Patents, Trademarks, & Intangibles Fair Value

A presentation for
LCPA Business Valuation
October 25, 2012
Presented by:
Riley J. Busenlener,
• Valuation of Customer Relationships,
Technology, and Non-Compete
– A Case Study
• Goodwill Impairment
A Case Study
• Presentation is in case format, outlining key
information needs, points for analysis, and
• Case Information
- Valuation of Intangible Assets of “AlcoBev Inc.”
- Was acquired on December 31, 2009 by the private
equity firm, Whimsical Investment Group for $150,000
– AlcoBev manufactures and distributes commercial
alcoholic beverage dispensing equipment
Fair Value in Financial Reporting
• Fair Value is the price that would be
received to sell an asset or paid to transfer
a liability in an orderly transaction between
market participants at the measurement
date. ‐ Topic 820
Fair Value in Financial Reporting
Elements of Fair Value:
• Exit price notion, from market participant
• Hypothetical transaction with a market participant
• “Market participants are unrelated parties,
knowledgeable of the asset or liability given due
diligence, willing and able to transact for the
asset/liability, and may be hypothetical”
• For a particular asset and liability
• Highest and best use for assets, credit standing
for liabilities
Fair Value in Financial Reporting
• Level 1: Observable inputs that reflect quoted
prices for identical assets or liabilities in active
markets and assumes the reporting entity can
access the markets at the measurement date
• Level 2: Inputs other than quoted market prices
included within level 1 that are observable either
directly or indirectly
• Level 3: Unobservable inputs reflect the reporting
entity's own assumptions about market participant
assumptions used in pricing an asset or liability
Step 1: Understanding the Assets
• Understand the Business
– History
– Products/Services
– Industry
– Regulations
– Competitors
• Understand the Transaction
– Motivations
– Consideration
• What creates strategic advantage?
– Technology/Better Product
– Supplier Relationships
– Distribution
– Contracts
– Systems
• What intellectual property(ies) support operations, such as: contracts, trade
secrets, brands, etc.?
• AlcoBev Systems Inc. produces and
distributes a line of refrigerated alcoholic
beverage dispensing equipment for
restaurants, bars, and similar establishments.
• Its products include draft beer dispensers,
bar coolers, and frozen beverage machines
• Strong historical growth, over 12% CAGR for
the last five years
• 2009 revenue was $90,909
Forecast from Management
Forecast Requirements
• Should not reflect synergies specific to the buyer. Should
reflect synergies available to other market participants.
• Eliminate amortization of prior intangible assets from books.
Those assets are replaced with new assets from this
• Forecast should be logical and supported by market data and
historical trends. This is a key point of audit review.
• Forecast should be tested using an implied IRR. This should
be reasonable when compared to a WACC for the Business.
• Support terminal growth rate. This is another key point in audit
Forecast Logic Assessment
Reasonably Objective
• Can facts be obtained and
informed judgments made about
past and future events or
circumstances in support of the
underlying assumptions?
• Are any of the significant
assumptions so subjective that no
reasonably objective basis could
exist to present a financial
• Would people knowledgeable in
the entity’s business and industry
select materially similar
• Is the length of the forecast period
Appropriate Assumptions
• There appears to be a rational
relationship between the
assumptions and the underlying
facts and circumstances
• The assumptions are complete
• It appears that the assumptions
were developed without undue
optimism or pessimism
• The assumptions are consistent
with the entity's plans and
• The assumptions are consistent
with each other
• The assumptions, in the
aggregate, make sense in the
context of the forecast taken as a
IRR Test – Forecast and Discount
Tax Amortization Benefit
TAB = VBA * n/[n-((AF * t * (1+r)^0.5)-1)]
TAB = Tax amortization benefit
VBA = Value before amortization
n = Number of amortization periods in years
(15 years in U.S., see IRC 197)
AF = Annuity Factor (AF = 1/r - 1/r(1+r)^n)
t = Tax rate
r = discount rate
Revenue Breakdown
Revenue Breakdown
• Allocate revenue by intangible asset
groups to be valued
• Consider lifing analysis data for
replacement of technology and turnover of
• Detailing break down provides test that
revenue split is logical
Asset Returns
• Asset investments reflect both a “return on” the
investment related to risk and a “return of” the
asset for the value decline from wasting of the
• Not all assets have a “return of”, since certain
intangible assets do not waste away
• All assets will have a “return on”
• Asset risks reflect the risk of the asset as part of a
portfolio of assets for a typical market participant
• Asset returns can be assessed in relationship to
Company WACC
Asset Return Spectrum
Asset Returns
Asset Returns
• Enterprise value WACC calculated based on
average industry capital structure
• Cost of equity reflects a CAPM methodology
using betas of market participants
• Cost of debt reflects the average debt rating
of market participants and current market
rates of interest
• Individual asset returns were assessed based
on risk in comparison to the company as a
AlcoBev patented a new beverage cooling technology that allows for the
rapid cooling of frozen drinks and beer at distribution (CoolzDown),
significantly reducing the energy consumption of traditional beer dispensing
and frozen beverage machines. The beverage can be stored at a lower
temperature prior to service and is brought down to serving temperature
with the CoolzDown technology.
The technology is patented, having a remaining 10 years of patent
The technology is used in 80% of the Company’s Beer Dispensing
Technology provides a 15% improvement in energy efficiency over
competitor products
Products with technology contribute an additional 6.5% profit margin over
other products
Technology is unique to Beer Distribution equipment and cannot be applied
to other products or services
Methods to Value Technology
Cost Approach
• Best used when
technology can
be replicated
• Requires analysis
of the cost to
recreate the
technology as it is
Relief from Royalty
• Best when actual
data or closely
royalty data is
Multi-Period Excess
• Captures the
economic value
in relationship to
the other
assets that
contribute to
cash flow
• Application can
be problematic if
other MPEE
analyses are
performed for
other assets
Application to the Model
• Methodology selected – relief from royalty
• Revenue reflects only revenue from products
using patented technology
• Discount rate utilized is based on the cost of
equity of the business
• New technology is anticipated to replace the
existing technology over a 10‐year period
• Analysis determined a market participant
royalty rate is approximately 2.5%
Royalty Rate Selection Overview
• Royalty rate data should be based on market data whenever
possible. Generally, the priority of data is:
– Third‐party negotiated royalty rates for the same product
– Third‐party negotiated royalty rates for similar products with appropriate
• Royalty Source –
• ktMINE ‐
• The Financial Valuation Group –
– Internal transfer pricing related royalty rates
– Estimated royalty rates based on typical market participant assumptions
• Selecting a royalty rate and supporting its reasonableness begins
with assessing the economic benefits provided by the IP
– Increased prices
– Increased unit sales
– Decreased costs
– Combination of any or all of the above
Selecting Royalty Rates based on
Market Data
Narrow the identified transactions to those closest to the intellectual
property (IP) that is being valued
Stratify transaction data into groups to identify important factors
– Geographic usage
– Rights differences
– Date of transactions
– Usage
Gather other supporting data that may be useful
– Profitability of public licensees (possibly by segment using IP)
– Comparable profit margin data
– Market share of licensee v. other entities in industry
Adjust transaction data for key differences if possible
– Market data may be used to adjust license for differences
Identify if Geographic areas have premiums or discounts
Identify if licensing for use in one type of product has premiums or discounts over other
products (clothing versus sunglasses)
Operating profit differences may be used to adjust royalties (if license in a market with 10%
operating margin (typically EBIT margin), in a market with a 5% margin the royalty rate might
be 50% less.)
Summary of Identified Market
• Similarities
– Cooling technology
– Related to beverages
• Issues
– Age of transactions
– Industry Use (food
packaging versus
– Range of Royalties
• Based on differences,
determined not to be
Profit Split Methods
• Involve assessing the components of profitability and considering
the expected reasonable portion of profit contributed by the
intellectual property being valued
• Can be used to check reasonableness of selected royalty rate from
market data
• Also can be used to identify a royalty rate when market data is
unavailable or inconclusive
• Encompasses a rule known as the 25% rule
– Often attributed to research by Robert Goldscheider in the late 1950s.
Based on 18 exclusive licenses for territories around the world
Licenses were by a Swiss subsidiary of a large American company
Each related product was number 1 or 2 in its market
The intellectual property rights licensed included a patent portfolio, a continual
flow of know‐how, trademarks, and copyrighted marketing and product
description materials
• Found royalty rates at approximately 25 percent of pre‐tax operating income
– Generally considered to be a 25% to 33% rule of thumb
25% Rule – The Good and the Bad
• Arbitrary in nature
• What does it apply to? Patents,
trademarks, trade secrets
• It is imprecise in measuring
incremental profit contribution
• Used as a base line among
licensing professionals
• Some analytical support from
Smith and Parr Study
• Comparison of licensed royalty
rates from Royalty Source
database for 15 industries
showed the median royalty
rate as a percent of average
licensee operating profit
margins to be 26.7 percent,
(ranging from 8.5 percent for
semiconductors to 79.7
percent for the automotive
Profit‐Split Considerations
• What is the expected normalized rate p of
operating profit?
– Look at Normalized Historical (25.8%)
– Look at Forecast (25.5%)
• Analyze the factors affecting value to
determine a reasonable split
– Technology is a key component of product and a
major selling point
– Consider Georgia Pacific factors (following slides)
• Consider relative bargaining strength of
typical buyer and seller in the negotiation
Georgia Pacific Factors Page 1 of 2
The royalties received by the patentee for the licensing of the patent in suit, proving or
tending to prove an established royalty.
The rates paid by the licensee for the use of other patents comparable to the patent in
The nature and scope of the license, as exclusive or non‐exclusive; or as restricted or
nonrestricted in terms of territory or with respect to whom the manufactured product may
be sold.
The licensor's established policy and marketing program to maintain his patent monopoly
by not licensing others to use the invention or by granting licenses under special
conditions designed to preserve that monopoly.
The commercial relationship between the licensor and licensee, such as, whether they
are competitors in the same territory in the same line of business; or whether they are
inventor and promoter.
The effect of selling the patented specialty in promoting sales of other products of the
licensee; that existing value of the invention to the licensor as a generator of sales of his
nonpatented items; and the extent of such derivative or convoyed sales.
The duration of the patent and the term of the license.
The established profitability of the product made under the patent; its commercial
success; and its current popularity.
The utility and advantages of the patent property over the old modes or devices, if any,
that had been used for working out similar results.
Georgia Pacific Factors Page 2 of 2
The nature of the patented invention; the character of the commercial embodiment of it
as owned and produced by the licensor; and the benefits to those who have used the
The extent to which the infringer has made use of the invention; and any evidence
probative of the value of that use.
The portion of the profit or of the selling price that may be customary in the particular
business or in comparable businesses to allow for the use of the invention or analogous
The portion of the realizable profit that should be credited to the invention as
distinguished from nonpatented elements, the manufacturing process, business risks, or
significant features or improvements added by the infringer.
The opinion testimony of qualified experts.
The amount that a licensor (such as the patentee) and a licensee (such as the infringer)
would have agree upon (at the time the infringement began) if both had been reasonably
and voluntarily trying to reach an agreement; that is, the amount which a prudent
licensee – who desired, as a business proposition, to obtain a license to manufacture
and sell a particular article embodying the patented invention – would have been willing
to pay as a royalty and yet be able to make a profit and which amount would have been
acceptable by a prudent patentee who was willing to grant a license.
Relief from Royalty Model
Relief from Royalty Model
• Deduct from cash flows any costs NOT
saved by owning the intellectual property
that don’t go away, like maintenance R&D
• Tax amortization benefit reflects potential
tax savings form amortizing the asset
under IRC 197
Non‐Compete Agreements
• As part of the purchase of AlcoBev, certain key management
personnel entered into 3‐year Non‐Compete agreements
• Discussions with management indicate that Mr. Bill Jones, Chief
Marketing Officer, is the primary individual that could cause
significant losses in future income if he competed with the company
Bill Jones Profile
17 years in marketing
5 years with AlcoBev
Prior experience:
• 10 years with TapServe Equipment, Ltd., AlcoBev’s largest competitor, with his
last position as head of sales for U.S. division
• 2 years prior experience with Acme Bar Accessories
– Age 42
– Married with 2 Children, 1 in College and 1 a High‐School Junior
– Strong personal relationship with head of PubStuff Distributors, one of
AlcoBev’s largest customers, and Kegs‐N‐Taps Equipment Supply,
another large customer (Together representing 10% of total sales)
Basis of Value
• The value of a Non‐Compete Agreement
stems from
– potential loss from competition,
– the likelihood of competition, and
– the likelihood that the agreement will be
• Standard Valuation Method – Differential
Discounted Cash Flow Analysis (a.k.a., a
With and Without Analysis)
Deriving the Forecast – Identifying
Potential Loss
• Assess potential loss
Historical loss or gain from similar competition
Historical growth
Management estimates
Assess likelihood of competition without Non‐Compete Agreement
Job satisfaction
Market demand
Prior history
Economic factors
• Duration of loss calculation
– Terms of the agreement
– Time lag before competition could occur
– Potential effects after contract agreement (multi‐year contracts with
clients, renewal of lost customer agreements, growth from lost
customers, etc.)
Non‐Compete Example Facts and
• Chief Marketing Officer
– Is well known in the industry
– Was hired from a competitor and brought key customers with whom he
had a long‐term business relationship
– Has a 3 year Non‐Compete agreement
– Is not independently wealthy and would need to work if he left the
• Forecast Adjustments for Without Scenario
– Revenue reflects loss of 3% of revenue in Years 1‐3 of the forecast
• Total potential loss is approximately 10% of revenue given his personal
relationships with customers
• Potential of competing without the Non‐Compete Agreement is only 30%
Is compensated at market rates
Has strong ties to community
Could receive a signing bonus and has been approached by competitors
Is young enough to have at least 2 decades potential with an employer
– Working Capital changed relative to change in revenue
• Discount rate utilized is based on the cost of capital of the business
The With and Without Model
Customer Relationships
• The typical customer base consists of companies that sell and
service equipment and supplies to restaurants and bars
• Customers enter into a 3‐year contract with automatic
continuation thereafter unless canceled with 30 days notice
• Customers vary by size, but have similar characteristics
regarding the expected life and buying decisions
• Customer turnover over the last 5 years has averaged 20%
• Turnover is lower the longer the customer has been with
• Actual turnover data is available for 6 years
Methods to Customer Related
Cost Approach
• Best used when valuing
customer lists or other
assets that are not unique
and can be replicated
• Requires analysis of
market cost for lists or the
cost to recreate the
contracts or other assets
Multi-Period Excess
• Captures the economic
value in relationship to
the other supporting
assets that contribute to
cash flow
• Application can be
problematic if other
MPEE analyses are
performed for other
Application to the Model
Methodology selected – Multi‐Period Excess Earnings
Revenue reflects only revenue from existing customers
– Based on total revenue estimate for existing customers without turnover
Prior Year revenue grown as price increases and demand increases from customers
Rate used is 2.5% inflation and 0.8% population increase (3.3%)
– Turnover estimated from actual client data and regression of curve
Based on 7 years of data available a revenue weighted turnover was determined
Turnover curve was fit to a trend line to extrapolate the curve beyond the derived curve
Expenses applied based on a percentage of revenue
Expenses related to selling to new customers was eliminated
Royalty for patents applied to eliminate contribution of patents to earnings
Contributory asset charges applied for other supporting assets including
working capital, fixed assets, and Non‐Compete agreements
Discount rate utilized is based on the cost of equity of the business
Contributory Asset Charges
Contributory Asset Charges
• Required to eliminate other assets that contribute
to the revenue stream to derive revenue
generated only by the asset being valued.
• Reflects charge for asset value in each year of
• Our analysis assumes that the contributory asset
relationships remain constant as a percent of
revenue over time
• Reflects asset returns previously described
• Technology charge is based on royalty rate and
not included in the CAC calculation above
Multi‐Period Excess Earnings
Weighted Average Return on
Assets (WARA)
Weighted Average Return on
Assets (WARA)
• WARA Analysis tests reasonableness of asset returns
used in analysis
• Weighted Average Return on Assets should
approximate IRR/WACC of Business
– Rounding often makes it impossible to perfectly match
– Return on Excess Purchase Price (Goodwill) should be
assessed on relative risks of the associated assets
• Return for goodwill should be at cost of equity at a
minimum unless in very unusual circumstances
• If WARA does not approximate IRR/WACC, reassess
key assumptions especially:
– Relative rates of return for assets
– Royalty rates or profit split
Purchase Price Allocation Data
from 2008
Goodwill Impairment Studies
• Duff & Phelps and the Financial
Executives Research Foundation
published the “2010 Goodwill Impairment
Study”, which provides an analysis of the
companies examined over the 12-month
period before and after the goodwill
Goodwill Impairment Studies
• Highlights for Study
– Financial service firms had the greatest
proportion of total impairments in 2009. Over 70
percent of total impairments were recognized in
the financial services, industrials, and information
technology sectors
– FEI members were asked whether they
performed an interim goodwill impairment test in
either 2009 or 2010. Fifty percent of the
respondents indicated they had, with nearly 30
percent citing economic declines as the triggering
Goodwill Impairment (Topic 350)
• Goodwill is not amortized, but tested for
impairment at the reporting unit level (the
operating segment or one level below)
• The fair value of goodwill can be measured
only as a residual of all other assets.
• If condition exists that it is “more likely than
not”, that fair value of reporting unit is less
than its carrying value, then the FASB
requires a two-step impairment test to identify
potential goodwill impairment and measure
the amount of loss to be recognized (if any).
Goodwill Impairment (Topic 350)
“Step Zero”
• Previously, Goodwill was tested annually for
impairment, or more frequently if certain
events occur and circumstances change
• Entities have the option to first access
qualitative factors to determine if test is
• “more likely than not” fair value < carrying
value then perform step one test. If not, then
no need to test
• Unconditional option to skip qualitative
assessments and perform step one test
Step One: Goodwill Impairment
• Identify the reporting unit
• Determine the fair value of the reporting
• Compare the fair value of the reporting
unit to the carrying value
• If the carrying value exceeds the fair
value, an impairment is indicated
• Perform step two of the goodwill
impairment test
Step Two: Recognition and
Measurement of an Impairment Loss
• Calculate the implied value of goodwill
– Subtract the fair value of net tangible assets and
identifiable intangible assets from the fair value of the
reporting unit as of the test date.
– Include intangible assets not previously given
recognition in the financial statements
– The difference is the implied value of goodwill
• Determine whether goodwill is impaired
– If the implied value of goodwill exceeds the carrying
value of goodwill, there is no impairment
– If goodwill’s carrying value exceeds the implied value,
a goodwill impairment exists and the difference must
be written off
Carrying Value Concerns
• Enterprise Value Premise
– Debt is excluded from the liabilities assigned
to a reporting unit and consequently from the
fair value of the reporting unit
• Equity Value Premise
– Debt, like any other liability, is available for
assignment to a reporting unit
FASB’s ASU 2011-08 Testing
Goodwill for Impairment
• Objective is to simplify thus reducing the cost and complexity
of performing Step 1 of the two-step goodwill impairment test
• Adds an optional qualitative approach to determine whether it
is more likely than not (having a likelihood of more than 50%)
that the fair value of a reporting unit is less than its carrying
amount; if so, then Step 1 is required
• Applies to public and nonpublic entities
• New qualitative factors replace existing triggering factors for
interim goodwill impairment testing
• Does not change the current guidance for testing indefinitelived intangible assets for impairment
• Published in September 2011 and effective for annual and
goodwill impairment tests performed for fiscal years beginning
after December 15, 2011 (early adoption permitted)
FASB’s ASU 2011-08 Testing Goodwill for
Impairment: New Qualitative Factors
• General macroeconomic conditions
Deterioration in general economic conditions
Limitations accessing capital
Fluctuations in foreign exchange rates
Other developments in equity and credit markets
• Industry and market considerations
Deterioration in the operating environment
Increased competition
A decline in market-dependent multiples
A change in the market for the entity’s products or services
A regulatory or political development
• Cost factors that have a negative effect on earnings
– Increases in raw materials, labor or other costs
FASB’s ASU 2011-08 Testing Goodwill for
Impairment: New Qualitative Factors
• Decline in overall financial performance
– Negative or declining cash flows
– A decline in actual or planned revenues or earnings
• Entity-specific events
– Changes in management or key personnel
– Changes in strategy or customers
– Bankruptcy or litigation
• Events affecting a reporting unit
– A change in the carrying amount of net assets (write offs)
– Plans to sell or dispose of a portion or all of a reporting unit
– Testing for recoverability of a significant asset group within a reporting
– Recognition of goodwill impairment in a component of the reporting unit
• A sustained decrease in share price, both absolute and relative to
Applying ASC 820 Framework to
Reporting Units
Step 1: Determine the unit of account
Step 2: Determine the valuation premise
Step 3: Identify the potential markets
Step 4: Determine market access
Step 5: Determine the fair value
Assigning Assets and Liabilities to a
Reporting Unit- Additional Considerations
• Debt recognized at the corporate level
• Deferred taxes related to assets and
liabilities of a reporting unit
• Cumulative translation adjustment
• Contingent consideration arrangements
• Non-controlling interests
Issues and Best Practices of Measuring Fair
Value of a Reporting Unit
• Highest and best use:
– Issue: current use of a specific reporting unit may be
different from how a market participant may intend to
hold the same net assets
– Best practice: consider the interrelationships or
synergies among the reporting units to determine the
fair value of each
• Discounted cash flow method:
– Issue: are market participant assumptions reflected?
– Best practice: incorporate market participant
assumptions in the prospective financial information
(PFI) (i.e. cash flows and weighted average cost of
Issues and Best Practices of Measuring Fair
Value of a Reporting Unit
• Consideration of Market Participant
assumptions in management’s PFI
– Issue: Planned acquisition activity
• In general assumptions should not include planned
acquisition activity
– Issue: Working Capital
• Adjustments may be necessary if not at normal levels
– Issue: Deferred Revenue
• PFI should be modified to reflect cash flows
– Issue: Non-operating assets and liabilities
• PFI should be analyzed to see if adjustments should be
Issues and Best Practices of Measuring Fair
Value of a Reporting Unit
• Legal form of reporting unit:
– Issue: legal forms where the reporting units is not subject
to the payment of income taxes however a market
participant would be subject to income taxes
– Best practice: in most cases the discounted cash flows
should be calculated on an after-tax basis to ensure
consistency with market participant assumptions
• Depreciation and amortization amounts:
– Issue: depreciation and capital expenditures are usually
equal in the terminal period
– Best practice: consider, in some cases, capital
expenditures may exceed depreciation for companies
involved in capital intense industries
Issues and Best Practices of Measuring Fair
Value of a Reporting Unit
• Share-based compensation:
– Issue: management’s PFI may include an
upward adjustment for share-based
– Best practice: noncash expenses related to
share-based payments should not be included
as an adjustment as they are already
captured in PFI as other accruals

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