First we have to set a few ground-rules and provide a framework for our discussion. There are many different types of valuation, almost as many as there are reasons for wanting to determine a value. Before even starting the valuation, the valuer has to discuss with his client the purpose of the valuation and who will be the target audience. If the valuation is for supporting an end of year financial audit, Fair Value will most likely be the correct basis of value. If the valuation is required to assist in an acquisition of the asset, Market Value will most likely be preferred. If the valuation is required for insolvency purposes or the seller is under duress, then Forced Sale Value might be more appropriate. The key is to ensure that the basis of valuation is matched to the purpose of valuation. It also follows that you should not blindly take a valuation prepared for one purpose and try to use it for an alternative purpose, it may be completely inappropriate.
For the purposes of this discussion, and unless indicated otherwise in future articles, we will assume that the basis of valuation is Market Value. Unfortunately, having decided on the basis of value doesn't solve all our problems as there are many different standards which define or describe how valuations should be performed. While it is important to select the appropriate basis of valuation, it is equally important to use the correct set of valuation standards for the situation as well. We will use the International Asset Valuation Standards as the basis for all our future discussions, again, unless indicated to the contrary.
Having settled on the valuation standards and the basis of valuation, we can now look at the definition of Market Value. The International Asset Valuation Standards define Market Value as “the estimated amount for which an asset should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s-length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently and without compulsion”. While we could devote the rest of this article and the better part of a textbook on exactly what this means, we won't. We merely provide the definition here to help set the scene for intellectual property valuation.
Now, on to a few key rules which relate to intellectual property and valuation. Firstly, simply because something has cost money to develop doesn't mean that it has value – cost does not equal value. Secondly, just because something has a value to you doesn't mean that it has a market value – market value is based on the concept of value in exchange and if the asset cannot to transferred or exchanged, it has no market value as a standalone asset. That doesn't mean it has no value, it simply means that it may not have a market value if sold as a separate asset, it may need to be bundled with other assets to realise its value. This is especially true of intellectual property and other intangible assets which cannot be clearly identified, described or legally defined, they add value to a business and enhance its Market Value, but may not meet the criteria for valuation as separate assets.
For intangible assets to have a market value, they must meet the following criteria. Failure to meet any one of the following means that the asset cannot have a Market Value by itself and will need to be bundled together with other assets to be ascribed a Market Value.
- The asset must be able to be identified and defined. If it cannot be fully described then it cannot be transferred.
- There must be some physical manifestation of the asset – innovations can be defined by patents, business practices can be described in procedures or work rules, manufacturing rights can be defined in license agreements.
- It must be separable from the other assets with which it is used. By themselves some items have no Market Value as they are unable to be transferred to a third party.
- An asset must have a date of creation. All assets come into being at a specific date, this date must be known and able to be proven.
- An asset must generate measurable economic benefits if it is to have a market value. If we cannot reliably identify cash flows attributable to an asset, it cannot be valued by itself. This doesn't mean it won't have value as part of a bundle of assets.
Having established a few basic parameters for the valuation and the assets being valued, we define below each of the three approaches to value:
The Cost Approach
The Cost Approach considers the cost to reproduce or replace in new condition the assets appraised in accordance with current market prices for similar assets, with allowance for accrued depreciation arising from physical, functional and economic causes. The cost approach generally furnishes the most reliable indication of value for assets without a known market.
The Market Approach
The Market Approach considers prices recently paid for similar assets, with adjustments made to indicate market prices to reflect condition and utility of the appraised assets relative to the market comparative. Assets for which there is an established market may be appraised by this approach.
The Income Approach
The Income Approach is the conversion of expected periodic benefits of ownership into an indication of value. It is based on the principle that an informed buyer would pay no more for an asset than an amount equal to the present worth of anticipated future benefits (income) from the same or equivalent project with similar risks.
In a perfect world, each of the three approaches should yield the same result. Unfortunately, as we all know, we do not live in a perfect world. Therefore, part of the valuer's skill lies in selecting the correct valuation methods for the assets being valued given the specific circumstances of the valuation. While we have only identified the three basic approaches to value in this article, it is worth noting that there are numerous methods based on these approaches, many of which combine elements of two or more of the three basic approaches. Future articles will examine each of the three approaches in detail and describe how these can be applied to intellectual property and other intangible assets.