Valuation of Intellectual Property Assets Professor Derek Bosworth Intellectual Property Research Institute of Australia Melbourne University

Coverage of the presentation IP as a component of IC Nature of the management problem The Diageo problem Nature of the accounting problem Accounting issues surrounding intangibles Accounting methods for intangible assets Options pricing and optimal stopping [Other strategic issues]

Not covered in the presentation Economic approaches to valuation Production function and market valuation – dealt with in a previous presentation Patent valuation analysis – using renewal data Methods of valuing product characteristics Conjoint analysis (marketing) Hedonic analysis (economics)

IP as a component of IC

Human Capital Relational Capital Organisational Capital Intellectual Capital Human Capital Relational Capital Organisational Capital Intellectual Property “Sociological” Skills and Capital “Technological” Skills and Competencies Infrastructure Capital

Organisational (structural) capital: examples of IP/IPRs • patents • copyrights • design rights • trade secrets • trade marks • service marks • trade dress • utility models • plant & seed varieties

Nature of the management problem

Why Value Intellectual Capital Measurement of IC - enables a more efficient management of the company - i.e. to: understand where value lies in the company have a metric for assessing success and growth provide a basis for raising finance or loans If borrowing can only be secured against tangible assets, then knowledge-based companies will be disadvantaged in investment and growth.

The Diageo problem

Diageo: the company Grand Metropolitan - formed as a hotel company in 1962 by mid-1980s strengths in variety of branded products became known as Diageo in 1997, on merger with Guiness

Previous accounting practice GrandMet – often bought and sold brands Acquired Heublein from Nabisco in 1987 Paid £800 million, of which over £500 million was for the Heublein brands (i.e. intangibles) Given the accounting procedures at the time, GrandMet published its next set of accounts in January 1988 the Heublin brands were not valued £565 million of the £800 million paid for the company was written off as goodwill against reserves as a result, the balance sheet net assets fell, giving the impression than £565 million had been wasted

Changed accounting practices Subsequently GrandMet introduced brand capitalisation after acquiring Pilsbury in 1989, the balance sheet showed the importance of brands brands £2.7 billion other assets £6.9 billion liabilities (mainly debt) (£6.7 billion) net assets £2.9 billion Without brand capitalisation the balance sheet would have shown net assets of only £0.2 billion Corbett (1997) argues that this would have been an absurd situation

Further example of brand aquisition GrandMet acquired Pet in 1995 at a cost of £1.8 billion Again, the acquisition affected GrandMet's balance sheet brands £3.8 billion other assets £7.3 billion liabilities (7.7 billion) net assets £3.4 billion

Accounting issues surrounding intangibles

Accounting concerns Is the intangible asset clearly identifiable Does the company hold an unambiguous title to the asset Could the intangible asset be sold separately from the business Does the intangible give rise to a “premium” not earned by other companies?

Tangibility and uncertainty Replicated plant and equipment Product modification Innovation New factory Staff training Research and development Most certain Most uncertain Source: Webster

Tangibility and Separability: the Spectrum of Assets Separable Not separable Wholly tangible (i.e. machine tool) Highly intangible (i.e. goodwill) Source: Wild and Secluna

Accounting methods for intangible assets

Accounting approaches to valuation Cost based valuation historical creation cost - how much did it cost to create? current recreation cost - how much would it cost to recreate an identical intangible? Market based valuation - evidence from sale or purchase of similar assets (i.e. individual brands, branded divisions or whole companies) Income based valuation looks at the stream of income attributable to the intangible asset, based on: historical earnings (i.e. multiple of earnings) expected future earnings (i.e. discounted cash flow)

External influences on IC measurement and disclosure Writing off expenditures on intangibles against profits or reserves seems wrong Thus, there is considerable pressure on accounting bodies devise new accounting codes of practice (SSAPs/GAAPs) Examples: SSAP 13, 1989 - covers the treatment of R&D expenditure Draft SSAP 22, “Accounting for Goodwill” SSAP – statements of standard accounting codes of practice GAAP – generally accepted accounting principles

IC audits

Towards an IC audit Various authors suggest an IP audit – see e.g. Brooking 1997 Each company produces a taxonomy and set of checklists similar to Slide 3 above Weights are applied to each item on the checklist – reflecting importance in achieving company goals Large “dots” reflect very important and small less important Position within the target reflects the perceived strengths (close to “bull”) and weaknesses (far from “bull”) of each asset.

Brooking’s “target”

Conclusions on IC audits Majority of the 8 large dots (more) and 22 small dots (less important), in IP quadrant Brooking argues target is consistent with an IP dominant company (40% of listed assets are IP assets) if the company is not intended to be IP dominant, then “severe changes are required” 66% of the IP assets are below average in value, including the significant ones Tracking likely changes over time, she argues “The IC of this company looks like its in pretty bad shape and likely to get worse.”

Options valuation and optimal stopping techniques

Options values Options pricing methods are potentially the way forward Only method that really deals with risk Applicable to every stage of creative process: investment in R&D decision to patent, etc. decision to commercialise the invention But: Need information about wide range variables Inventive process is a multi-stage decision – which makes the calculation very complex

Underlying principle Black-Scholes→Merton→Dixit & Pindyck equations that allow for changes in the degree of risk over time in the D&P model the benefits of waiting one more period minus costs of waiting = value of the option often called optimal waiting models

Value of a real option The value of real option is determined by: present value of project cash flows (+) investment cost of project (-) time remaining to invest in the project (+) standard deviation of the project value (+) risk free interest rate (+) Pitkethly (2002)

Optimal stopping rules Use the distribution of possible returns to decide: how much to do how long to go on doing it Uses the distribution to calculate a “reservation return” R* which indicates: whether to do any R&D whether to accept a given result, R, and exploit, R>R* or carry on doing research

Strategic issues

Measurement versus Disclosure Measurement of IC is imperative as organisations become more “knowledge-based” increasingly managing intangible items embedded in production activities, products and services However, the knowledge-base of the company defines its core competencies measures of IC provide information of value to competitors (i.e. about strengths and weakness) Advantages because disclosure enables the capital market to determine the true asset base of the company determine a correct market valuation loan funds secured against intangibles

What form of reporting The unresolved debate amongst accountants reflects the uncertainty about the way forward, i.e. “… a complete revamping of financial statements, so that they reflect the growing knowledge base of companies.” [Brennan, 1992] or a new financial statement, to “… contain expenditures that have not yet been classified as an asset or expense at the company’s financial statement date. In a sense this statement represents a place where expenditures can sit in a holding pattern until their status as a potential asset or potential expense is resolved.” [Rennie, 1999]