Reilly’s ‘Six Rules’ of a credible IP valuation report
Any type of valuation report prepared for any type of intellectual property (IP) assets intended for any type of audience should adhere to the following six rules, Robert Reilly (Willamette Management Associates) told attendees at the BVR/Morningstar Summit on Best Practices in Intellectual Property Valuation, held in Chicago last week. The “Six C’s” of the IP valuation engagement, as Reilly calls them, include:
- Compliance. The report should do more than recite compliance with generally accepted professional standards; the analyst should identify which particular standards apply to the particular engagement and why, and then explain how the report complies. It should also identify and explain any litigation standards that apply.
- Competency. The report should also clearly state the analyst’s qualifications to perform the IP analysis. It should also clearly and precisely define the IP and the assignment.
- Completeness. The report should specifically make this assertion—and then, of course, it should set forth all of the analyst’s data, opinions, exhibits (supporting documentation), and conclusions. “Is the report sufficient to allow the reader to replicate the analysis and conclusion?” Reilly asked. “Does it ultimately answer the valuation assignment?”
- Correctness. In addition to confirming the valuation analysis and ultimate conclusions, the analyst should also check (and re-check) the report for typos and mathematical mistakes. “An error is an error,” Reilly said, and it can immediately impair credibility.
- Clarity. Is the IP analysis coherent and convincing? “Does the report flow from valuation assignment to data gathering to analysis to conclusion?” Reilly asked. Make sure you haven’t included any undefined terms or unsupported variables.
- Consistency. Is the report consistent with the analyst’s previous IP positions? “This is most important for litigation experts,” Reilly said, because opposing attorneys are sure to challenge your opinions based on prior reports and publications. But consistency is also important when reporting to management. If your prior opinions differed, be sure to explain what justifies the change in this case.
With IP, Reilly also thinks it's particularly important to be sure to explain why you chose not to use certain methods. As a valuation professional, you know that certain approaches or methods may not be effective for intangible assets--but the ultimate users of your report may not know the distinction. "Be sure to include a sentence such as 'I used these three methods, and did not use these other four methods because they weren't applicable' so that other users at least know that these were considered and rejected," he advises.
Three fallacies when tax-affecting
If you’re confused about whether to tax-affect, Mark Harrison (Meyers Harrison & Pia) asks you to consider some statistics that undermine the “29.4% benefit” that seems to often appear post-Bernier and Delaware MRI.
- Few private companies pay the maximum 40% C corporation rate every year–or any year. The model used in the Delaware MRI case compares pass through tax rates to the maximum (40%) tax rate. But, this isn’t true. In a small business, the profits may be small compared to compensation, or other fact patterns might be present. So, rather than taking 40%, it’s important to calculate the real likely tax rate on a year-by-year basis (for a multi-period analysis). It’s likely to be much less than 40%, and even if you drop it to an average of 30%, the benefits of S corp taxation are reduced to less than 1%.
- State taxing agencies offer fewer benefits to S corps–simply by adding a 4% pass-through state tax reduces the benefit of the federal pass-through. Omitting state taxation will overstate this tax-affecting value benefit.
- Actual distributions to owners are rarely at 100%–most corporations don’t distribute all their earnings, or distribute only to cover taxes. So, you need to look at actual distributions, and thereby adjust the implied corporate tax rate. The lack, consistency, ability, or timing of distributions all guarantee that a blind application of the Delaware MRI model will give you the wrong answer. “They also guarantee that you’ll be torn apart on cross-examination,” Mark warns.
Mark Luttrell (Mayer Hoffman McCann), who joined the panel with Mark Harrison, also pointed out statistically that over 90% of C corporations in the U.S. pay less than $10,000 in tax at the enterprise level. This confirms Harrison’s concern about using the actual federal tax paid when tax-affecting, rather than just plugging in the maximum tax rate.
An investment strategy based on IP value beats the market
Ocean Tomo tracks, at a macro level, the components of the S&P 500 market value. It’s a familiar graphic for those who do a lot of IP valuation, but it’s still a shock to realize that 79% of corporate balance sheets are made up of intangibles. “There’s a lot wrong with this number,” admits Michael Freedman (Ocean Tomo) last week during his session “IP Valuation and Management and Their Impact on Shareholder Value” at the BVR/Morningstar Summit on Best Practices in Intellectual Property Valuation.
“It’s not all copyrights and patents and trademarks—there’s goodwill and other intangibles included. But there’s still no better way to make the point that IP plays a dominant role in many valuations.”
Freedman concludes that investor value is going to be created by analysts who can correctly value IP. “There’s a caveat; there is more correlation in the market now than at any time since the ’87 crash.” So, at this particular moment in time, finding transparent value anywhere in this market is near impossible. Eventually, Freedman hopes that we’ll return to “a market of stocks rather than a stock market” and that IP value will be identifiable based on three criteria:
- The value of the technology
- The ability of the group to bring the technology to market, and
- The quality of the legal work that protects the IP
One way Ocean Tomo monitors potential IP value is to measure maintenance rates. Via regression analysis, they found 53 factors that gave them predictability. They create an “IPQ” grade and they can predict how likely it is that the patents will be maintained. “Our assumption is that IP owners wouldn’t pay to maintain their patents if they didn’t think they were worth more than the maintenance costs,” explained Freedman.
By combining this proprietary research with sector and other market trends (betas), OT has been able to create enhanced investment vehicles based on intellectual property value. For example, they have an enhanced NASDAQ fund, an enhanced S&P 500 Index fund, and others. “In all these cases we outperform their specific benchmarks with lower risk,” he claims. Evidence of this: OT’s 300 patent index (NYSE Euronext: OTPAT), the first IP indexed fund, invests in a diversified portfolio of 300 companies with the highest “innovation index.” Morningstar rates this fund 5-stars—and as the fund with the highest return over the last 3 ½ years.
Mike Pellegrino (Pellegrino and Associates), conference chair, asked Freedman about whether current financial accounting standards limit the success of their method. As Mike points out “Word is not on Microsoft’s balance sheet, but they bought Visio, so that is—typical of the misstatements in corporate balance sheets everywhere under FASB.” Freedman’s response: Ocean Tomo’s patented IP rating system relies on maintenance rates of patents—it’s not influenced by the financial data most other analysts live and die by.
Clarification: Court did not opt for Ibbotson’s supply side ERP
The recent item “Grabowski draws conclusions from ERP arguments in the Global GT case” (BVWire™ #96-1) reported: “…the Court rejected the use of Ibbotson’s “historical” equity risk premium, and instead opted for a significantly lower “supply-side” equity risk premium.” However, Roger Grabowski (Duff and Phelps) clarified the matter, stating “the Court did not opt for Ibbotson’s supply side ERP.”
Ibbotson’s lower supply side ERP was merely one brick in the wall used by the Court (among many “bricks”) to build a case against using the historical ERP, but the Ibbotson supply side ERP was not the ERP ultimately chosen by the Court. The ERP chosen by the court was the petitioner’s expert’s 6.0% estimate, which the Court based on many different things, including the SS ERP, ERP estimates based on historical data over longer time periods than Ibbotson, recent valuation research, and surveys. The fact that the lower ERP the Court settled on was similar to the lower SS ERP was coincidental only.”
The Court cited recent research, (including Pratt/Grabowski) (from the Client Alert, see below):
“…wealth of recent academic and professional writings that supports a lower ERP estimate…” that were put forth in the hearing. The Court went on to say that the “…relevant professional community has mined additional data and pondered the reliability of past practice and come, by a healthy weight of reasoned opinion, to believe that a different practice should become the norm...”
The Court also cited surveys:
“…also cites to a survey of finance professors, which found that the mean ERP taught by 369 professors is 5.96%, and a report of JP Morgan estimating the ERP to be in the range of 5% to 7%. Although the surveys cited by (petitioners’ expert) are not so compelling as to be conclusive, they suggest that current academic thinking puts the ERP closer to 6.0% than to 7.1%.”
The Court also cited other more long-term studies:
“If one is going to use an approach that simply involves taking into account historical equity returns, then one has to consider that very well-respected scholars have made estimates in peer-reviewed studies of long-term equity returns for periods much longer than Ibbotson, and have come to an estimate of the ERP that is closer to the supply side rate Ibbotson himself now publishes as a reliable ERP for use in a DCF valuation…”
Grabowski has offered Duff & Phelps’ Client Alert: “Delaware Chancery Court Fails to Adopt the Morningstar/Ibbotson Historical Equity Risk Premium (ERP)” to BVWire readers via BVR’s free downloads section here.
Measuring the value of IP for your corporation
Michael Porter (Harvard) has popularized the competitive forces theory–believing that you look for the areas of the highest margin and then jump in and try to develop products–after which you spend all your time fighting off competitive forces.
Patrick Sullivan (Intellectual Capital Management Group) cites an alternative and complementary approach–the resource-based theory. “This has the advantage that you can control it–you develop value by controlling assets that you have at hand. So it’s particularly applicable to intangibles value,” he told the audience at last week’s BVR/Morningstar Summit on Best Practices in Intellectual Property Valuation.
“We continue, particularly among our ‘ICM’ group of intangible asset managers, to believe that one of the most important thing to increasing value is to have an IP asset manager.” The ICM group meets three times a year to discuss this topic–“knowledge that can be converted to profits.” Sullivan has written books on what he’s learned from all the years of discussions on this topic, including Value Driven Intellectual Capital.
Sullivan respects accountants (“some of my best friends…”) but recognizes that financial accounting, even with fair value improvements, has severe limitations:
- It can’t quantify internally generated intangibles
- It can’t recognize projected future values, and
- It tends to only identify one value stream for each asset
So, whether for investment, management, licensing, or other reason, IP managers and appraisers are often left to non-financial accounting methods.
Why do companies issue restricted stock?
When using restricted stock studies, you need to ask this question. It can influence the discount, points out Jay Fishman (Financial Research Associates). Discounts are smaller if redemption is likely to be soon, of course, but the transactions that supposedly “arms length” may, in fact, turn out to have some sort of insider or warrant or other component that will affect their objective credibility. For that reason, Fishman argues that you really need to see the underlying data for restricted-stock derived DLOMs (or, he points out, for pre-IPO and other methods for deriving DLOM).
Experts: educate your attorney on subjective conclusions
“Measuring active and passive appreciation in separate property remains a complicated issue in divorce matters,” Stacy Collins (Financial Research Associates) told the audience last week at the BVR/Morningstar 3rd Annual Summit on Business Valuation in Divorce. That’s why “to be effective as an expert make sure you support your subjective conclusions,” added Mark Sobel (Greenbaum Rowe Smith & Davis). And “your job isn’t done until you have read the other expert’s report and highlighted areas that are subjective and areas that are appropriate for cross examination,” he added. “Letting the attorney know what the other expert has done that is subjective is a great way to attack,” Mark Harrison (Meyers Harrison & Pia) concurred.
Court decisions may force patent owners to reexamine patent value
Drew Voth (Grant Thornton) and David Binney (K&L Gates) present historic and current court rulings relating to the methods for companies to use when analyzing apportionment issues and the value of their patents in the most recent issue of Grant Thornton’s Business Valuation Monitor. “An important part of the value of a patent is how large a royalty it can command,” writes Voth and Binney. The authors discuss court cases that show “that one way, and in reality sometimes the only way, to generate a significant royalty stream is through litigation.”
The complete article “Recent court opinions impact patent valuation” is available here.
Acquisitions of failed banks increasing
In their recent newsletter Adams Capital, Inc. reported an increase in bank acquisitions with buyers purchasing at a discount and enjoying the benefit of FDIC loss guarantees. According to the firm “the largest asset acquired is usually the loan portfolio. Loan portfolio valuation provides the buyer and the FDIC with clarity on the amount and timing of the loss-share.“
For the complete report click here.
BVR congratulates Parnell Black and Judy O’Dell
“Every year, Accounting Today compiles a roster of the thought leaders and change makers in the profession,” writes Bill Carlino, Accounting Today’s Editor-in-Chief. This year two members of the BV community, Parnell Black, CEO of NACVA and Judy O’Dell, Chair, FASB Private Companies Financial Reporting Committee and president of O’Dell Valuation Consulting, were included in the publication’s 2010 Class of the Top 100 Most Influential People.
For the complete article click here.
Free webinar: the new FMV DLOM Calculator
By the end of the week, BVR and FMV Opinions will introduce The FMV DLOM Calculator at BVMarketData.com. This Calculator utilizes data in The FMV Restricted Stock Study and applies the same methodology FMV Opinions uses in-house. Based on a variety of financial metrics of the appraiser’s subject company, the Calculator streamlines the process for determining a discount for lack of marketability (DLOM) by automating the comparative analysis with restricted stock issuers and adjusting for market volatility and the additional illiquidity of private company stock. The Calculator also allows users to inflation-adjust all underlying restricted stock data. What would otherwise require hours is now accomplished in minutes.
Join us Tuesday, September 28th at 10am Pacific (1pm Eastern) for a free one hour webinar presented by Kyle Vataha of FMV Opinions – you’ll receive 1 CPE credit for attending. Kyle will demonstrate the use of the Calculator and answer your questions. Sign up here.
M&A market is stabilizing
“Entering the second half of 2010, the M&A market is well-positioned for a continued rise in activity thanks for major developments in key sectors,” according to the recent report, “Deal Drivers North America”, published by mergermarket in association with Merrill Datasite. The “Technology, Media and Telecommunications” sector had the strongest increase in deal flow over last year, followed by “Business Services” and “Industrials.”
For the 72-page report click here.
Valuing an architecture or engineering firm? Learn from the experts
Architecture and engineering firms will be the focus of BVR’s latest Industry Spotlight Series Webinar on Thursday, September 23. Presenters Ian Rusk and Michael O’Brien (Rusk O’Brien Gido+ Partners) will discuss valuation challenges, operations peculiarities, and emerging trends unique to this industry. For more information on “Valuing Architecture & Engineering Firms,” starting at 10:00 am PT/1:00 pm ET is available here. Two CPE credits available.
The bench and BV practitioners converge to resolve tax & legal issues
Join the experts on November 10 for the Advanced Summit on Business Valuation: Resolving Tax & Legal Issues, presented by Business Valuation Resources and Georgetown School of Law. It’s a perfect advanced tax valuation add-on to the AICPA National BV Conference the two days before in Washington.
Among the sessions are these two important panel discussions on valuation and tax matters:
- Expert appraiser Jay Fishman (Financial Research Associates), a member of the IRS advisory committee, will host three IRS employees in a discussion of how the agency handles valuation issues and where these issues are taking us. This session will feature Diane Ryan, Chief of Appeals, Susan M. Kurzweil, National Business Valuation Coordinator, and Jeffrey Myers, Manager, Engineering & Valuation
- Conference co-chair Hon. David Laro, long the most widely read federal tax judge in the BV community will join his colleagues Hon. Robert Wherry and Hon. David Gustafson in a discussion of how the federal tax court looks at business valuation issues in the context of legal proceedings.
For full descriptions of these and all other sessions click here.
ASA and CICBV members meet in Miami
The second of the “big three” BV conferences starts a week and a half from today. Join U.S. and Canadian business appraisers in Miami for “a wave of momentum” – BV momentum that is. The ASA and CICBV have put together a conference featuring the following tracks:
- Valuation for financial reporting
- Transactions/advisory services
- Fair market value/litigation, and
- A special post-conference international valuation seminar
The conference is scheduled October 4-6. For more information click here. And, of course, stop by the BVR booth to say hello!
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