Valuation and Accounting of Intellectual Property (IP) Assets: Importance, Methods and Challenges Guriqbal Singh Jaiya Director SMEs Division ( ) SMEs Division ( ) World Intellectual Property Organization (WIPO)

Value of Companies 1978: Book Value (95 % tangibles) and Market Value (5 % IP and Other Intangibles) 1998: Book Value (28 % tangibles) and Market Value (72 % IP and Other Intangibles)

Intangibles Assets as % of S & P Market Capitalization 1982: TA=62%; IA= 38% 1992: TA=38%; IA= 62% 2002: TA=13%; IA= 87% Tangible Assets (TA) Intangible Assets (IA) Source: Brookings Institute

IP and Business Plan Patents Vs. Trade secrets Ease or difficulty in detecting patent infringement (>hidden processes, e.g., petroleum, pharma) (<Products with serial numbers, e.g., automobiles, software) Intensity of rivalry within the industry Many patents or a few multi-claim patents Strength of patent; blocking patents Patent clusters: Horizontal or vertical

Financing Options Grant Loan (Portfolio of IP) Equity Bonds Securitization

Source of Financing Prudent Investors look before they commit Family, Friends, and Fool (Idea) Government (Grants, soft loans) Banks/Financial Institutions Angel Investors (Pre-venture or ‘seed type’) Venture Capitalists (Proven Idea)

Motivations For IP Valuation (1) Traditional Bank Financing Angel/Venture Capital Investing Licensing Sale, Merger, Acquisition Gift Bankruptcy/Liquidation IP Investment Holding Company

Motivations For IP Valuation (2) Taxation/Transfer Pricing Insurance Joint Ventures Estate Duty Capital Markets/Securitization Enforcement/Litigation Off-balance sheet financing

Who Cares? Employees Investors Shareholders Investment Bankers IPO Specialists Wall Street analysts Merger & Acquisition Interests Licensees, Franchisees Internal asset Managers International affiliates The Media Other Stakeholders

Standards of Value Fair Market Value/Market Value Insurable Value Fair Value Collateral Value Ad Valorem Value Acquisition Value Use Value Investment Value

Valuation Of a Company Of its IP Assets Due Diligence (Evaluate, Valuation) Accounting of Intangibles (Balance sheet)

Valuation Steps A. Data Collection and Analysis (Due Diligence) B. Valuation Methods C. Economic Life Analysis D. Value Conclusion E. Reporting

Due Diligence Expensive: To be amortized over the life o the loan as a higher rate of interest

Grants Government Schemes (e.g., Singapore, Canada) University Municipal/Local Bodies Foundations

Loans Acceptable Collateral should be: Readily Identifiable Durable Marketable Value reasonable ascertainable Securable

Collateral: Priority in Interest ‘Perfecting’ a security Interest; due diligence Recording requirement: IP register IP as ‘hostage’ for good behavior (‘Moral Hazard’) Contingency Plan for repossessed collateral (‘Market for Lemons’: Information asymmetry)

IP Valuation Methods Market Approach Cost Approach Income Approach Judicial Approach

Market Approach Expected sale price at a specific time, in a particular market, based on comparable arm’s length market transactions Extensive knowledge of comparable data required

Cost Approach Economic principle of substitution Reproduction cost (Exact replica) Replacement cost (Different form or appearance)

Cost Approach COMPONENTS Materials Labor Overheads Intangible Asset Developer’s profit/reward Entrepreneurial Incentive

Cost Approach OBSOLESCENCE: Physical Functional Technological Economic

Income Approach Present Value of Future Income Stream Future Income Stream (Economic Income) Duration (Life: Legal, contractual, judicial, physical, technological, functional, analytical, economic) Risk (Uncertainty of receiving expected income; interest rates and investment climate)

Methods to Determine Income Stream Residual Earnings Approach Excess Earnings Approach Loss of Income Approach Relief From Royalty Approach Stock Options (Black- Scholes/Merton Approach)

Residual Earnings Approach Business Unit Scale Technology Scale Product Scale Trademark or Patent Scale

Residual Earnings Approach Methods Monte Carlo Knowledge Capital Score Card Tech Factor Method Crystal Ball Technology Risk and Reward Unit Metrics Technology Review Patent

Judicial Approach Hypothetical Negotiation Between Willing Seller and Buyer Georgia Pacific Factors (15)

Georgia Pacific Factors (Patent) 1. Commercial success, current popularity, and profitability of Patented Product (PP); 2. Advantages of PP over old products; 3. Nature of patented invention, character of products embodying invention, benefits to those using the invention; 4. Likely profit margin on PP; 5. Portion of profit credited to patented invention;

Georgia Pacific Factors (Patent) 6. Benefit to non-patented items by sale of PP; 7. Duration and other terms and conditions of patent license; 8. Extent to which infringer has made use of the patented invention; 9. Prior and existing licenses under the patent; 10. Terms for licensing other technologies by licensee;

Georgia Pacific Factors (Patent) 11. Patent owner’s licensing and marketing policy; 12. Commercial relationship between the licensor and licensee; 13. Nature and scope of license: territories, field of use, exclusivity, etc; 14. Industry specific practices for comparable patents (established royalty agreements); and 15. Opinion of Experts

Trademark/Brand-related Bundle Logo and Logotype Sub-brands Domain Names Trade dress related Copyrights Secondary trademarks Advertising Concepts Graphics Labeling and Packaging design Product shapes Web-based assets

Attributes Affecting TM Value 1 Age Use Potential for Expansion Potential for Exploitation Associations Connotations Timeliness Quality

Attributes Affecting TM Value 2 Profitability Expenses of promoting Means of promoting Market share Market potential Name recognition

Accounting of IP Patents protect inventions (products, processes) Mark/ Geographical Indications protects distinctive words, logo, names, slogans, symbols Industrial Design protects appearance of products, packaging Trade Secrets protect business plans, know how, client portfolio, tacit knowledge, processes Only IP that generates direct cash flows in a commercial transaction is considered Copyright/Related Rights protects literary and artistic works; performers, phonograms, broadcasters; software Protection against Unfair Competition

As an intangible asset, IP is... Risky Successful IP creation requires creativity and inventive abilities; commercialization Non- Rivalrous in Consumption IP can be used simultaneously by different people without diminishing in its worth Transferable IP is transferable to a new or similar business context Context sensitive Background of users & context determine relevance of IP to business Useful for Excluding IP guarantees right to exclude others and ‘freedom to operate’ in the market Nature of IP Perishable Over time IP may become outdated, e.g. technology cycles

… which accountants finds difficult to grasp Impact on Type of Language developed for IP Silence about a lot of a firm’s IP due to inherent definitions and assumptions in accounting Internally and externally generated IP is treated differently Goodwill Historically evolved to report tangible assets/liabilities Quantitative stock of performance Documentation of past financial position Factual, precise, objective, comparable information Determines perception of a firm’s management and other market participants Rationale behind Accounting

Accountants recognize the challenge... FASB & SEC recommend Voluntary IP Reports “Companies are encouraged to continue improving their business reporting & to experiment with types of information disclosed & the manner by which it is disclosed.” US GAAP allows to account IP explicitly in M&A FAS 141 & 142 require to identify each single asset & determine its fair value The amortization of Goodwill is replaced by an annual impairment tests Basel Committee on Banking Supervision recognizes the inadequacy of “fair value” for financial assets “In the absence of active markets it will be difficult to obtain or calculate a reliable fair value for certain non-marketable financial instruments held at cost.”

Explicit IP Accounting Gains Momentum — Comparison of different Accounting Standards — Recognition of IP US-GAAP German HGB Forbidden: § 248/2 HGB Exception: acquired IP IAS/IFRS Recognition of IP if IAS criteria are met: IAS 38 Recognition of IP: Novel approach under FAS 141 &142 Trend towards the explicit recognition of IP increases Internally Generated IP Immediately expensed Recognition of acquired IP: § 255/4 HGB Acquired IP Recognition of acquired IP if IAS criteria are met: IAS 38 Purchase Price distributed across all items: FAS 141 Impairment Test of Goodwill: FAS 142

Advantages of Reporting IP Communicates the value of IP to investors Shows what IP the company owns Puts a value to the IP Explains how the IP relates to business segments INVESTORSINVESTORS MANAGERSMANAGERS Get information on how IP drives growth Receive adequate inputs for earnings/sales forecasts Can better estimate risks/revenues of an investment Can better understand the nature of a business Increases predictability while decreasing volatility

The IP Reporting Process Align IP portfolio to overall business strategy Explain to all in the firm why IP matters IP Audit Set ownership in correlation to expected results Understand legal and business scope of IP assets Use a reporting system for demonstrating the value of IP in business Create IP ownership Understand IP Ownership Report IP Generate Superior Results Create IP Ownership Build IP Business Culture Ensure market position through IP ownership Establish an enabling IP policy and environment $$$ or ¥¥¥ or £££

Elements of an IP Report Executive Summary How does IP relate to the bottom line of your business? How do you make money and what role does the IP play in it? Relate your income streams to IP What were the returns from IP protected business segments? Does the IP help you to gain market share and/or improve profitability? Relate IP to your position in the Market How did IP give you an advantage over your competitors? Do you have “freedom to operate” & exclusivity in the market place? Demonstrate your managerial skills How determined are you to extract revenue from IP? What experience do you have in managing IP? Understand the legal scope of the IP rights What level of protection does your IP guarantee you? What is the risk that you infringe the IP of others and/or that others (legally) free-ride/steal your IP?

The Key Message ! Till there is an adequate accounting standard for IP, SMEs are best advised to develop a voluntary IP report to enhance their position in the market, facilitates access to funding & improves its overall management