Understanding the critical role of IP valuation in M&A negotiations has become an indispensable part of every deal. Organizations in every sector across the board are recognizing the value of Intellectual Property (IP) and intangible assets.
These assets are becoming the cornerstone of companies of every scope and scale worldwide as commerce shifts to knowledge-based economies. IP has become critical for maintaining that elusive edge over the competition and a presence in the market.
IP assets are as valuable as other fixed assets, equipment, and capital and act as leverage when negotiating M&A transactions. Sellers can get better value for their companies even if they only have intangible assets as their USP.
Aside from synergy, product portfolio diversification, customer base, and growth, dealmakers focus on innovations and technology. The core objective of M&A deals has become acquiring trademarks, trade secrets, copyrights, patents, brand names, know-how, and goodwill.
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Statistics indicate that M&A transactions worldwide were valued at an average of $1 trillion for eight consecutive quarters from Q3 2020 to Q2 2022. Further, close to 90% of the value of S&P 500 firms and companies is attributed to IP assets.
Even though the maximum transactions occur in IT industries, artificial intelligence (AI), and software, non-IT sectors also play a significant role. Verticals like media, telecommunications, pharmaceuticals, and medical tools and equipment also see IP-driven M&A deals.
However, research also demonstrates that regardless of their IP assets, companies of all scales find it hard to attract investors. Particularly, financiers tend to pass on startups and small and medium-sized (SME) businesses as funding candidates.
That’s because financial analysts find it challenging to assign monetary value to Intellectual Property and Intangible Assets. In comparison, assets like stock, inventory, fixed assets, and equipment are easy to evaluate. Without an accurate evaluation, dealmakers may not be able to close the deal.
So, what is the role of IP valuation in M&A negotiations? Read ahead to find out.
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Why the Role of IP Valuation in M&A Negotiations is Critical
For many companies, their Intellectual Property assets drive their value. Intangible assets without any physical existence, but only creations and innovations of human intellect and talents, have more value. Such assets also have legal protection, and rights to them are enforceable in a court of law.
IP and Intangible Assets (IA) have independent status, and their owners can sell them separately during their economic life. With the advice of experts specializing in IP assets, you can leverage legal instruments to protect and monetize them.
Sellers are typically aware of IP value and must manage them effectively as part of their business strategy. The first step in the right direction is to undertake a valuation to assess the monetary worth of the IA.
With this figure in hand, sellers can negotiate transactions for licensing, selling, or donating the IP. They can also enter into partnerships and joint ventures to deploy the assets and develop products and services from them.
Several jurisdictions across the US have now mandated that companies identify and value all their recognizable intangible assets. IP owners entering into cross-border M&As also need to value their assets. That’s how they can stay compliant with EU local laws and international accounting agencies.
As a result, accurately valuing IP assets and deploying measures to protect that value has become crucial for M&A success. Especially when the deal is IP-driven, however, dealmakers should also differentiate between the price and value of the IA.
The price is the market value of the assets or the perceived value that the buyer may be willing to pay. The value is determined after calculating the assets’ quality against an orderly tested set of methods, standards, and benchmarks.
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Criteria for Valuing Intellectual Property and Intangible Assets
The role of IP valuation in M&A negotiations starts with identifying the main criteria. Here are some of them:
- The IA should be identifiable independently with a recognizable description.
- The time of its creation should be identifiable.
- It should meet the conditions for qualifying for legal protection and transfer.
- The owner should have complete and exclusive rights to the assets with the capability to prevent competitors from using them.
- The IP assets should generate a measurable amount of economic benefits for their owner separate from the revenues from other assets.
- When associated or used with other assets, the IP should enhance their value.
- The IP asset should represent present and future monetary benefits to its owner or any other user who has authorization.
- Owners should be able to exploit the asset by selling or licensing it to third parties separately from other assets.
- The ability to raise barriers to entry in the sphere or lower the threat of substitutes or copies has value.
- The asset should carry tangible evidence of its existence, such as a license, registration certificate, or contract. A record in the company’s financial statements is also adequate proof.
- Owners should be able to destroy or terminate the asset at an identifiable point in time.
When Do IP Owners Need Valuation
Intangible Asset owners may need to take their property through valuation at different points during their company’s lifecycle. For instance:
When securing funding, company owners can use intangible assets as collateral. Demonstrating that the IP has value separate from the other assets raises the company’s chances of getting investor backing. For that to happen, owners may need to assure investors that the IP assets will remain viable and valid.
This validity should remain for the duration of the loan or financing repayment period. In case the company files for bankruptcy or foreclosure, the IA should remain marketable as a separate asset.
Venture capitalists and other investors can thus maximize their returns with minimal risks.
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Licensing and Franchising
The role of IP valuation in M&A negotiations is especially critical when the company intends to license the assets. Or is entering into a franchise deal with partners. Having determined their accurate value, dealmakers will be in a better position to make informed decisions.
They will also draw up the terms and conditions of the license agreement more efficiently. Working out fair royalty rates is quickly done after precise valuation.
Owners have a better handle on managing issues like the infringement on IP assets if they are valued with precision. Making decisions on the best strategy to adopt to protect their rights becomes more streamlined.
IA owners can work out whether to leverage anti-infringement laws and file lawsuits or look for alternative dispute resolution. They can also consider licensing the assets to the party infringing on the rights. Owners can also calculate damages and exact compensation according to the IP value.
Entering into Partnerships
When entering into partnerships and collaborations, IP owners can present their assets as valuable contributions to the alliance.
Why Calculating IP Value is Challenging
Valuing physical assets is an easy process because assigning a value and their depreciation uses a standardized approach. However, there are no globally accepted standards for valuing IA.
Calculating the precise value is challenging since it is largely dependent on perception and situation. IP assets have a high level of subjectivity, and several dynamic factors are involved. For this reason, dealmakers may find it hard to arrive at an accurate and consensual number.
For this reason, owners are hesitant to include IA in their financial statements or annual inventories, similar to other tangible assets. Further, incorrect or inflated valuation can result in brand destruction after the merger or acquisition concludes.
Acquisitions by competitors often lead to the destruction or depreciation of the value of the IP assets. This is why assessing value accurately using the same valuation techniques is crucial. Dealmakers need to adopt techniques that will consider different outcomes subject to upcoming technology that has not been commercialized.
They must adopt common and pre-determined valuation practices to arrive at reliable figures. These practices or standards take into account not just the IP assets but also their potential for growth. Any limitations and encumbrances on their usage, including pending litigation and liens, also influence their value.
IP Valuation Techniques
The role of IP valuation in M&A negotiations starts during the due diligence process. This process is reliant on accurate and verifiable data that dealmakers present. This data indicates the IP’s potential benefits, economic lifespan, usage boundaries, and ownership rights.
Before working out the appropriate method for valuing the IP, dealmakers must work out their goals, such as:
- Identifying the IP asset and its dimensions and specifics
- Targeted buyer
- Reasons for evaluating the IP
- Present users of the IP and competitors
- Seller’s IP policies for protecting the assets
- IP concentration in the business vertical
- Potential for litigation depending on industry norms
Before we talk about understanding IP valuation methods, you should also know how to value your company. Check out this video where I have explained how it’s done.
The market method takes into account the dynamic market and the price of similar IP assets in comparable conditions. If the assets are entirely dissimilar, dealmakers deploy variables and other market information to arrive at numbers.
The market method is straightforward and delivers approximate values that dealmakers can use for estimating applicable taxes and royalties. They also calculate other metrics for the income method.
This method evaluates a cluster of similar IP assets against the available data about the scope of IP in the M&A transaction. The terms and conditions of the deal and the economic landscape factor in the value.
Analysts arrive at the figures by obtaining data on sales, transactions, listings, licenses, and offers of similar assets. Next, they verify the data for accuracy and select the relevant units for comparison. For instance, dollars per unit, which can be per line of code, per customer, per location, or others.
Essentially, the market value assesses the product’s performance in the market. The end result is reliant on the supply and demand of similar IPs and consumer purchasing behaviors.
The cost method is the cost of replacement and evaluates the IP asset by calculating the cost of similar assets. This method is best suited for assets that are easy to reproduce, but the monetary benefits cannot be determined accurately.
Sellers may also use this method to calculate the cost of developing similar IP assets and potential monetary benefits. This is why this technique is also called the cost of replacement. The objective here is to estimate the cost of the new IP against its current earnings and the earnings it can generate through its lifetime.
This role of IP valuation in M&A negotiations is especially relevant to IP assets that are not generating revenues. Nor do they have any unique or novel defining features.
Dealmakers frequently use the income method since it simply takes into account the IP’s monetary benefits. Or, the potential earnings it can generate through its economic lifetime adjusted to current values. This method works well for IP assets that are already generating positive cash flows directly or indirectly.
This factor ensures reliability and consistency for future earnings that investors appreciate. The lower risk factor allows sellers to negotiate for higher prices. At the same time, acquirers also factor in the time for which the innovation stays relevant before becoming redundant. This factor could drive down prices.
If the IP is patented, its expiry date is another factor that can discount the asset’s pricing. The income method is reliant on several variables that account for the commercial and economic factors that influence cash flows.
Relief from the Royalty Method
The relief from royalty method calculates the revenues the seller will lose out on by selling the IP asset. Or if they have to license the asset for use from third parties. The royalty is the cost of licensing the asset.
When estimating this value, dealmakers consider similar deals and pricing that third parties have concluded. Essentially, this method is similar to the income method and evaluates the market share and market size the IP captures.
That’s why the relief from royalty method is also called “a rental charge other businesses would pay to use it.” On the flip side, this method is not all that reliable since it estimates rental charges that other licensees may or may not pay.
Accurate Valuation Drives IP-Based M&As
Determining the value of intangible assets is challenging since there are several variables to account for. Most importantly, the innovation sphere is consistently evolving with new technologies coming out in the market.
Any current valuations cannot be reliable since the assets can become redundant or form the basis of advanced assets. For this reason, dealmakers evaluate the assets in subjective terms depending on how and why they are performing the valuation.
Using a blend of techniques could be a more advisable and reliable way to arrive at results. That’s how dealmakers can negotiate the terms and conditions of the transaction before arriving at a consensus.
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