IP Valuation Using the Relief From Royalty Method

In today’s business environment, the valuation of intellectual property (IP) is critical. Accounting rules governing fair value measurements and the treatment of acquired goodwill and other intangible assets make it more important than ever to obtain accurate IP valuations.

Several methods can be used to value IP. One of the most effective can be the relief from royalty (RFR) method.

Reasons for Valuing IP

There are four general types of IP: patents, copyrights, trademarks and trade secrets. IP also may include unpatented proprietary technology, trade names, trade dress, brands, computer software, customer lists and other assets that fall within, or are closely related to, the four categories listed above.

There are many potential reasons for valuing IP, including:

• Financial reporting (fair value measurements, annual impairment tests),
• Tax compliance (gift and estate taxes, charitable contributions),
• Litigation (damage calculations, shareholder disputes, divorce, bankruptcy), and
• Sale or licensing transactions (business sales, IP sales/licenses).

The value of IP is particularly relevant to Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations, and SFAS 142, Goodwill and Other Intangible Assets. Under those standards, companies are required to 1) allocate the purchase price of an acquired company among the tangible and intangible assets being acquired, and 2) test acquired goodwill and other intangibles annually for impairment and write them down if their fair values drop below their carrying amounts.

Testing goodwill for impairment is a complex process, but, in general, the value of goodwill depends on the value of a company’s tangible and identifiable intangible assets, including IP.

Not All Valuation Methods Will Do

Like most assets, IP assets can be valued using one or more methods within the three basic valuation approaches: the market approach, the income approach and the cost approach.

When applied to IP assets, however, the cost and market approaches can be a challenge. That’s because it can be difficult to identify and quantify all the costs involved in creating an IP asset. Moreover, the cost of creation may have nothing to do with the IP’s value. And the market approach may not be workable because comparable transactional data for IP and other intangible assets can be difficult to obtain.

Some assets — such as trademarks, trade names or brands — are rarely bought and sold in the marketplace. And even for assets that are sold, such as copyrights and patents, transactional data may not be published.

RFR — A Fitting Alternative

In light of these limitations, the RFR method is often an effective alternative. Generally, RFR is categorized as an income-based method (somewhat similar to the discounted cash flow method), although it may also share some attributes of the market and cost approaches. The RFR method estimates the portion of a company’s earnings attributable to an IP asset based on the royalty rate the company would have paid for the use of the asset if it didn’t own it.

In other words, the value of the IP asset is equal to the value of the royalty payments from which the company is relieved by virtue of its ownership of the asset. The RFR method projects cost savings to the company.

To apply the RFR method, the valuator begins by selecting a royalty rate based on available market data for licenses involving similar assets, industries, territories and other characteristics. Next, the valuator selects an appropriate, risk-adjusted discount rate to determine the present value of the royalty payments.

Typically, this hypothetical license is treated as a perpetual license. To estimate the value, the valuator calculates the present value of projected royalty payments over a certain period (10 or 15 years, for example) and then calculates the present value of the residual at the end of that period.

How Do You Spell Relief?

Accurate valuations of IP are important in a variety of business and litigation contexts. The RFR method is a straightforward IP valuation method that avoids many of the shortcomings of traditional valuation approaches.