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Mergers &
Acquisitions
Intangible Property Drives Business
Value
Scott Wait, CPA, McLean Group
Managing Director, Reno, NV
Summary: Growing business value sometimes can have
different meanings to different stakeholders. A business owner may
perceive real value in increasing cash in the bank for a “rainy
day fund,” for instance. Most bankers, investors, and prospective
buyers, on the other hand, assess value by looking at how to
increase cash flow from current operations. What drives value from
the perspective of bankers, investors, and prospective buyers is
intangible property.
Recent surveys indicate many business owners don’t have a clear
understanding of how to value intangible property, so it’s
important that valuators educate the owners they work with. The
three ways of assessing the value of intangible property are the
cost approach, the market approach, and the income approach.
Here’s how each approach works. |
Growing business value may be interpreted in many
ways depending on one’s point of view. To a business owner, it may mean
increasing cash in the bank for a “rainy day fund” while keeping top
employee talent busy and productive. To such outsiders as bankers or
investors, growing business value is based on drivers that increase cash
flow from operations. Short term financial buyers or strategic buyers look
for ROI (Return on Investment) and payback time. From the perspective of
bankers, investors or prospective buyers, intangible property drives the
business’ value up or down.
Common examples of intangible property include the business’ proprietary
software, customer lists, customer loyalty and patented process(es). Other
intangible assets that seldom surface in a business’ financial statements
include its brand image, sales process(es) and product “know how.” The
common element among valuable intangibles: they differentiate the company
and drive up earnings.
Holland & Hart patent attorney Robert Ryan emphasizes the importance of
Intangible Property (IP) based on the Ocean Tomo 2006 research on
intangibles. In a recent presentation, Mr. Ryan observed that IP as a
percent of cost (book value) in 1975 averaged 2%. By 2005, IP as a percent
of cost (book value) had risen to 43%. In 1975, IP accounted for some 16%
of market capitalization (public company value) on average. This figure
rose to 80% by 2005. Wow!
In a May 6, 2002 Entrepreneur.com article, many business owners admitted
that they did not have a good understanding of how intangible assets
contribute to their companies’ value to potential buyers. As a refresher,
intangibles can be valued using three methods:
The cost approach values the sum of actual costs the company incurred to
develop the intangible asset, including development costs, patent
application costs and prototyping costs.
The market approach compares the company’s intangible asset values to
those of similar assets offered in the market. These market methods are
similar to the real estate model of finding asset comparisons. The
challenge presented by the market approach (and it can be a big one) is
identifying relevant matches in the industry that also are comparable on
the basis of the size of the marketplace in which the intangible asset is
used.
The income method to valuing intangibles estimates the revenue and
earnings that the intangible asset will generate over time to establish
the intangible asset’s value. The income method takes a similar approach
to the Internal Rate of Return (IRR) computation used to value
investments. IRR is defined as a rate of return used in capital budgeting
to measure and compare the investment’s profitability.
The income approach takes a few steps in computing the value of the IP.
The first step is to determine the current income stream produced by the
IP. Next, the IP’s income is projected conservatively for five to 10 years
into the future. The total projected income then is discounted monthly,
quarterly or annually to the present. With such IP as brand names and
customer loyalty, the approach compares the annual income stream to
unbranded business, or to a company that has IP that is considered to be
an industry median value standard.
Once the IP is analyzed by one method or another, the business owner may
be pleasantly surprised to learn how to increase its value, or at least
gain a better understanding as to how much that IP contributes to the
company’s overall value.
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