Valuing Intangibles

By: George D. Abraham
Business Evaluation Systems

What is an Intangible Asset?

Intangible Assets are nonphysical assets such as franchises, trademarks, patents, copyrights, goodwill, equities, mineral rights, securities and contracts (as distinguished from physical assets) that grant rights and privileges, and have value for the owner.
According to the IRS Valuation Guide for Income, Estate and Gift Taxes , Intangibles, for purposes of valuation, are divided into two categories:

  1. Intangibles with a determinable useful life, and
  2. Intangibles with a nondeterminable useful life

The valuation guide also points out, that for a taxpayer to be entitled to a depreciation deduction under Section 167, three requirements must be met:

  1. The assets must be separate from goodwill and/or going concern value.
  2. The assets must be susceptible to valuation.
  3. The assets must have a determinable, limited useful life.

The IRS also notes that the qualities that make intangibles so attractive to a buyer, such as providing a competitive advantage (or excess earnings) are the same qualities that make the intangible assets so difficult to identify and value. However, the courts hold that the burden of proof remains upon the taxpayer to provide sufficient and reasonable evidence to support a claim that an acquired intangible asset exists, has value separate and distinct from goodwill, and a limited useful life .

Valuing the Intangible Asset

All three approaches to be value may be used, depending on the type of asset being valued. In many cases the Market Approach may be difficult to use due to the lack of information about comparable sales of similar intangible assets, but should not be overlooked. Other problems facing the appraiser when attempting to use the Market Approach:

a) is that the intangible assets are not often sold separately from the business assets.
b) buyers and sellers of intangible assets tend to keep the transactional data very proprietary so it is difficult to obtain and verify the transactions or if they were arms length
c) cash equivalency analysis is very difficult as some have short term servicing agreements and long term noncompete agreements that accompany the sale and if there is an earnout or other payment terms.

Nonetheless, most appraisers would agree that when the market approach can be used it is one of the best methods to use in valuing intangible assets. The Income Approach provides a good system for estimating the value of the intangible asset based on economic income capitalization or on the present value of future "economic income" to be derived from the use, license, or rental of that intangible asset. Under the income approach, economic income can be defined in many ways, including the following: a) net income before tax, b) net income after tax, c) net operating income, d) gross or net rental income, e) gross or net royalty income and f) operating cash flow and g) net cash flow. The income capitalization procedure can be accomplished in many ways, including the following:

a) capitalizing the current years economic income,
b) capitalizing an average of several years economic income,
c) capitalizing a normalized or stabilized period’s economic income and
d) projecting economic income over a certain time period and determining a present value.

The C ost Approach may be used for such assets as architectural drawings of computer software, whereas the income approach is probably more appropriate for copyrights, patents and trademarks. The cost approach also provides a system for estimating the value of an intangible asset based on the principle of substitution in that a prudent investor would pay no more for the asset than the cost that would be incurred to replace the subject asset with a substitute of comparable utility or functionality.

Another factor that needs to be mentioned is the Remaining Useful Life Analysis of the intangible asset. This estimation is important mainly in the market approach because the appraiser will want to select sales/licensing transactions where the sold/licensed intangible asset has a similar remaining useful life to the subject intangible asset. This is because the appraiser will need to estimate the time period over which to project (and capitalize) the economic income associated with the subject intangible asset. There are several measures to consider when estimating the remaining useful life of the intangible asset:

  1. Remaining legal or protected life (e.g., trademark protection)
  2. Remaining contractual life (e.g., lease term)
  3. Statutory or judicial life. (e.g., some courts have allowed a “standardized life” of five years for computer software)
  4. Remaining physical life. Some just wear out from continued use (e.g., blueprints or technical libraries)
  5. Remaining functional life. (e.g., some assets, like chemical formulations that need to be continually updated)
  6. Remaining technological life (e.g., period in which the current technology becomes obsolete, for patents, proprietary processes, etc.)
  7. Remaining economic life (e.g., period in which the intangible asset will no longer generate income, such as a copyright on a book that’s out of print)
  8. Actuarial/analytical life (e.g., remaining life of a group asset, such as customer accounts, by reference to the historical turnover, or mortality)

Above all, the appraiser must have a clear understanding of the purpose of the appraisal and the appraisal agreement should clearly specify the intangible asset that is the subject of the appraisal and the legal rights associated with that asset. Ideally, the appraiser will be able to form an estimate of value by using at least two or more valuation approaches and based on the degree of confidence, weigh the results to form an opinion of value.

Site Credits: MediaLinkers