Unlocking the Value of Intangible Assets

Unlocking the Value of Intangible Assets

Unlocking the Value of Intangible Assets

  • Posted by kalyani
  • On March 26, 2024
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By

Anand Shah
Associate Partner - Valuations

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In the realm of modern business and evolving financial reporting, the importance of intangible assets like brand recognition, patents, technology, and customer relationships has significantly increased.  Understanding their value becomes paramount as these assets play a crucial role in generating revenue and sustaining business operations, especially during a merger or acquisition. In the below sections, we will explore the accounting of intangible assets during a business combination, and the methodologies used to fair value them, offering practical insights for navigating this complex landscape.

What are Intangible Assets?

As defined by the “International Glossary of Business Valuation Terms” (“IGBVT”), Intangible Assets are “non-physical assets such as franchises, trademarks, patents, copyrights, goodwill, equities, mineral rights, securities and contracts (as distinguished from physical assets) that grant rights and privileges and have value for the owner.”

Intangible Assets can be classified into categories based on the source of their existence:

  • Purchased
  • Acquired; or
  • Internally generated

A further classification can determine the lifespan or useful life of these assets:

 (1) Purchased and (2) Acquired intangible assets can generally be classified as either a definite (finite) or indefinite (infinite) useful life depending on the asset, whereas (3) Internally generated intangible assets can only have a finite lifespan.

The treatment for the finite and infinite life of these assets differs as follows:

Intangibles with finite lives are subject to amortization over the useful life of their value creation, whereas the same does not apply to those with infinite lives. Moreover, while all intangibles are required to be tested for impairment, intangibles with infinite lives are required to be impairment-tested at least once a year.

The State and Nature of Intangible Assets Today

Given the trend of increasing importance of intangible assets, there is an unprecedented environment for the need for adequate classification, understanding, and valuation of these assets. With divestitures and consolidation in the corporate world, increasing deal flow, and an observably larger appetite for M&A, the accounting of intangibles acquired in a business combination has taken the spotlight.

It is essential to understand that while rules and regulations govern the treatment of intangible assets, they also require the careful consideration and discretion of the management and valuation professionals scrutinizing the legitimacy of their recognition.

As per IAS38: Intangible Assets, for an intangible asset to be identified separately from goodwill, either of the following criteria must be satisfied in accordance with the financial reporting standards:

  • is separable, i.e., is capable of being separated or divided from the entity and sold, transferred, licensed, rented, or exchanged, either individually or together with a related contract, identifiable asset, or liability, regardless of whether the entity intends to do so; or
  • arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.

Contemporaneous accounting standards (ASC 805: Business Combinations, Ind AS 38: Intangible assets) specify criteria on similar lines.

Identifiability Criteria Flowchart[1]

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Commonly observed Intangible Assets

Intangible asset Description
Existing customer relationships
  1. Customer relationships usually meet the separability criterion as they can be sold or transferred independently, as well as the contractual criterion if they are formal agreements (such as subscription contracts, service agreements, or loyalty programs) that explicitly define the terms of the relationship and provide the company with control over future economic benefits.
  2. Customer relationships are commonly recognized as significant intangible assets on corporate balance sheets due to their crucial role in generating revenue and maintaining business continuity.
  3. Analyzing trends in customer attrition and acquisition provides insights into the durability and value of these relationships, helping to determine their specific useful life and identify areas for improvement.
Trademarks
  1. While intangibles such as trademarks, internet domains, trade dress, and marketing-related assets typically satisfy the contractual-legal criterion, in the absence of legal protection, if there are observable exchanges and transactions of such assets in the business environment, then the separability criterion is satisfied.
  2. Trademarks can be a significant intangible asset as they help build and sustain a company’s competitive market position, fostering customer loyalty and brand recognition.
  3. Benchmarking the royalty rate of similar/identical agreements and assessing useful life is the fundamental premise while valuing trademarks.
Developed technology/Software
  1. Developed technology typically meets the separability criterion as it can be sold, licensed, or transferred independently. Moreover,  suppose there are formal agreements or patents associated with the technology, such as licensing agreements or intellectual property rights. In that case, it satisfies the contractual criterion by explicitly defining the terms of use and providing the company with control over its future economic benefits.
  2. For  technology-focused companies, developed technology is recognized as a significant intangible asset on corporate balance sheets due to its pivotal role in innovation, product development, and competitive advantage. It represents the culmination of research, development, and investment efforts aimed at creating proprietary solutions or products.
  3. Assessing the obsolescence and useful life of developed technology is important in determining its value to the organization. As technological landscapes evolve rapidly, maintaining relevance and competitiveness hinges on the ability of the technology to adapt and innovate over time.
Non-compete agreements
  1. Non-compete agreements (“NCA”) typically meet the contractual criterion as they involve a legally binding contract between parties. Further,  in many cases, the agreements, being standalone contracts that can be negotiated, executed, and enforced separately meet the separability criterion.
  2. For intangibles such as non-compete agreements, the terms and conditions of the agreement require detailed consideration to assess the enforceability and, hence, the fair value associated with it.
  3. Duration of NCA, geographic scope, competitive landscape, potential revenue, or expected cost savings are critical presuppositions that  affect the value of NCA.
Employment contracts
  1. While certain provisions within employment contracts may meet the separability criterion, the contracts as a whole generally fulfill the contractual criterion as legally binding agreements between parties.
  2. Employment contracts can result in intangible assets or intangible liabilities in a comparable manner to lease and service contracts. The contract can be below or above market levels of comparable agreements. However, it is uncommon to see firms recognizing this on their financial statements, given the nature of at-will employment coupled with short notice periods.
  3. Contract duration, compensation structure, and performance metrics are the significant assumptions to be factored in while valuing employment contracts.
Assembled workforce
  1. While individual employment contracts may satisfy the requirements to be identified separate from goodwill, an assembled workforce does not meet the criteria in both legality and spirit. Assembled workforces cannot be transferred or exchanged separately without impacting the business operations of the firm being acquired. Moreover, the individual employees’ contracts meeting the criterion would only add to the redundancy of factoring in the impact of an assembled workforce, albeit for collective workforce synergies.
  2. Therefore, for PPA purposes, the assembled workforce is typically subsumed within the valuation of goodwill rather than being recognized as a distinct intangible asset.
  3. Even though not separately recognized, the assembled workforce is considered a contributory asset and is valued only for the purpose of employing the Multi-Period Excess Earnings Method (“MEEM).
  4. Average salary, headcounts, fringe benefits, hiring & training costs, months until full productivity, and % effectiveness of new hires are the significant assumptions to be factored in while valuing the assembled workforce.
Favorable / Unfavorable contracts (Leases)
  1. An essential  type of intangible to consider is favorable and unfavorable contracts.
  2. These contracts and their associated terms can be compared to currently existing market prices in order to determine the value of outflow below (above) the market in order to recognize an asset (liability) in the existence of favorable (unfavorable) contracts. These assets (liabilities) are then amortized over the tenure of the contract, with the tenure often being extended to the next renewal period, given that it continues to remain favorable.
  3. Analyzing the terms of lease agreements and comparing the rentals with similar properties provides insights into the favorability and value of these contracts.

Valuation Methods:

The valuation of intangible assets borrows some basic principles from the methods and techniques used to value tangible assets and economic entities as a whole. This entails the income approach, market approach, and replacement cost approach. Some commonly used valuation methods used to value intangible assets are: [2]

  • Multiperiod Excess Earnings Method: This method isolates the projected cashflows associated with the intangible asset being valued and discounts the projected stream of flows using a suitable discount rate to the present value. This method is beneficial when the presence of an asset is directly tied to certain cashflows and can be quantified. Customer relationships, client lists, and computer software can often be valued using this approach. Moreover, this approach is helpful for valuing developed technology assets.
  • Relief from Royalty Method: Owning an asset eliminates the need to rent the permission to use somebody else’s asset and also minimizes the costs associated with facilitating the permission. It uses the hypothetical royalty payments associated with licensing or borrowing the asset to estimate the cost savings and, hence, the value of the intangible. This method is often used to value licensed software, domain names, trademarks, and R&D that is associated with a revenue stream that would likely incur royalty costs. It is imperative to estimate the useful life of the asset and collect market data on suitable and comparable royalty rates.
  • With and Without Method (“WWM”): Adopting a fairly simple ideology, the WWM makes use of calculating the difference between two discounted cashflow models- one that factors in the cashflows with the asset in place and another that considers the potential cashflows without the asset. The difference in value is often used to value intangibles such as non-solicitation and non-compete agreements.
  • Replacement Cost Method Less Obsolescence: This model aims at concluding the value of constructing the intangible asset with current market prices, production standards, labor skill set, and available resources in mind that would provide the utility equivalent of the intangible asset being valued. This is considered as the cost of replacing the asset with current economic headwinds and tailwinds in mind. This method is useful for valuing intangibles such as proprietary software, internal systems, and assembled workforce.
  • Real Option Pricing Method: When considering the contingent success of an asset in generating future cash flow, an option pricing method can model the price of the intangible asset similar to an option priced using the Black-Scholes Option Pricing Model. Patents and right of use of natural resources can often be valued using this method since it gives the patent holder the right but not the obligation to prevent competitors from utilizing the cash-flow generating intangible asset for a fixed period of time (time to expiration) with certain uncertainty (volatility) and an expected cost of delay (dividend yield).

In addition to above discussed commonly used valuation methods, alternatives like the distributor , greenfield , and cost savings methods offer nuanced approaches for appraising intangible assets. These techniques provide varied perspectives, assessing factors such as market position, developmental costs, and operational efficiencies to determine assets’ value.

Summary:

In summary, intangible assets come in various forms, and their accurate assessment entails domain-specific expertise to not only appropriately value them but also categorize and ascertain their relevance for both financial due diligence and valuation.

 

[1] Reference: PWC, Business combinations and noncontrolling interests
[2] CFA Institute, The Intangible Valuation Renaissance: Five Methods
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