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How Intellectual Property is Valued during a Transfer of Business

March 19, 2019
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This article is written by Col. Rajesh Tandon, pursuing Diploma in Intellectual Property, Media and Entertainment Laws by Lawsikho as part of his coursework.  Col. Rajesh works with the Indian Army for the past 29 years and has been handling the legal matters for 2 years.

Introduction  

The property rights have always played their role in promoting the social economic and political development in various societies. The concept of property includes a person’s legal rights of whatever description. The Honourable Supreme Court of India in R.C Cooper Vs Union of India has defined the property as the highest right a man can have to anything to include the right of a man to ownership, estate, interest in corporeal things, the right to land or tenements, goods or chattels, the right to trade Mark, copyright, patents and even rights  in personam capable of transfer or transmission such as debts and something signifying a beneficial right thing considered as having a money value. Largely the property is either corporeal or incorporeal. Corporeal property is the right of ownership in material things. Incorporeal property is of two kinds namely Jura in re aliena i.e encumbrances ( like leases, Mortgages and servitudes) and Jura in repropi  (i.e patents, copyrights and trademarks). Intellectual property is the product of the human mind and intellect which emanates from the exercise of the human brain, something that involves the visual expression of a mental conception. When we talk of the transfer of business, it is imperative to understand the scenarios under which the transfer of business takes place. The ownership in the course of transfer of businesses can take place by the sale of a business or through the addition of a partner or Lease purchase or Family Member Transfer or through the process of merger/amalgamation, demerger, acquisition or takeover, divestments, strategic alliances or slump sale. While the transfer of business occurs, the assets and liabilities also do get transferred. In such a scenario wherein, the assets and liabilities are being transferred, it is very important to get to evaluate the value of intellectual property. A thorough evaluation of the value of intellectual property puts in a clearer perspective of the assets and liabilities to those to whom the business is being transferred.

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The intellectual property       

The Convention establishing the world intellectual property organization (WIPO) concluded in Stockholm on July 14, 1967, provides that intellectual property shall include the rights relating to:-

  1. Literary, Artistic and scientific works
  2. Performances of Performing Artists, Phonograms and Broadcasts.
  3. Inventions in all fields of human endeavor
  4. Scientific discoveries
  5. Industrial designs
  6. Trademarks, Service Marks and Commercial Names and Designations
  7. Protection against unfair competition
  8. All such rights resulting from intellectual activity in the Industrial, Scientific, Literary Or Artistic Fields.

Branches of Intellectual property      

Intellectual property is usually divided into two main branches as under

Necessity to assess the value of Intellectual Property of the Business   

There are various reasons to carry out an evaluation of the IP assets to ascertain their value. Some of these are as under:

  1. Evaluating the value of IP for shareholders.
  2. Evaluating the value of IP for:
    • Mergers
    • Acquisition
    • Divestment
    • Strategic Alliance.
    • Management Buyout or By in

In all these cases, the valuation of IP enables the parties to make an informed decision for the acceptable cost of Capital i.e the rate of return that could be expected from such Business transfers.

3. Fund Raising

4. IPO

5. Licensing and Franchising of Intellectual property assets: In the course of licensing and franchising of intellectual property assets, the valuation of the intellectual property assets is of prime importance on account of the following:

6. Assignment of Intellectual property Assets: The valuation of intellectual property assets facilitates the determination of Royalty rates to be charged while assigning the intellectual property assets.

7. Corporate Finance: The valuation of the portfolio of patents held by the firm is often carried out to assess the value of the intangible or incorporeal property for the purpose of obtaining corporate finance. A new phenomenon of securitization called Royalty Interest Securitisation is the trend in the market for obtaining Finance using IP. The salient features of Royalty Interest Securitisation are:

8. Litigation: Whenever the cases of infringement are filed by a patentee, a royalty is often awarded to compensate the pit and the poor the unauthorized use of the patent by the infringer. In such a scenario it is very important that the value of patent must be assessed and determining the damages in the case of patent infringement litigation and for the purpose of assessment of reasonable royalty.

9. Transfer Pricing: A transfer pricing is the rule/method for determining the price for pricing transactions within and between the enterprises under common ownership. In layman’s terms, the transfer pricing is the rule for determining taxable profits/losses of a company in a country. Wherever there is a transfer of tangible or intangible assets, the rules of transfer pricing get applicable to such transactions.

Essential Pre-requisites for Undertaking Evaluation of Intellectual Property

There are certain fundamentals which must be satisfied before taking an evaluation of the intellectual property. Therefore a checklist is warranted before going in for evaluation of the intellectual property.  Such a suggested checklist is as under:

  1. Whether there is a recognizable description of the intellectual property that is owned by the business which can be identified appropriately?
  2. Whether the intellectual property used by the business is such which is used by business with or without the permission of others who own such intellectual property?
  3. Who is the owner of the existing intellectual property assets viz:
    1. The company or
    2. one or more employees or
    3. consultants or
    4. Business partners of the company/firm

4. Whether there is Tangible evidence of the existence of the asset in the form of intellectual property needs to be there in terms of the following:

5. Whether there is an intellectual property that can be legally enforced and legally transferred?

6. Whether there is an intellectual property that is able to generate its income distinct from the other assets of the business?

7. Whether there is an intellectual property that can be sold without selling the other assets of the business?

8. Whether there is an intellectual property that  has got a definite period of existence

9. What are the factors which can affect the value of intellectual property viz:

Method for valuation of Intellectual property

Normally one of the following methods for valuation of intellectual property are adopted:

Cost-Based Method

The different Cost Based methods are discussed below as under:

  1. Historical Cost Based Method: The salient features of this method along with the method of calculation are as under:
    • Firstly, aimed at assessing the actual cost involved in the creation and development of intellectual property.
    • Secondly, largely used for evaluation of IP assets in the research and development phase.
    • Thirdly, the cost-based method works out the Actual costs incurred in creating and developing the intellectual property [H],  and therefore takes into account the following parameters:
      • Funds Invested- [F]
      • The time cost of money [T] (based on a risk-free interest rate).

2. Replacement Cost Method: It is a method which calculates the cost involved in an recreating the functionality or utility of the IP in question. However, the IP so created by replacement may be in a form or pages that may be different from the IP in question. The salient features of this method along with the method of calculation are as under: 

3. Reproduction Cost Method: This method involves evaluating the price involved in creating an exact replica of the IP in question/a duplicate Asset. The salient features of this method are as under: 

        Reproduction Cost=  D+R+T+L+O= Amount Rs X/-

The Concept Of Obsolescence   

There are various kind of obsolescence which affect the value of the intellectual property:

    1. Functional Obsolescence:  It is a case where the user of the IP has to incur taxes operational cost to use the IP depending upon the various alternatives including the state of the art to overcome the obsolescence so set in the IP.
    2. Technological obsolescence:  It is a situation wherein on account of the advent of technology the better technological options are available in the market and the intellectual property becomes insignificant.
    3. Economic obsolescence:    This is a situation wherein the intellectual property despite in its best form, yet it does not fetch adequate returns on the investment because of being unique, wherein the intellectual property has a little use beyond its particular function. 

Alternative method of working out the cost taking into account the factor of Obsolescence, the  reproduction cost, replacement cost

  1. Stage  I: Initially in this stage,  the replacement cost is worked out through the formula:

       Reproduction cost-Curable Functional & Technological Obsolescence= Replacement cost

2. Stage II: In this stage, the replacement cost so worked out is used to estimate the value of IP as under:

 Replacement Cost-Economic Obsolescence-Incurable Functional & Technological Obsolescence= Cost of IP

Market-Based Method

 In this method, the valuation of IP, is worked out by drawing a comparison with the actual price paid for similar intellectual property asset under comparable circumstances (i.e whether the circumstances of cross-licensing or circumstances which make license agreed-upon in settlement of litigation). There are various factors which should be considered for the purpose of compatibility such as:

Economic Based Valuation Method or Income Method

Conceptually supposed to be the superior method as it addresses the issue of the contribution of the intellectual property. In this method, the amount of economic income that the IP as it is expected to generate is adjusted to its present-day value The two distinct components of this method are:

Here, 

PV= Present Value

CF= Cash Flow

t= time representing years of IP asset economic life

n=time that economic life is expected to end

r = Annual rate of discount(representing the risk factor) or time value of money and assumed.

                         1                                 2                                    3

PV= 50,000/ (1+0.05) +50,000/ (1+0.05) +50,000 /(1+0.05)

                        4                                      5

            +50,000 /(1+0.05) + 50,000 /(1+0.05)

i.e

PV= 47619.04 +45351.47+43191.87+41135.12+39176.35=216,473.85

Thus , the company A  would expect to receive at present, an amount of Rs 216,473.85/-, as  Royalty Rate, if it licenses its patent for five years

Royalty Rate method

In this method, the value of intellectual property is arrived by capitalising the post-tax royalty paid annually for the use of intellectual property under a hypothetical licensing arrangement.

There are three different approaches to work out the royalty rate method as under:

These factors are then considered in relation to the specific circumstances of the license.

The resultant comparison gives out the incremental cash flow that will arise from the grant of License. Such incremental cash flows can be divided between Licensor or licensee in terms of ratios like:-

Conclusion   

In order to have effective decision-making, to negotiate the IP related contracts/agreements with a commanding position and to meet the legal accounting standard requirements and taxation liabilities, the evaluation of the intellectual property assets in a business enterprise is of prime importance and must be carried out from time to time.


Students of Lawsikho courses regularly produce writing assignments and work on practical exercises as a part of their coursework and develop themselves in real-life practical skills.

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