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
Kossovsky, Nir, Brandegee, Bear, Giordan, Judith C., Research-Technology Management
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).
IP fair market value is important to many (8): managers need to track how IP's financial returns will impact corporate financials (9); investors and analysts seek new avenues for IP-centered portfolio diversification; the IP markets, comprising licensees, licensors and the intermediaries facilitating this transaction space, are equally eager to take positions in IP-based financial instruments and IP litigation (10); the Internal Revenue Service is also keenly interested in the fair market value of IP as it relates to the tax benefit arising from charitable donations (11,12). The obligation to satisfy both internal and external constituents rests not only with business leadership but also with CTOs and CFOs. We discussed the opportunities for CTOs to embrace and lead this value-harvesting process in a previous RTM article (13).
But inherent in these new opportunities for IP financial management are obligations to determine fair market value and develop and exploit IP to its maximum utility, as we discuss now.
Determining Fair Market Value
In theory, a company's fair (market) value generally represents the net sure of the fair value of both its tangible and intangible assets (14). Therefore, a company's market capitalization--the value established by the stock market--generally represents the sum of the fair value of assets, including those such as IP. This key relationship is the basis for calculating fair market value when such value cannot be observed directly.
In order to appreciate the differences between observed and calculated value, the following section sets forth the definition of "Fair Market Value"; presents a hierarchy of valuation methods for observing or calculating that value for IP assets; and presents in greater detail a new market-based method, for valuing a hypothetical technology we shall call Gizmo.
Fair market value (FMV) is the price that an asset would sell for on the open market. It is the price that a willing buyer and seller would agree on, with neither being required to act, and both having reasonable knowledge of the relevant facts (15,16). Within the accounting world, fair market valuation is a relatively novel concept in general (17). It is particularly novel with respect to valuing IP where non-market notions such as "intrinsic value" have long been advocated (18).
A valuation hierarchy
In principle, estimates of fair value should be based on observable market prices and market assumptions. Thus, the more market inputs, the more reliable the estimate (19). Unfortunately, IP markets--excluding music and software licensing--are generally not observable, and the assets are relatively unique. The most rational approach therefore is a fait value hierarchy that defines and prioritizes an agreed set of market inputs to be …
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Publication information: Article title: 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. Contributors: Kossovsky, Nir - Author, Brandegee, Bear - Author, Giordan, Judith C. - Author. Journal title: Research-Technology Management. Volume: 47. Issue: 3 Publication date: May-June 2004. Page number: 33+. © 2009 Industrial Research Institute Inc. COPYRIGHT 2004 Gale Group.
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