Intangible assets in business valuation, with emphasis on real options approach

Table of Contents:

List of Figures – Tables – Exhibits – Graphs

List of Abbreviations

1 Intangible Assets
1.1 Definition
1.2 Goodwill
1.3 Classification of Intangible Assets
1.4 Valuation of Intangible Assets
1.5 When to Value Intangible Assets
1.6 Valuation Methods
1.7 Value of an Intangible Asset

2 Options
2.1 Stock Options
2.1.1 Call Options
2.1.2 Put Options
2.1.3 Positions in Options
2.2 Real Options
2.2.1 Variables in Option Valuation
2.2.2 An Anecdote: The first ever Real Option in History
2.3 Classification of Real Options
2.4 Figures in Real Options
2.5 Comparison of Valuation Methods
2.5.1 NPV method
2.5.2 Decision Tree Analysis
2.5.3 Real Options Analysis
2.5.4 The Marketed Asset Disclaimer(MAD)
2.5.5 Risk-Neutral Probability Approach
2.5.6 Black Scholes Approach

3 Patents & Real Options in Valuation of Patents
3.1 What's a patent?
3.2 Why value patents?
3.3 When value patents?
3.4 The Value of a Patent
3.5 Patent Valuation Methods
3.5.1 Cost Based Approaches
3.5.2 Market Based Approaches
3.5.3 Income based methods
3.5.4 Time and Uncertainty – DCF based approaches
3.5.5 DTA based methods
3.5.6 OPT based methods

4 Case Study
4.1 The Background
4.2 Calculation
4.2.1 Value without Flexibility
4.2.2 Implementing the Options
4.2.3 ROA Calculations
4.2.4 Optimal Decisions

5 Conclusion

List of sources

Appendix

List of Figures – Tables – Exhibits – Graphs

Figure l.l Intellectual Capital Grouping

Figure 2.l Call Option Payoff

Figure 2.2 Put Option Payoff

Figure 2.3 Payoffs Summarized

Figure 3.l Patenting Process

Figure 3.2 Valuation Methods

Figure 4.l Free Cash Flows

Figure 4.2 Letter Latice

Figure 4.3 ROA Period7

Figure 4.4 ROA Period 6

Figure 4.5 Optimal Decisions

Exhibit 2.l Variables of Real Options

Exhibit 2.2 RO Effects

Table 4.l Table of FCF's

Table 4.2 PV beforedividend

Table 4.3 PV after dividend

Graph 4.l PV w/o flexibility

Graph 4.2 ROA plot w/ flexibility

List of Abbreviations

illustration not visible in this excerpt

1. Intangible Assets

1.1 Definition

Before starting off with the meaning of intangible assets it is necessary to define assets due to the fact that The International Accounting Standards Board (IASB) defines intangible assets as a particular type of asset. According to the IASB Framework the corresponding definition is as follows:

“An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.”

Expanding on this definition The International Accounting Standards Board accepts the following definition in IAS 38 for the intangible assets.

“An intangible asset is an identifiable non-monetary asset without physical substance.”

For an item to be recognized as an intangible asset there are two criteria that are needed to be fulfilled by it. These are (a) the definition of an intangible asset and (b) recognition criteria.

(a) As the definition points out, an intangible asset needs to be identifiable. For an asset to be identifiable it has to be (i) separable, capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, asset or liability; or (ii) it has to arise from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.^[1]

(b) For the realization of the recognition criteria of the intangible assets the item in consideration has to

(i) produce probable future economic benefit and (ii) there must be a reliably measurable attribute to it such as its cost. As their name already suggests intangible assets have no physical form, yet they are a serious potential source of future economic benefit for the investing organization. However though this economical benefit is neither guaranteed nor measurable. Similar vagueness exists in the case of allocating a measurable cost to the intangible assets. Due to these reasons accountants are having trouble how to deal with intangible assets in their accounts. If an intangible item does not meet both the definition of and the recognition criteria to be an intangible asset, IAS 38 states that all the expenditure on the item should be recognized as expense.

1.2 Goodwill

Goodwill refers to the extra value that a company has in addition to its tangible assets. It is in a way the appearance of intangible assets on the financial reporting or more broadly the difference between the market value and the assets.

Goodwill that is acquired by purchase fulfills the criteria of being recognized as an intangible asset and therefore can be recorded on the financial sheets. On the contrary, goodwill that is internally generated. according to IAS 38 Intangible Assets, shall not be recognized as an asset. This particular kind of goodwill generated internally is unidentifiable and therefore cannot take place on the financial sheets as an asset. This kind of goodwill though does eventually get recognized in case the company generating the goodwill gets taken over.^[2] In such a case the company taking over the other one can recognize the acquired goodwill as an asset since there exists an exchange transaction that documents a reliable measurement of the asset. This is further examined by the Australian Accounting Standards Board:

In determining the amount of purchased goodwill the purchaser needs to recognize all assets acquired, whether of tangible or intangible nature. This might involve recognizing some intangible assets which, if internally generated by the purchaser, would not normally be recognized as assets because the absence of an exchange usually prevents them from being measured reliably. (AASB 1013, para. 5.6.1)

Some intangibles that do suffer from such absence of reliable measurement and form part of goodwill include market penetration, effective advertising, good labor relations and a a superior operating team. Other examples of identifiable intangible asset candidates include: brand names, publishing titles, motion picture films, computer software, licenses, franchises, customer lists, copyrights, patents, mortgage servicing rights, industrial property rights, recipes, formulas, models, designs, prototypes, intangible assets under development.^[3] In case these have been purchased from another party than the cost of the acquisition is a measure good enough to fulfill the recognition criteria. On the other hand if they have been generated internally they can be classified under either research or development costs according to the IAS 38 Intangible Assets. It is clearly stated that it is not possible for the an asset to be recognized if it is arising from research. All the expenditure on research should be booked as expense. If though the expenditure is a development expenditure then fulfillment of the following six criteria, along with the previously discussed criteria for being classified as intangible asset, will enable the items to be recognizable as assets. According to the IAS 38 Intangible Assets, these rules are as follows:

An intangible asset arising from development (or from the development phase of an internal project) shall be recognized if, and only if, an entity can demonstrate all of the following:

(a) the technical feasibility of completing the intangible asset so that it will be available for use or sale.
(b) its intention to complete the intangible asset and use or sell it.
(c) its ability to use or sell the intangible asset.
(d) how the intangible asset will generate probable future economic benefits. Among other things, the entity can demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset.
(e) the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset.
(f) its ability to measure reliably the expenditure attributable to the intangible asset during its development.

Internally generated brands, mastheads, publishing titles, customer lists and items similar in substance shall not be recognized as intangible assets.

So far all the definition discussion has been from an accounting perspective. Including the accounting perspective Bosworth and Webster (2006) have named more perspectives in their collection of researches called The Management of Intellectual Property, to approach the intangibles from.

When approached from a management perspective what's important is the potential of competitive advantage that the intangible assets impose on the owners of the assets, which cannot randomly be used by other competitors.^[4] This perspective defines intangible assets as sources of future benefits that are without a physical embodiment.^[5]

1.3 Classification of Intangible Assets

The classification of intangibles and the various different types of intangibles has been a long discussed topic and many researchers have examined them under different classifications. Intellectual Capital(IC) make up most of the Intangible Assets(IA) according to the definition raised by Bosworth and Webster^[6] where they point out that in addition to including the Intellectual Capital, Intangible Assets embrace access to distribution networks and markets, systems to optimize the rate of innovation and structures that improve workspace and enterprise efficiency. Hunter2006^[7] on the other hand, goes on to integrate the Relational (Market) Capital, which arguably is identified not as part of IC by other researchers, into IC and achieves a more combined definition which might seem like a mixture of IA and IC but exposes a more explanatory and wholistic view. The difference will be highlighted as the topics unfold. Let's concentrate on the Intellectual Capital first and follow the arrangement presented by Contractor (2001) and divides intangibles into three sets. Please note the appending nature of categorization here.

(a) Intellectual Property
(b) Intellectual Assets
(c) Intellectual Capital

A schematic representation of these three sets is shown in figure 1.1. It is important to note that the set of Intellectual Capital is a super set of the rest, containing them all.

illustration not visible in this excerpt

Figure 1.1

(a) Intellectual Property: This category comprises the formally registered intellectual property rights such as patents, brand names and copyrights. Intellectual Property contains elements both of competences and know-how from the firm's human capital and products of research and development (R&D) undertaken within the firm. In other words intellectual property is the product of intangible capital from which a legal right of exclusivity may be granted.^[8] These can be patents, brands, copyrights, etc.

One further definition to include before proceeding is the meaning of intellectual property rights. They are the “legal entitlements granted in respect of intangible subject matter emanating from human intellect” (Christie, 2006). Lynn (1998) includes these intellectual property rights (IPRs) under the intangibles category 'Organizational Capital'.

(b) Intellectual Assets: This category besides the Intellectual Property category, includes the codified but not registered corporate knowledge. These can be drawings, blueprints, written trade secrets, data bases, formulas, recipes which are codified (stored in written form) but not registered with governmental authorities. They are part of the firm's secrets.

(c) Intellectual Capital:

Intellectual Capital comprises the kind of Human and Organizational Capital which resides uncodified within the firm. The origin of such capital is the thinking of employees and the organizational routines. According to these origins the sub categories of knowledge can be defined. (i) Human Capital and (ii) Organizational Capital.

(i) Human capital raises from the skills, knowledge and experience of the management and workforce. These attributes can never literally be owned by the enterprise but only be hired for the time period during which the management and/or workforce is an employee of the enterprise. Although the enterprise might have enriched the human capital by investing in these people through trainings or education, the capital remains with these people in case they decide to leave the enterprise. They take this human capital to the following employer with themselves.

(ii) Organizational capital is the product of investment by the company in building up organizational systems, procedures and routines that are believed to be commercially advantageous to the company^[9] In other words, these are organization specific structures, procedures and routines.

Hunter2006 compiles a different classification of intangibles which isn't far away from the accepted classification within this thesis. That classification is based upon the origin of the capital or more specifically where it was created. It is as follows:

(a) Human Capital
(b) Organizational (or Infrastructure) Capital
(c) Relational (or Market) Capital
(d) Intellectual Property

Note that the items are almost exactly the same as the classification of the thesis with an addition of the type Relational (Market) Capital. It is worth mentioning the meaning of this type as well, which is as follows:

Relational capital is the product of investment by the company in nurturing relationships with customers and suppliers via development of databases, product and quality certification.^[10] Relationships with customers, suppliers, partners and business associates classify under this type of capital.

This kind of capital is created in house, within the company, therefore it is faced with the failure of a reliable measure of value in order to be recorded as intangible assets on the financial sheets. Only in the case of a merger or an acquisition is a value attributed to the intangibles.

Relational capital is also included within the super set of Intellectual Assets but depending on it being codified or not, or being registered or not it will fall into corresponding sub categories.

“Once you really understand intangibles , you’ll never run a company the same way again. You’ll operate by new rules. You’ll create and learn to track new performance measures….You’ll keep your eye on aspects of your business that can’t easily be counted, but that are essential to the company’s future health” (Jonathan Low and Pam Cohen Kalafut, “Invisible Advantage”, 2002)

In traditional business economics, competitive advantage is often attributed to the successful exploitation of economies of scale underpinned by a set of physical assets, a unique technology or a dominance of geographical markets or supply-chains.

It is now widely accepted, however, that sustainable competitive advantage is more often grounded in the accumulation and creative exploitation of so-called intangibles.

1.4 Valuation of Intangible Assets

The change in the economy in the 20th century is more towards an economy based on ideas, away from the matter based economy of earlier times. The emphasis has shifted from natural resources to thought, ideas, design and organization^[11] Services replaced the importance of manufacturing. Contractor 2001, names this overall change as a de-materialization of the economy and quantifies the significance of the change by pointing out that by the end of the twentieth century 79 percent of jobs and 76 percent of the GNP in the United States were in the service sector. This change wasn't visible only in the US. European and Emerging nations did also portray similar trends.

In 1969 Tobin introduced a new ratio called Tobin's q Ratio^[12], which have been a great influence on the valuation/measure of intangible components of enterprises. Having a look at the example of Microsoft's ratio between its market value and its book value, which in 1999 25 to 1 was, reveals the fact that most of the value is in the form of knowledge capital, in its employees, organization, patents, copyrights, brand value, etc. This ratio is bound to increase as the importance of intangible assets rises over the course of years. Though this increase is certain and expected, the valuation of these assets is still not clarified nor agreed upon. The value of the intangible assets is of importance to different audiences such as academicians, scholars, accountants, consultants, etc. and they haven't been able to come up with one single approach to solving the problem. This thesis will focus on a particular subset of intangible assets, namely patents, and demonstrate how to value them.

1.5 When to Value Intangible Assets

Previously it has been pointed out that intangible assets are of importance to a wide array of audiences, let's see which circumstances raise the need to learn the value of intangible assets. Contractor 2001 lists seven different cases where valuation of intangible assets is necessary.

(a) Stock Exchange:

Being a representative of the market, it's taken granted that measure of intangible assets is important in

(b) Sale, Merger, Acquisition:

In the case of a change in the ownership of the company, be it via the sale of the company, a merger or an acquisition the book value of the company fails to represent the value of the intangible capital generated throughout the company's lifetime. Therefore a careful valuation of the intangible capital is important for all the parties involved in the transaction. At the end these intangibles will mainly accumulate and appear as goodwill.

(c) Case of Separable Assets:

Companies might possess assets such as brands, patents, copyrights, data bases, or technology which can be transferred, sold, or licensed to another party. This sort of assets are called separable assets. (Contractor 2001) In this case it's not the complete set of intangible assets that the company has that needs to be valued, but only those that are subject to transaction.

(d) Intellectual property infringement:

In the case of intellectual property infringements, it is likely that the party whose intellectual property has been illegally handled files a case. In such a situation it is important for the court to know the cost/value of the property in order to sentence a righteous penalty.

(e) Tax liability:

In case of transaction of intangible assets, the value of the transaction is also important in terms of calculating the associated tax liabilities.

(f) Corporate Alliance:

When a strategic alliance between firms has been established it is important to calculate the contribution of each parties for the sake of the business. The fees, rates and shares will be allocated accordingly.

(g) R&D management:

Valuing the contribution that a particular R&D project brings is crucial in terms of prioritizing the projects. Besides, it is equally important in the case of jointly developed projects to figure out the contribution of each party.

1.6 Valuation Methods

When talking about valuation, one is usually confronted with three different approaches to solve the issue. This is true for valuation of all kinds of assets. (a) The cost approach tackles the situation by trying to figure out how much it would cost to produce the same asset today. (b) The market approach tries to find the value of a similar, comparable asset in a liquid and transparent market. (c) The income approach counts on the future cash flows that the asset is projected to generate and their present value.

(a) The cost approach:: This approach tries to find the value of an asset by calculating the cost it would be required to reconstruct or replace the asset with a similar/comparable one. This is referred to as the development cost of the asset. In the case of intangible assets, this approach isn't the most appropriate choice most of the time. The future benefits expected from an intangible asset are usually not very much correlated with the amount of investment or the production cost for that particular asset. Other general problems with this approach are the allocation of costs and the presence of sunk costs.^[13] The latter refers to the cost that have already been incurred but might not be relevant in future decision making. The allocation of costs, for example refers to the problem of how much of his/her time has the employee put on the asset that is trying to be valued, so how much of the salary should be allocated to the asset.

(b) The market approach: When the market approach is undertaken in a valuation project, the value will be measured by analyzing the properties of a comparable, similar asset. In the case of intangible assets it would make sense to search among the other firms for similar intangible assets and analyze the previous intangible asset transactions.

It has already been mentioned that a major reason why intangibles are problematic is the fact that there is no liquid and transparent market for them to be traded in. This approach fails to perform at its best due to this lack of the presence of such a market for intangibles. Some benchmarking opportunities are available though. It is also quite difficult to find a previous intangible asset interaction in the past that can be compared to the asset trying to be valued. Even if found it is difficult to allocate a specific amount to the asset because the transactions are usually on a bundle basis, where the money paid is the value of a group of assets.

(c) The income approach: This approach measures the value of an asset by the present value of its future economic benefits.^[14] In this context what's meant by benefit are any earnings, cost savings, tax deduction, etc. In this respect the value of the project/asset would be the value of these benefits, discounted at a rate of return that's calculated with all the risks associated with the project/asset considered. This kind of valuation approach is used commonly with valuation and economic analysis of intangible assets like patents and copyrights.^[15]

The challenge with this type of valuation approach is the uncertainty and difficulty in determination of the future income stream. The selection of the most appropriate discount rate is an equally critical decision that requires careful decision making.

[...]

---

^[1] IAS 38 Intangible Assets, IASC Foundation

^[2] Wyatt, p.43

^[3] Wyatt, p. 45

^[4] Hunter, p. 67

^[5] EUROPEAN COMMISSION Presentation 2003, p. 10

^[6] Bosworth & Webster, p. 86

^[7] Hunter, p. 68

^[8] Christie, p. 26

^[9] Hunter, p. 68

^[10] Hunter, p. 68

^[11] Contractor, p. xi

^[12] q ratio is equal to the market value of the company divided by the replacement cost of its assets[illustration not visible in this excerpt]

^[13] Sarathy 2001, p. 236

^[14] Haeussler, Clarry 2001, p.191

^[15] Schweihs 2001, p. 252