstances could justify capitalization (even though I didn’t use it).
In closing, Chang, let me also say that I disagree strongly–but respectfully–with your statement that the valuation method(s) used “depend on the company being evaluated, the people looking at the valuation, and the industry/size/geography of the business.” Anyone who thinks so is probably a member of that unnamed membership organization to which I referred above. Those three factors have NO IMPACT–none – zero, zip, zilch, nada–on the methods we use and those that we see in the valuation reports of serious professionals who have serious credentials and do valuation full-time. The methods used usually reflect the knowledge of the professional. And, to restate a key point I tried to make above, knowledgeable professionals using the GPC method and the DCF method. Period.
John P McNeill from the Law Office of John P. McNeill, P.C. emailed me today with some very helpful information on trademark valuation:
Here is a link to an article I found a few years back (May 2012) that provides a breakdown of trademark value by industry sector, https://lexdellmeier.wordpress.com/2012/05/23/did-you-know-46-of-a-companys-value-derives-from-trademarks/.