Valuation of Intellectual Property Assets

1. Valuation of Intellectual Property Assets Professor Derek Bosworth Intellectual Property Research Institute of Australia Melbourne University

2. Coverage of the presentation • IP as a component of IC • Nature of the management problem • The Diageo problem • Nature of the accounting problem • Accounting issues surrounding intangibles • Accounting methods for intangible assets • Options pricing and optimal stopping • [Other strategic issues]

3. Not covered in the presentation • Economic approaches to valuation • Production function and market valuation – dealt with in a previous presentation • Patent valuation analysis – using renewal data • Methods of valuing product characteristics • Conjoint analysis (marketing) • Hedonic analysis (economics)

4. IP as a component of IC

5. Intellectual Capital Human Capital Relational Capital Organisational Capital “Sociological” Skills and Capital Intellectual Property “Technological” Skills and Competencies Infrastructure Capital

6. Organisational (structural) capital: examples of IP/IPRs • patents • copyrights • design rights • trade secrets • trade marks • service marks • trade dress • utility models • plant & seed varieties

7. Nature of the management problem

8. Why Value Intellectual Capital • Measurement of IC - enables a more efficient management of the company - i.e. to: • understand where value lies in the company • have a metric for assessing success and growth • provide a basis for raising finance or loans • If borrowing can only be secured against tangible assets, then knowledge-based companies will be disadvantaged in investment and growth.

9. The Diageo problem

10. Diageo: the company • Grand Metropolitan - formed as a hotel company in 1962 • by mid-1980s strengths in variety of branded products • became known as Diageo in 1997, on merger with Guiness

11. Previous accounting practice • GrandMet – often bought and sold brands • Acquired Heublein from Nabisco in 1987 • Paid £800 million, of which over £500 million was for the Heublein brands (i.e. intangibles) • Given the accounting procedures at the time, • GrandMet published its next set of accounts in January 1988 • the Heublin brands were not valued • £565 million of the £800 million paid for the company was written off as goodwill against reserves • as a result, the balance sheet net assets fell, giving the impression than £565 million had been wasted

12. Changed accounting practices • Subsequently GrandMet introduced brand capitalisation • after acquiring Pilsbury in 1989, the balance sheet showed the importance of brands • brands £2.7 billion • other assets £6.9 billion • liabilities (mainly debt) (£6.7 billion) • net assets £2.9 billion • Without brand capitalisation the balance sheet would have shown net assets of only £0.2 billion • Corbett (1997) argues that this would have been an absurd situation

13. Further example of brand aquisition • GrandMet acquired Pet in 1995 at a cost of £1.8 billion • Again, the acquisition affected GrandMet's balance sheet • brands £3.8 billion • other assets £7.3 billion • liabilities (7.7 billion) • net assets £3.4 billion

14. Accounting issues surrounding intangibles

15. Accounting concerns • Is the intangible asset clearly identifiable • Does the company hold an unambiguous title to the asset • Could the intangible asset be sold separately from the business • Does the intangible give rise to a “premium” not earned by other companies?

16. Tangibility and uncertainty Replicated plant and equipment Product modification Innovation Research and development New factory Staff training Most certain Most uncertain Source: Webster

17. Separable Not separable Wholly tangible (i.e. machine tool) Highly intangible (i.e. goodwill) Source: Wild and Secluna Tangibility and Separability: the Spectrum of Assets

18. Accounting methods for intangible assets

19. Accounting approaches to valuation • Cost based valuation • historical creation cost - how much did it cost to create? • current recreation cost - how much would it cost to recreate an identical intangible? • Market based valuation - evidence from sale or purchase of similar assets (i.e. individual brands, branded divisions or whole companies) • Income based valuation looks at the stream of income attributable to the intangible asset, based on: • historical earnings (i.e. multiple of earnings) • expected future earnings (i.e. discounted cash flow)

20. External influences on IC measurement and disclosure • Writing off expenditures on intangibles against profits or reserves seems wrong • Thus, there is considerable pressure on accounting bodies devise new accounting codes of practice (SSAPs/GAAPs) • Examples: • SSAP 13, 1989 - covers the treatment of R&D expenditure • Draft SSAP 22, “Accounting for Goodwill”

21. IC audits

22. Towards an IC audit • Various authors suggest an IP audit – see e.g. Brooking 1997 • Each company produces a taxonomy and set of checklists similar to Slide 3 above • Weights are applied to each item on the checklist – reflecting importance in achieving company goals • Large “dots” reflect very important and small less important • Position within the target reflects the perceived strengths (close to “bull”) and weaknesses (far from “bull”) of each asset.

23. Brooking’s “target”

24. Conclusions on IC audits • Majority of the 8 large dots (more) and 22 small dots (less important), in IP quadrant • Brooking argues • target is consistent with an IP dominant company (40% of listed assets are IP assets) • if the company is not intended to be IP dominant, then “severe changes are required” • 66% of the IP assets are below average in value, including the significant ones • Tracking likely changes over time, she argues • “The IC of this company looks like its in pretty bad shape and likely to get worse.”

25. Options valuation and optimal stopping techniques

26. Options values • Options pricing methods are potentially the way forward • Only method that really deals with risk • Applicable to every stage of creative process: • investment in R&D • decision to patent, etc. • decision to commercialise the invention • But: • Need information about wide range variables • Inventive process is a multi-stage decision – which makes the calculation very complex

27. Underlying principle • Black-Scholes→Merton→Dixit & Pindyck • equations that allow for changes in the degree of risk over time • in the D&P model • the benefits of waiting one more period • minus costs of waiting • = value of the option • often called optimal waiting models

28. Value of a real option The value of real option is determined by: • present value of project cash flows (+) • investment cost of project (-) • time remaining to invest in the project (+) • standard deviation of the project value (+) • risk free interest rate (+) Pitkethly (2002)

29. Optimal stopping rules • Use the distribution of possible returns to decide: • how much to do • how long to go on doing it • Uses the distribution to calculate a “reservation return” R* which indicates: • whether to do any R&D • whether to accept a given result, R, and exploit, R>R* • or carry on doing research