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. Human Capital Relational Capital Organisational Capital
Intellectual Capital
Human Capital
Relational Capital
Organisational Capital
Intellectual Property
“Sociological” Skills and Capital
“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
New factory
Staff training
Research and development
Most certain
Most uncertain
Source: Webster

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

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, covers the treatment of R&D expenditure
Draft SSAP 22, “Accounting for Goodwill”
SSAP – statements of standard accounting codes of practice
GAAP – generally accepted accounting principles

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

30. Strategic issues

31. Measurement versus Disclosure
Measurement of IC is imperative
as organisations become more “knowledge-based”
increasingly managing intangible items embedded in production activities, products and services
However, the knowledge-base of the company
defines its core competencies
measures of IC provide information of value to competitors (i.e. about strengths and weakness)
Advantages because disclosure enables the capital market to
determine the true asset base of the company
determine a correct market valuation
loan funds secured against intangibles

32. What form of reporting
The unresolved debate amongst accountants reflects the uncertainty about the way forward, i.e.
“… a complete revamping of financial statements, so that they reflect the growing knowledge base of companies.” [Brennan, 1992]
or a new financial statement, to
“… contain expenditures that have not yet been classified as an asset or expense at the company’s financial statement date. In a sense this statement represents a place where expenditures can sit in a holding pattern until their status as a potential asset or potential expense is resolved.” [Rennie, 1999]