Intangible Assets Valuation for Dummies

Introduction

As for present day business, non-material values assume an important position in determining the value and competitiveness of a company. Intangible assets on the other hand are non-physical assets that could greatly cause a shift on the firm’s operations and market share or even profitability. Specific topics covered in this essay consist of: Process, Models, Assumption and Definitions for Valuing the Intangible Assets such as Software, Customer Database, Concessions, Goodwill, Capitalized Research and Development Costs and etc.

Definition of Intangible Assets

The intangible assets are the other type of resources which are non-material, but they are useful because they offer the owner certain legal privileges. Intangible fixed assets are defined under the accounting standards as tangible assets that have recognisable value and that are non-material and non-physical. They are typically recognized on a company’s balance sheet if they meet certain criteria, including:

Identifiability: The asset can be disposed of rapidly separated from the company and sold, transferred License or to be rented.

Control: The company has the ability to direct the future permitting economic benefits, to be obtained from the asset.

Future Economic Benefits: It is believed that the asset will give future economic benefits.

Categories of Intangible Assets

Software: One being software that has been created or acquired with the specific intent to be used internally or to be resold.

Customer Databases: Databases containing information on customers that can be utilised towards marketing and selling.

Concessions: Business permissions, which may be issued by the government or some other body, to run some types of business processes.

Goodwill: A key aspect of acquisition costs, which is the amount that indicates extra value over the recognized assets, based upon factors such as a company’s brand and customer connections.

Research and Development Costs (Capitalized): Expenses that are spent to capture intangible benefits in the future, they might be to introduce new products or new technologies.

The Valuation Process

Adopting non-financial items has several processes, which must be followed to produce the correct evaluation. The general process includes:

Identification: Identify which assets are intangible and understand more about these assets, the attributes they possess and the possible value they can hold.

Valuation Method Selection: Deciding which model of valuation to apply, certain basic requirements in relation to the type of asset and available information have to be met.

Data Collection: Identify and collect all the information that may be useful in arriving at the valuation of the company.

Valuation Execution: Employ particular models and techniques on the selected intangible assets to conduct their valuation.

Validation and Reporting: Summarize the results and develop a comprehensive report which include findings of the study and the assumptions made.

Valuation Models and Methods

Suppose there is a tech start up, Innovate Tech Inc. Which has crafted a first-of-its-kind software patent of a new AI algorithm. One idea being discussed at the firm is to sell this particular patent to a bigger tech firm and this makes it important for the company to assess the value of this patent. That way, we will illustrate how the various intangible asset valuation models and methods work by using this scenario.

Income Approach

One of the valuation models which is important for estimating the firm’s value is the Discounted Cash Flow (DCF) Method.

Forecast Future Cash Flows

Revenue Projections: As for Innovate Tech, the company believes that the software patent should produce royalties that would be 1 million naira for the period of 10 years.

Cost Estimates: Annual expense of operating costs pertaining to the specific patent are projected to be Two hundred thousand US dollars.

Determine the Discount Rate:

Risk Assessment: They have used a discount rate of 12% this is due to the high risks involved in this competitive technological industry.

Calculate Present Value

Net Cash Flow Calculation: Free cash flow = 1,000,000 – (500,000+300,000) = 200,000.

Discounting: According to the DCF method, the value of the patent’s cash flow in the next 10 years is around 5. 6 million naira.

Relief-from-Royalty Method

Estimate the Royalty Rate

Comparable Rates: The data of the industry supports a royalty rate of about 5 % for such patents.

Forecast Royalty Payments

Projected Sales: Annual sales potential of the products embodying the patent are at 20 million naira.

Royalty Payments: Twenty million divided by 10 is 2 million, Five percent of 2 million is 10,000 and five percent of 20 million naira is 1 million per year.

Discount the Royalty Payments

Present Value Calculation: Based on a discount rate of 0.12, the present value of royalty payment is estimated at 5.6 million naira, a figure which is in confirmation with the DCF calculation.

Market Approach

Guideline Transaction Method

Identify Comparable Transactions: Data Collection: A survey of recent sales of similar software patents reveals prices that range from 4 million naira to 6 million naira.

Adjust for Differences:

Comparability: The subject patent is slightly more advanced, this results in an increase of +10% to the rating.

Determine Value:

Value Range: By doing so, the value that can be estimated on the patent is approximately 5,600,000.

Guideline Public Company Method

Identify Comparable Public Companies:

Analysis: Firms with similar patents have a P/E ratio of 15-20.

Analyze Financial Metrics:

Application: By using the P/E ratio methodology and applying P/E of 18 to the patent’s annual net cash flow of 800,000, naira the value of the patent is 14. 4 million.

Adjust for Differences:

Risk Adjustment: Where InnovateTech is relatively small in nature, a decrease in the value is taken. The final picture of Shire’s valuation is brought down to around 7 million naira.

Cost Approach

Reproduction Cost Method

Estimate Reproduction Costs: Development Costs: It takes years and 3 million, the cost of recreating the patent (R&D & development) to do so.

Subtract Obsolescence:

Adjustment: A technological factor is considered in terms of a 20 % reduction with given subsequent years.

Adjusted Cost: 3,000,000*20/100 = 2,400,000.

Replacement Cost Method

Estimate Replacement Costs:

New Development Costs: They estimate that replacing the patent with a new, similar technology will cost 4 million of US dollars.

Adjust for Obsolescence:

Depreciation: If we use 15% obsolescence factor then the replacement cost will come as 3.4 million naira.

In this case study, we see that the valuation of InnovateTech’s software patent yields a range of values depending on the method used: In this case study, we see that the valuation of InnovateTech’s software patent yields a range of values depending on the method used:

Income Approach: 5.6 million naira

Market Approach: from 5.6 million naira to 7 million naira

Cost Approach: In this regard, the organisation should spend between 2.4 million naira and 3.4 million naira.

The method that one will use to value the patent depends on the use of the valuation and the situation relating to the patent in question. For instance, in a sale negotiation the market and income approaches could be of more significance than the cost approach, although the latter gives a ground on which the cost of creation can be ascertained.

Assumptions in Valuation

Discount Rate: This is an important assumption especially where one does a discounted cash flow (DCF) valuation. The discount rate represents the risk that is attached to the investment or asset as well as the time value of money. Most commonly it comprises the Risk-free rate, plus the Risk premium. This is another reason that shows that the choice of the discount rate method can dramatically alter the valuation result.

Cash Flow Projections: In DCF valuations, the forecast of cash flows is critical in the process. Most of the techniques used in valuations fall under one of the two categories. These projections can be affected by such assumptions such as growth in revenue, increases in profit margins, operating costs and capital expenditures. Such assumptions are derived from prior out-of-convention net operating margin performance, current, and industry trends alongside management forecasts.

Growth Rates: The predictability of future growth rates for revenues, earnings or cash flows is also important. Such adjustments may be calculated with reference to past growth rates and/or market trends and reflections about future economics/industrial conditions.

Terminal Value: In a DCF model the terminal value refers to the value that is assigned to the asset or business after the given forecast period. There are significant implications on the overall valuation when assumptions made about the perpetuity growth rate or exit multiple to estimate terminal value are inaccurate.

Market Conditions: Valuations take a number of assumptions of market factors including the interest rates, inflation rates, and balance of the economy. Fluctuations in these conditions lead to changes in discount rate, growth rate or overall estimated values.

Risk Factors: This is to imply that the risk associated with the various assets or businesses is never constant. Expectations of business risk, financial risk and operational risk influence the discounting factor and therefore the fundamental value.

Comparable Multiples: Relative valuation (for example by multiples) always comes with the question how the respective multiple was determined and if the used comparable firms or transactions are appropriate. Environmental factors such as size, market position and characteristics of operations may impact on the relevance of the multiples.

Capital Structure: The estimates made about the capital structure, concerning the ratio of debt and equity components, can also affect the value. For instance, an improvement in leverage results in a change of the cost of equity and the permitted risk.

Tax Rates: Estimations or assumptions of existing and future tax rates have implications on cash flows and profitability. Such assumptions can be affected by tax regulations and possible changes in the tax laws.

These estimates are normally derived from past experience, other businesses in the same line of production and the opinion of professionals. This is as an analyst and an investor must assess these assumptions and consider how alterations of them could affect the valuation results. Another common application which is most frequently utilised when testing the impact of change of the taken assumptions is sensitivity analysis. 

Practical Considerations

When valuing intangible assets, practitioners must consider several practical factors:

Data Availability: Information is very vital for any valuation process to be effective,and that information must be correct as well as relevant.Lack of proper or sufficient data impacts the preparation of valuation.

Regulatory Requirements: It is important to observe the accounting standards and rules like IFRS or GAAP as they contribute to the correct and consistent Models of Valuation.

Expertise: Most of the time appreciating intangible assets calls for professional skills when it comes to accounting and business, as well as the field of specialisation.

Acquisition of Intangible Assets

Tangible assets as we have seen can be bought by various means and each method affects their value and reporting in the financial statements differently as the following classification of intangible assets shows. Here’s a brief overview of the five primary methods through which intangible assets can be obtained:

By Separate Purchase

Definition: Separate acquisition of intangible assets refer to purchasing of the asset from the seller in a separate deal than the normal business operations.

Characteristics:

Transaction Basis: The asset is usually bought through a negotiation process in an unrelated transaction in which the price of the asset is usually negotiated by the buyer and the seller.

Valuation Considerations: Thus, the value of the intangible fixed asset is the purchase consideration, which can also take into consideration market value or even bargain cost.

Examples: Buying patents, TM or copyrights from another company or a person.

Financial Reporting: An intangible asset that was procured is reported on the balance sheet for the amount paid to acquire it.

This cost is the actual outlay which a company incurs in acquiring or otherwise in obtaining the asset,which might include lawyers’ fee or fees for registration among others.

 As Part of a Business

 Definition: Acquired goodwill is mostly in the form of intangible assets which are purchased in business combination or acquisition where goodwill forms part of the whole business being bought.

Characteristics:

Transaction Basis: The asset is purchased together with other assets and liabilities of a business at a single point in time for example in merger or acquisition.

Valuation Considerations: In this respect, the values assigned to intangible assets are considered in terms of their proportionate share of the total purchase consideration of businesses, and may necessitate fair value measures of every acquired asset.

Examples: Closing of an organisation with its customers list, special software and its goodwill.

Financial Reporting: The intangible assets which have been acquired are initially recognized at the fair value at the date of acquisition while any amount by which the purchase price exceeds the net fair value of the identifiable assets is recognized as goodwill.

Combination by Government Grant

 Definition: The intangible assets under this category cover the rights or assets mobilized by government grant but paid through government funded or incentivized programs.

Characteristics:

Transaction Basis: The asset is received from the government mainly through grants in order to assist in research, development or in innovations.

Valuation Considerations: The value of the grant will depend on the conditions that were agreed on, if there were any for instance, frequency of performance or generation or any other report to be submitted.

Examples: Accepting an offer of a government grant on a private incubation project that is given to the development of new technology or an idea.

Financial Reporting: The intangible asset is stated at fair or cost if measured at fair value, and the corresponding government grant is recognised as revenue or as a reduction in the cost of the intangible asset if measured at cost in accordance with the applicable accounting policies.

By Exchange of Assets

Definition: Intangible assets acquired by exchange are made through barter where one party will exchange an asset with another one with a value that will be less than the cost of acquiring it.

Characteristics:

Transaction Basis: The exchange entails parting with an asset or a bundle of assets with a view of obtaining an intangible asset.

Valuation Considerations: The value of the acquired intangible asset is then estimated by using the fair value of the asset so relinquished or fair value of the asset acquired.

Examples: Changing one patent for another trademark or exchanging licences of using certain software for research findings.

Financial Reporting: In this case, the intangible asset obtained is recognised at the acquisition cost of the asset that was given up. Any of the gain or loss that results from the exchange is accounted based with the help of the difference whereby the carrying amount of the asset(s) being exchanged and the fair value of asset received.

By Self-Creation (Internal Generation)

Definition: The type of intangible assets that require self-creation is acquiring an intangible asset through creation of the asset in the organisation.

Characteristics:

Transaction Basis: It is a newly developed product or a new idea that comes out of the hat of the company by particular research and development efforts.

Valuation Considerations: Most often, the value of the self-generated intangible assets is calculated with reference to the costs for their creation that includes direct and indirect expenses.

Examples: Products which are in the innovation development stage can be developing their own unique software, creating their own brand or new patents through the internal investigation and creations.

Financial Reporting: Sourcing intangible assets are normally recorded on the balance sheet where they have fulfilled certain tests, for instance illustrating prospective economic value and satisfying capitalization regulations. Whereas the costs that are directly attributable to research activities are generally taken to the expense line, development costs may be capitalized in the balance sheet if they meet stipulated requirements.

It seems quite important to understand those ways of obtaining the intangible assets in order to correctly assess the financial statements and the value.

The various acquisition methods have consequences on the accounting and reporting of the asset, the structural financial statement, as well as the company’s financial performance.

Case Studies

To illustrate the application of valuation methods, consider the following case studies:

Background: Tech Innovations Inc. is a start-up company that was founded to deal with innovative technologies in the area of artificial intelligence (AI) application. The company has a few of the proprietary technologies and patents in the field of AI and machine learning. Over the past few weeks, Tech Innovations Inc. has received an expression of interest from a larger technology company who have sought to buy them. As such, the value of intangible assets is an important factor that requires both the buyer and the seller in the acquisition to consider.

Intangible Assets Identified:

Patents: Currently, the company has five patents relating to AI algorithms each of which is used in different technological fields.

Trademarks: Tech Innovations Inc. has protectively filed for Trademark for all of the product names and the logo used in advertising the products.

Proprietary Software: The use of AI is crucial to the company’s operations since it owns and uses a distinctive AI software.

Customer Relationships: Some of the major strategies that the company has employed include developing good relations with its clients who depend on its service in applying AI solutions.

Research and Development (R&D) Expertise: Experience is a major plus point as the team has done extensive work in the field of AI or artificial intelligence before.

Valuation Approaches:

Cost Approach: Cost the development of the intangible assets which were established. In the case of patents and proprietary software it consists of one’s costs incurred for conducting research on the invention, hiring a lawyer to prepare for the registration of the patent and costs accrued in developing the software.

Market Approach: Arriving at its value based on the price that can be derived from similar transactions in the market. Compared with recent acquisitions of similar companies in the AI sector, get an idea of the worth of patents, trademarks and proprietary soft wares.

Income Approach: Ascertain the future cash flows that the intangible assets are likely to come up with. Regarding the proprietary software and the customer relationships: estimate the future cash inflows and use a discount factor to determine their worth today. This one entail predicting the revenues from the patents as well as from the software.

Analysis

Patents: Hence, the total cost to acquire and maintain those patents is estimated to be 2 million naira in the case of cost approach. Market approach whereby estimates have been based upon recent sales of similar patents gives the value of 5 million naira. Using the income approach and the projected revenues from future licences the value is determined to be 4 million naira.

Trademarks: The overall market approach which was established using other recent trademark sales specifically in the technology sector indicated a value of one million US dollars. The cost approach; which considers the branding and marketing expenses, puts the value at 500,000 naira.

Proprietary Software: The last method based on revenues, following the revenue generating capacity of the software sales and licensing in the future, has a value of 10 million naira. Other costs mentioned here under the cost approach, comprising development costs, are 3 million naira.

Customer Relationships: In the income approach, which determines the future earnings based on existing contracts and client loyalty, the value put for this intangible asset is 2 million naira.

R&D Expertise: Why is this measure more difficult to quantify? It may be estimated in the valuation, though, in terms of potential contribution towards the future innovation and product development.

Conclusion

Therefore, it can be noted that intangible assets have a great significance in the firm’s and corporation’s value. Based on the case study, the estimated values for each intangible asset are as follows:

 Patents: 4 million naira, and this has been arrived at by taking an average of the cost, market and income approaches.

 Trademarks: There was also evaluation wherein the cost approach and the market approach were averaged out to be at 750,000 naira.

Proprietary Software: Table 2 Based on above table, its value according to income approach is 10 million naira.

 Customer Relationships: 2 million dollars (using the income method).

 R&D Expertise: Difficult to measure in terms of dollars and cents though it is of immense importance to getting the overall value proposition.

Total Estimated Value of Intangible Assets: This indicates that, for this bridge’s cost, it could have been constructed with or built as a brand-new bridge for at least 16.75 million naira

Concerning the modes of acquisitions, Tech Innovations Inc. should focus on the high value of its patented software and strategic importance of patents and customer base. Besides, determining the intangible assets’ worth is not only necessary to estimate the correct acquisition price but also to assess the firm’s growth and profitability capability.

From the observations made in practice, the valuation of intangible assets is done using a combination of methods in order to avoid overstatement or understatement of assets. After the adoption of each approach, the results may differ and hence, the buyers and sellers should adopt various approaches and methodologies to arrive at an adequate valuation.

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