Using the Market to Determine IP's Fair Market Value; New Valuation Methods Can Help CTOs Carry out Their Mission of Being "Business Scientists, "Extracting Maximum Cash Value from Their Organization's Intellectual Property

Article excerpt

The value of a company's intellectual property (IP) helps determine both the quantity and cost of its working capital. This relationship is a relatively new phenomenon and is neither linear nor transparent. Because R&D activity is now under a financial microscope, both the composition of this relationship and the numerous efforts to make it more linear and transparent are important phenomena for CTOs to understand. Following a brief review of recent legal and accounting events and principles of finance, we set forth an algorithm for determining fair market value of IP capital assets, describe in greater detail a new (capital) market-oriented method especially useful for early-stage R&D, and illustrate the spectrum of financially-oriented asset management opportunities and practices enabled by both the new value and valuation paradigms.

About Fair Market Value

Corporations could not exist without working capital. But capital is not free, and its cost is particularly important to publicly traded companies. Being listed on an exchange means the market--through the power of stock price--will determine at least one important portion of the corporation's cost of capital (1). And when the markets favor a stock, working capital becomes less expensive. Corporations that lower their cost of capital can deploy their capital assets toward commercial objectives more profitably.

To determine how management is extracting profits from its capital assets, professional investors, who help establish stock price, look to several financial performance metrics. These include profitability, or the bottom line, and two metrics that are becoming important for CTOs: "asset profitability" and "asset utilization efficiency." Combined, these asset-focused metrics help investors anticipate future profits. Public capital markets are forward looking. Therefore, current asset utilization efficiency and profitability metrics create profit expectations that corporations are obligated to achieve in subsequent months lest the stock price fall on missed expectations.

The stock-price-based value is known as "fair market value," and it implicitly defines the value of all the company's component capital assets, tangible and intangible. Therefore, in order to set strategy, manage risk, and measure and report on the entire value creation process, leaders must obtain complete information about the fair market value of the assets under their operational control (2). For CTOs, this means IP intangible assets.

For research-intensive companies, creation and deployment of IP is one of the most effective tools for creating value and achieving above-average and sustainable profits (3). Until relatively recently, however, the added value of IP to corporations, excluding the pharmaceutical industry, was debatable. Empirical studies show that the lack of consistent legal interpretations in IP enforcement eroded much of IP's implied value (4). Then, in the fall of 1982, Congress created the Court of Appeals of the Federal Circuit. Coupled with high-profile patent enforcement actions such as Polaroid v. Kodak (Oct. 1986), Kearns v. Ford Motor Co. (Nov. 1989) and Lemelson v. Mattel Inc. (Feb. 1990), the importance of patents and other forms of IP became increasingly apparent (5).

Unfortunately, accounting systems did not have mechanisms for recording the value of a company's IP transparently on its books; book value reported the assessed value of capital assets such as property, plant, equipment, cash, etc., but not intellectual property. The public capital markets noted the omission and between 1978 and 1998, the non-book value of all publicly traded companies rose from 5 to 72 percent of market value (4). Finally, in July 2001, the Financial Accounting Standards Board (FASB) issued SFAS 142, Goodwill and Other Intangible Assets (6). Suddenly intangible assets and other intellectual properties achieved balance sheet visibility, and since then, public markets have anticipated the fair value reporting of IP on corporate ledgers (7). …