Intellectual Property Valuation: What You Should Know
Posted by Dan Peters on February 1, 2021
As technology continues to drive changes in the global economy, many companies— especially those that are technology-based—are finding that intellectual property (IP) increasingly comprises the lion’s share of their value. The result is that regulations concerning the valuation of IP are evolving worldwide.
However, the intangible nature of intellectual property means it’s often harder to value, difficult to define, and challenging to price fairly. As such, reliable valuation is essential for multinational corporations engaging in IP transactions. This article provides an overview of intellectual property valuation methods and best practices for achieving accurate results that comply with global regulations.
What is intellectual property valuation?
Intellectual property is an intangible asset that is the product of a company’s work or reputation. It might be a patented or patentable product, process, or service, or a trademark, copyright, or brand name. In short, intellectual property is a category of non-physical assets that are protected by law from unauthorized use. It is the unique creation of the company and, though intangible, it is often a significant driver of value within a company.
IP valuation is the process used to evaluate the arm’s length or fair market value of IP assets. Intellectual property valuation helps to determine not only the value of the IP, but the true value of the business as a whole. Because IP often represents the most valuable assets a business possesses, calculating an accurate valuation of the business depends on accurately valuing its intellectual property.
Why is intellectual property valuation becoming more important?
The shift to a global service economy over the past four decades upended traditional notions of value. In the new service- and technology-oriented economy, physical assets no longer comprise the bulk of business value. The largest part of the value of Ford or GM in 1960 would have been their manufacturing facilities and inventory; by contrast, the value of Tesla today is not primarily in the cars the company produces or its production facilities, but in the company’s underlying technology and IP.
The same holds true for other manufacturing concerns. In most sectors, IP is becoming more important for manufacturers, since what differentiates them from competitors is their trade secrets and other intangible property.
Firms often invest heavily in the creation of IP, and there is a significant risk of wasted investment. This risk is counterbalanced by the potential for profit if the company succeeds in “building a better mousetrap” that can be incorporated into products/services sold to customers or licensed to others. Unless the value of the intellectual property is assessed, the company’s balance sheet will reflect only the investment that has been made in IP creation, and as a result, the company may be undervalued.
Establishing the value of IP is critical for determining sales, licensing, or transfer pricing for IP assets, and for merger and acquisition (M&A) transactions. But IP valuation is complicated, the result of the difficulty in valuing intangible assets and the changing regulations governing IP valuation, which vary from one jurisdiction to another. The method by which a company values its IP can also vary depending on whether the valuation is being performed for accounting, tax, or transfer pricing purposes.
Evolving Intellectual Property Regulations
The global tax landscape has seen constant change in recent years, with new regulatory guidelines and increased scrutiny of intercompany transactions causing many multinational organizations to rethink how they structure their IP ownership. The Organisation for Economic Co-operation and Development (OECD) has expressed that misallocation of profits generated by intangibles has heavily contributed to base erosion and profit shifting (BEPS), as many multinationals have transferred their IP to low-tax jurisdictions to minimize taxes and maximize profits.
Recent new and proposed regulations seek to assign revenue to the jurisdiction where it was generated. Using Apple iOS as an example, if Apple has $1 billion in sales in the U.S., another $1 billion in sales in China, and $1 billion in sales in Europe, that revenue has to be allocated to the region where the sales occurred—not to a low-tax jurisdiction chosen by the company to escape higher tax rates in the jurisdictions where the revenue originated. Under these regulations, sales in countries other than where the company has its legal headquarters are treated as transactions between the jurisdictions.
Action 8 of the OECD's BEPS initiative provides updated guidance on the definition of intangible assets, methods and models to use for valuations, approaches for managing “hard-to-value intangibles” (for which no reliable comparables exist), and aligning IP ownership with value-added services. It also acknowledges that high-value services offered by senior executives that contribute to the development of IP should be valued in ways similar to the valuation of intangible assets.
In 2017, the U.S. passed its first major tax reform in over 20 years with the Tax Cuts and Jobs Act (TCJA). This U.S. tax reform makes it less advantageous for companies to shift the ownership and development of intangible assets outside the U.S. The TCJA introduced the Global Intangible Low-Tax Income (GILTI) provision, which is meant to discourage companies from shifting IP profits to low-tax jurisdictions. As a result of the differing guidelines in different jurisdictions, the appropriate intellectual property valuation model to use varies widely depending on geographical location. With so many changes to the way intellectual property is defined, protected, valued, and priced, it’s not surprising that some organizations are bringing IP back to the U.S. to avoid potential disputes.
Need advice on the most reliable valuation method for your IP assets? Talk to us about how we can help.
Intellectual Property Valuation Methods
Two approaches are typically used to value intellectual property:
- Income Method: IP valuation is based on future projected cash flows related to the IP.
- Market Method: IP valuation is based on observations of actual third-party transactions of comparable intellectual property to determine a market price.
Different intellectual property valuation methods can lead to wildly different results, which is why it’s essential for companies engaging in intercompany transfers of IP to choose the most appropriate method. How to know which one to choose? The OECD’s guidelines specify that, similar to the transfer pricing methods used for determining fair pricing for related-party transactions, multinational organizations must choose the most reliable method for IP valuation. The most reliable method is not necessarily the one with the most optimal financial outcome for the business, but rather the method that is fair to both parties in the IP transaction—and defensible should tax authorities raise questions.
Many factors come into play when determining the best intellectual property valuation method to use. Availability of data, the type of IP being valued, and business structure all play a role in which method is deemed most reliable. For example, if data is not widely available to perform a market method (e.g., if there aren’t royalties in the marketplace that can be considered comparable to what’s being valued), then the market method is less reliable. Likewise, without an accurate forecast of future IP-generated profits, the income method would be considered less reliable. Multinationals must balance all these factors to determine which intellectual property valuation model will achieve the most reliable results.
4 Tips For Achieving Reliable IP Valuation Results
IP valuation is not only the most complex and controversial aspect of what intellectual property valuation firms do, but also the area where the most significant planning and optimization opportunities exist. The following are some tips for IP asset management and valuation:
- Be pragmatic and rational. If the financial returns attributed to specific intellectual property seem too good to be true, it’s probably because they are. If both the buyer and the seller would view the results as too attractive for one party or the other, it’s likely not the most reliable intellectual property valuation model to use.
- Evaluate the potential outcomes. One of the best practices to follow is to conduct testing that will help evaluate the outcomes for both the buyer and the seller. If it appears as though both buyer and seller would view the IP transaction as economically reasonable, you can have confidence that the methodologies selected are reliable.
- Expect valuations to be disputed. IP valuation is controversial and often subject to disputes by tax authorities. Therefore, taxpayers should approach IP valuation with a defensive mindset. As mentioned earlier, companies should choose the intellectual property valuation method that is the most defensible in the event of a dispute—not necessarily the one that yields the most attractive financial results.
- Seek expert guidance. Very few companies have an IP valuation expert in-house, and expert help is necessary to avoid potential disputes. Working with a qualified practitioner significantly reduces your chances of an audit adjustment or, even worse, the imposition of penalties. The IRS and many foreign government bodies have the ability to impose penalties if an IP valuation is off by a significant amount. However, the rules that govern the imposition of penalties generally indicate that if the intellectual property valuation report compiled by the appraiser represents a good faith effort to comply with the requirements, even in the event of an adjustment, penalties may not be imposed. Hiring a qualified expert to ensure compliance with the applicable valuation regulations can be a taxpayer's best first line of defense.
Need expert guidance on intellectual property valuation?
Today, conducting accurate IP valuations is more challenging—and also more essential—than ever before. With the help of a seasoned consultant, your company can be confident it is using the most appropriate intellectual property valuation methods, significantly reducing the risk of disputes or penalties.
The world’s leading corporations trust Valentiam specialists to provide expert value opinions for all business assets, including intellectual property—and we can do the same for your organization. Let’s talk about your unique IP challenges and how we can work together to optimize your company’s global business.
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