How an IP Audit Strengthens Your IP Valuation
In 2021, global mergers and acquisitions (M&A) peaked at an all-time high, with over 63,000 transactions worth a colossal US$5.9 trillion. Among these, M&A deals in the technology sector make up the bulk of global M&A transactions.
Increasingly, according to Ernst & Young, M&A is driven by technology and other innovative capabilities that throw intellectual property (IP) fiercely into the spotlight. IP assets play a central role in M&A as they are often vital to business success, and ultimately, value. Companies are hence positioning their IP assets as key value drivers in business valuation amid the M&A frenzy.
It’s easy to see why, because IP assets account for one of three key components that measure the worth of a business as illustrated here:
Working capital – difference between current assets and current liabilities
Fixed assets – plant, machinery and equipment, land and building, office equipment and furniture, computers, vehicles and other tangible property used by the business
Intangible assets (IA) – assets without physical embodiment that are valuable to the business, including IP assets and other IA, such as customer lists, supply contracts, regulatory licences, and a trained workforce
It is important to note that IP assets are but a subset of a broader group of IA. Whereas IP assets are tightly linked to legal rights protected by law (such as trade marks, patents, copyright, and trade secrets), IA go beyond registrable rights to include equally valuable drivers like know-how, industry networks, client databases and more, that also need to be strategically managed to create value.
While more businesses are recognising IP as main value drivers, few might consider conducting an IP audit before valuation. Yet, this is an important process for uncovering intangible assets and business value.
Why do I need an IP audit for IP valuation?
Knowing what you have is the first step to knowing what they are worth. Many may not see a clear connection between IP audit and IP valuation. Yet, the value of IP assets essentially stems from the rights of an owner that are legally protected and enforceable to exclude competitors from using them. Therefore, an IP audit is vital in getting an accurate view of the IP assets owned by a business.
In this article, we reveal just how an IP audit can strengthen the analysis and credibility of your IP valuation.
An IP audit is a systematic review of the IP assets owned by a business. A comprehensive review of a company’s IP assets, related agreements, relevant policies, and compliance procedures provides a business with an updated inventory of its IP assets (whether used or unused). More importantly, an IP audit also provides a strategic assessment of a business’ core IP assets to support the value proposition of these IP assets during valuation.
To start off, valuing your IP assets broadly involves two steps: (1) identifying the IP assets for valuation, and (2) attributing value to these IP assets. Of course, this process also considers the purpose of the valuation, which impacts the resulting value. During step one, the valuer will gather substantial information about the IP assets under valuation, to understand how these assets create value for the business.
This is intricate work because in any business, IP assets are usually deployed together with other assets to generate economic benefits. With that, the value of IP assets is closely interlinked with the business and its other assets, and valuing IP assets commonly happens at the business level, or as a group of related assets.
Here is an overview of how IP audit can support the process for identifying and valuing IP assets:
Why identifying IP assets may be tricky
While it seems obvious that the starting point in any valuation is to identify what needs to be valued, this process is not straightforward. A business typically possesses various IP assets and IA. Many of these may not be readily identifiable, such as unregistered IP assets like copyright and trade secrets.
Furthermore, an IP asset is subject to several conditions before it can be valued, according to the World Intellectual Property Organisation (WIPO):
It must be separately identifiable (subject to specific identification and with a recognisable description)
It should have been created at an identifiable point in time
It should be capable of being legally enforced and transferred
Its income stream should be separately identifiable and isolated from those of other business assets
After meeting these stringent criteria, IP assets must then be examined for their unique characteristics which impact the valuation analysis.
4 characteristics of IP assets that influence the valuation outcome
There are four major characteristics of identified IP assets that are imperative to examine as part of IP valuation analysis—legal, market, functional and economic.
How do these characteristics influence the valuation process? They impact five crucial aspects, as clarified by the guidance note on “Valuation of intellectual property rights” in the second edition of Royal Institution of Chartered Surveyors (RICS). These are the 1) definition of IP assets under valuation 2) extent of investigation 3) choice of valuation methodology 4) valuation analysis and 5) valuation assumptions and inputs.
Case in point, it is important to consider legal characteristics as the value of IP assets essentially stems from their underlying legal rights, which are often complex. There are distinct rights that protect different subject matter, and the rights can vary by jurisdiction, scope, and duration of protection. However, legal rights alone do not determine the value of IP assets. It also depends on their commercial utility and marketability.
Notice how these IP characteristics are all interrelated. On one hand, obtaining the relevant registration and protection for IP assets in the markets can raise barriers of entry against competitors, thereby enhancing value. On the other, commercialisation of products can be restricted by the IP rights owned by other market players, thus lowering the value of its technology.
An IP audit can assess the ownership, validity, and scope of protection of the identified IP assets, including whether the deployment of these IP assets is likely to infringe the rights of others, or if others are infringing on the IP assets. In addition, an IP audit can provide a business with updated market and competitive information to assess whether the IP assets are meeting the business objectives, and help the business decide on alternative strategies, if needed.
What is the preferred approach for IP valuation?
Up till now, we have established the need to properly identify a business’ IP assets, and laid down four key characteristics that impact valuation. Now on to the actual valuation where the aforesaid will be analysed. Broadly, there are three main approaches:
The income approach values an asset based on the economic benefits which it is expected to generate during its economic life and the associated risk.
The market approach values an asset by considering transactions of comparable assets.
The cost approach values an asset based on the cost of developing an asset with similar utility.
Each approach of valuing IP assets has its own advantages and drawbacks. However, the income approach is often preferred as it focuses on the future economic benefits attributable to these IP assets. This is where the characteristics of different IP assets also influence the key valuation assumptions and inputs used to value them.
How does the lifespan of your IP assets affect their value?
Given that the income approach focuses on the `future economic benefits’ generated by IP assets, a longer `future’ or economic life would usually translate into a higher valuation due to a longer runway. In short, `economic life’ is the expected period that an IP asset can be used to generated economic benefits to the owner.
IP assets are legally protected only during a specified term. Therefore, their validity and statutory life can significantly impact value. Suppose the main value proposition of a technology resides within a patented invention, what happens when the patent protection ends—generally 20 years or sooner if a company overlooks its annual renewal? Should this patent lapse, the business may lose its unique competitive edge, which will negatively impact its valuation. Similarly, failing to renew patents or respond to office actions for pending patent applications can affect IP valuation.
Generally, the economic life of an IP asset may be shorter than its statutory life due to legal, market, functional, and economic factors. While a patented technology could be legally protected for say another 10 years, similar technologies and strong competition in the marketplace can reduce its economic life. Even technologies protected by trade secrets are not safe forever, as competitors can replicate or develop similar technology. Moreover, technology may become obsolete over time and customer preferences may change.
An IP audit provides an updated inventory of IP assets, which is a good starting point to assess the statutory life of a business’ IP assets. The IP audit can also provide detailed information on these IP assets to support the analysis of legal, market, functional, and economic factors to help determine their economic life.
What economic benefits do your IP assets bring to the table?
Beyond looking at the lifespan of IP assets which invariably affect `future economic benefits’, valuers must determine what sort of economic benefits can be derived. One of the most complex tasks in valuation is to attribute specific economic benefits to these IP assets. It is challenging because each business has its unique mix of IP and other IA to create value across different markets.
As the starting point for this process, historical financials and management projections are typically used. But valuers must perform additional analysis on such data originally developed for financial or management reporting purposes to attribute economic benefits embedded within the earnings of a business or a business unit to specific IP assets on a reasonable basis. These projected earnings and growth attributed to IP assets may then be further broken down by products and/or services.
What attracts the most scrutiny is where the valuation report is intended for external users such as investors or regulators. The report should therefore provide sufficient analysis of the relevant characteristics of IP assets to justify their valuation.
In addition to the legal characteristics of IP assets, an IP audit can also provide relevant information on their market, functional, and economic characteristics. This will help a business explain how the relevant IP assets are used across business units or products/services to generate economic benefits for the business.
How do you lower the risks in your IP assets that impact value?
In performing the IP valuation analysis, we have so far discussed the first two key valuation assumptions—determining the economic life of IP assets and projecting their earnings and growth. There is a third key element to account for under the income approach.
Valuers must consider the risks associated with these IP assets and adjust their calculation of present projected economic value based on an appropriate `discount rate’. This discount rate should reflect the specific risk profile of the IP asset, where a higher risk translates to a higher discount rate and thus, lower valuation.
What sort of IP assets may bear greater risks? Take for example, technologies protected via trade secrets which could have damaging consequences overnight if the information is leaked. Disclosure of these trade secrets would be fatal to its valuation, having lost its key value proposition of secrecy. However, the risks could fall substantially if they are properly identified (in an IP audit) and subsequently managed as part of the company’s business processes.
What about technologies protected by patents—can they circumvent risk? This depends heavily on their patent validity and scope of protection. Valuers must assess these along with the company’s ability to detect infringement and enforce its patents in the markets where the technology is commercialised.
Risk assessment is a key focus of an IP audit. It seeks to determine whether the IP assets are free from encumbrances for the intended business uses, and identifies potential issues that need to be proactively managed.
Technologies in development and new products or services yet to be launched in new markets can run a higher risk of exposure. An IP audit can help identify what kinds of additional protection are needed, and highlight any potential freedom-to-operate issues, to help the business manage these associated risks early.
An IP audit helps you recognise and support your IP’s value
In conclusion, the IP audit is a powerful tool that recognises and supports your IP’s value at every step of the rigorous IP valuation process which requires careful consideration of the various characteristics of different IP assets owned by your business.
However, there is no one-size-fits-all approach. IP assets and their uses are unique to each business, and this alone makes it challenging to identify and justify the value they bring. With IP assets becoming increasingly valuable to businesses, conducting an IP audit could improve the recognition of IP value to investors and other users of IP valuation reports.
Richard is a Chartered Valuer and Appraiser (CVA) with the Institute of Valuers and Appraisers, Singapore (IVAS). He has over 10 years of experience working with organisations in the technology and ICT sectors on tax and valuation issues arising from business transactions, research and development, intellectual property acquisition, and commercialisation.
IPOS International helps enterprises and industries use IP and intangible assets for business growth. To learn how you can leverage on your IP, book a complimentary chat session on your intangible assets with us today.
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