This article is written by Surya Rose Thomas pursuing Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from Lawsikho.

Introduction

Every company wishes to have an edge over its competitors. Let it be a start-up or a well-established company, being in the dominant position with a great consumer base and high profits is the zeal. This is the very reason for the importance of merger and acquisition deals. The convenience of pre-existing resources including technology, consumer base, infrastructure, market share, etc., are the reasons for the surge in merger and acquisition transactions today. Also, a company according to the terms of transaction receives both tangible and intangible assets of the target company. A company that owns Intellectual Property has a higher value than a company that does not have intellectual property. 

What are intellectual property rights?

Have you ever noticed the golden arch of McDonald’s? Can you find the same symbol of McDonald’s being used by any other company? You cannot. That golden arch symbol of McDonald’s is their trademark. A trademark is intellectual property. 

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Intellectual property rights are the rights given to persons over the creations of their minds. Patents, copyright, trademarks, geographical indicators, industrial designs, etc. are the main types of intellectual property rights. Rewarding the creations is vital because it encourages innovation. The importance of intellectual property rights can be seen more in developed countries like the USA, Canada, etc. Developed countries are developed due to their strong intellectual property regime. Intellectual property rights ensure that the owner of intellectual property has the sole authority to decide:

  • How can it be used?
  • When can it be used?
  • Who can use it?

Valuation of intellectual property rights

Intellectual property assets carry value with them. The process of identifying the value of intellectual property assets is known as IP valuation. IP valuation is done on many occasions. During merger and acquisition, intellectual property valuation is done. Especially when the acquisition is done for obtaining the IP of the target company to leverage it in favour of the acquirer, determining the monetary value of IP assets of the target company is exceptionally important.

Another instance is when you obtain a loan submitting IP assets as security. IP valuation is carried out also during disputes or intellectual property infringement. For claiming damages at the time of infringement, knowing the monetary value of infringed intellectual property helps the owner in a better way. 

The next occasion is when the owner of the intellectual property resorts to rendering a license. For the perfect deal, while authorizing license, it is pertinent that the owner himself knows the monetary value of his intellectual property. Not only the owner, but the licensee must also be aware of the value of the Intellectual property for which he is seeking the license. This is to avoid fraud. 

In short, the valuation of intellectual property rights is important in:

  • Merger and acquisition deals,
  • Securing loans,
  • Disputes and infringement,
  • Authorizing license.

There are certain prerequisites for conducting valuation in intellectual property. They are:

  1. Capable of identifying separately.
  2. Availability of any tangible pieces of evidence like a contract, registration document, license, etc. to affirm the existence of Intellectual Property. 
  3. Its creation can be traced back to an identifiable point in time. 
  4. Capable of getting enforced legally.
  5. Capable of being transferred.
  6. Capable of identifying its income separately and independently from those of other business assets. 
  7. It should be able to be sold independently of other business assets.
  8. It should be subject to destruction or termination at an identifiable point in time.

These prerequisites can be considered as qualifications that enable the valuation of intellectual properties. 

Intellectual property valuation methods

There are three methods for obtaining the monetary value of intellectual property assets. They are:

  1. Income method,
  2. Market method,
  3. Cost method.

Income method

This method is used to calculate the value of those intellectual property assets which accrue stable income flow. This is the common method for the valuation of intellectual property. It calculates valuation based on income generated by the IP for the Remaining Useful Life (RUL) of the IP and reduces from it the cost related to the IP like labour, raw materials, capital investments incurred, etc, and associated risk. Risk has to be discounted from the income using discount rate or capitalization rate. Remaining Useful Life (RUL) is the estimate of years that  

Income method can be divided into:

Direct capitalization method

In this method, value is obtained by dividing the Net Operating Income (NOI) and capitalization rate, both taken of the same period. 

Value = Net Operating Income/Capitalization Rate

The value and capitalization rate are indirectly proportional. That is, the more the capitalization rate, the less will be the value and vice versa. However, Net Operating Income and value are directly proportional. This means that the more the Net Operating Income, the more will be the value.

Discounted cash flow method 

This method obtains a present value for the future cash flows by discounting it with a discount rate. Here, the discount rate is the interest rate used for determining the present value of future cash flows. 

For example, suppose I invest 100 Rupees in a patent that gives a 20% interest rate. Here, the future value is 120 Rupees. Discounting the future value (20 Rupees) by the rate of 20%, we get the present value which is 100 Rupees. 

There are three steps involved in the discounted cash flow method. 

  • Firstly, anticipate the future income or cash flows.
  • Secondly, choose an appropriate discount rate.
  • Thirdly, discount the future cash flow with the discount rate to obtain the present value. 

Choosing the appropriate discount rate is important as well as difficult. This determines the worth of an investment. If the future cash flow is less than the investment money, such an investment would be a loss for the investor. 

Market method

Here, valuation is done by comparing the values of similar intellectual property. Different variables are taken and compared for this purpose. Some of the important variables include nature, duration, territory, uniqueness, the timing of IP assets, legal status and extent of the strength of IP rights, etc. This is a simple method. But information for comparison should be available for the effective application of this theory. This is not a very reliable method because each intellectual property is unique. That is the very reason why they are called intellectual property and rights for the same are granted. This method becomes effective only if accurate and reliable data regarding the subject intellectual properties are obtainable. 

Cost method

This is the least sought-after method. This is usually used to supplement the income method and is mainly used when the intellectual property does not generate any income. In this method, the cost to generate a similar intellectual property is calculated considering the current price. This method considers obsolescence and reduces it while valuing. The cost method does the valuation by aggregating the expenditures involved and adjusting it with inflation and considering the opportunity cost and reducing obsolescence. The cost method does not consider waste costs but the fact is that huge amounts are spent on research of intellectual property especially in the pharmaceutical industry. 

There are two kinds of cost methods. Reproduction cost method and replacement cost method. 

In the reproduction method, the cost incurred while generating the same intellectual property is considered. While in the replacement cost method, costs incurred for generating intellectual property with similar functions and utilities are calculated. 

Merger and acquisition transactions

Havells India Limited acquired Lloyd Consumer Durable Business Division (Lloyd Consumer) for 16 billion rupees. This acquisition by Havells gave them full ownership over the intellectual property of Lloyd Consumer. 

The acquisition of Daksh e-Services by IBM was mainly technology-driven. It not only gained control of Daksh e-Services but acquired the software codes of Daksh which were copyrighted and all the other related intellectual property. 

These are examples of merger and acquisition transactions through which the intellectual property of the target companies was also acquired. 

How intellectual property due diligence is important in merger and acquisition transactions?

Merger and acquisition transactions are not limited to any particular type of company. It happens in all kinds of business. Every such transaction happens for a reason. Some mergers and acquisitions are carried out for acquiring the intellectual property assets of target companies. This happens mainly in the case of acquisitions done in pharmaceutical companies, biotech companies, technology, and media-related companies, etc. Mergers and acquisitions are million-dollar transactions. Therefore, it should not result in catastrophic losses for the acquirer. Hence, due diligence is of paramount importance. 

Conclusion

We have discussed the various methods for intellectual property valuation as well as the importance of due diligence in the valuation process. Conducting intellectual property audits is also a way for gathering relevant information. Another important point is that the representation and warranties clause detailing the ownership of subject intellectual property must be included in the agreement. This helps the acquirer in case of any future disputes regarding the ownership of the intellectual property. Intellectual property, an intangible asset, is growing important each day. 

References

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