These guidelines come straight from the IRS Examination manual.
Part 4. Examining Process
Chapter 48. Engineering Program
Section 4. Business Valuation Guidelines
4.48.4 Business Valuation Guidelines
18.104.22.168 Development Guidelines
22.214.171.124 Resolution Guidelines
126.96.36.199 Reporting Guidelines
The purpose of this document is to provide guidelines applicable to all IRS personnel engaged in valuation practice (herein referred to as "valuators") relating to the development, resolution and reporting of issues involving business valuations and similar valuation issues. Valuators must be able to reasonably justify any departure from these guidelines.
This document incorporates by reference, the ethical and conduct provisions, contained in the Office of Government Ethics (OGE) Standards of Ethical Conduct, applicable to all IRS employees.
Valuations of assets owned and/or transferred by or between controlled taxpayers (within the meaning of Treasury Regulation section 1.482-1(i)(5)) may present substantive issues that are not addressed in these guidelines.
Successful completion of a valuation assignment includes planning, identifying critical factors, documenting specific information, and analyzing the relevant information. All relevant activities will be documented in the workpapers.
A review appraisal may be the best approach to the assignment.
Valuators will adequately plan the valuation assignment. Their managers will supervise the staff involved in the valuation process.
Quality planning is a continual process throughout the valuation assignment.
In developing a valuation conclusion, valuators should define the assignment and determine the scope of work necessary by identifying the following:
Property to be valued
Interest to be valued
Effective valuation date
Purpose of valuation
Use of valuation
Statement of value
Standard and definition of value
Restrictions, agreements and other factors that may influence value
Sources of information
In developing a valuation conclusion, valuators should analyze the relevant information necessary to accomplish the assignment including:
The nature of the business and the history of the enterprise from its inception
The economic outlook in general and the condition and outlook of the specific industry in particular
The book value of the stock or interest and the financial condition of the business
The earning capacity of the company
The dividend-paying capacity
Existence or non existence of goodwill or other intangible value
Sales of the stock or interest and the size of the block of stock to be valued
The market price of stocks or interests of corporations or entities engaged in the same or a similar line of business having their stocks or interests actively traded in a free and open market, either on an exchange or over-the-counter
Other relevant information
The three generally accepted valuation approaches are the asset-based approach, the market approach and the income approach. Consideration should be given to all three approaches. Professional judgment should be used to select the approach(es) ultimately used and the method(s) within such approach(es) that best indicate the value of the business interest.
Historical financial statements should be analyzed and, if necessary, adjusted to reflect the appropriate asset value, income, cash flows and/or benefit stream, as applicable, to be consistent with the valuation methodologies selected by the valuator.
The valuator should select the appropriate benefit stream, such as pre-tax or after-tax income and/or cash flows, and select appropriate discount rates, capitalization rates or multiples consistent with the benefit stream selected within the relevant valuation methodology.
The valuator will determine an appropriate discount and/or capitalization rate after taking into consideration all relevant factors such as:
The nature of the business
The risk involved
The stability or irregularity of earnings
Other relevant factors
As appropriate for the assignment, and if not considered in the process of determining and weighing the indications of value provided by other procedures, the valuator should separately consider the following factors in reaching a final conclusion of value:
Marketability, or lack thereof, considering the nature of the business, business ownership interest or security, the effect of relevant contractual and legal restrictions, and the condition of the markets.
Ability of the appraised interest to control the operation, sale, or liquidation of the relevant business.
Other levels of value considerations (consistent with the standard of value in Section 188.8.131.52.2 (1) list item g) such as the impact of strategic or synergistic contributions to value .
Such other factors which, in the opinion of the valuator, that are appropriate for consideration.
Workpapers should document the steps taken, techniques used, and provide the evidence to support the facts and conclusions in the final report.
Valuators will maintain a detailed case activity record (Form 9984, Examining Officer's Activity Record) which:
Identifies actions taken and indicates time charged
Identifies contacts including name, phone number, subject, commitments, etc.
Documents delays in the examination
The case activity record, along with the supporting workpapers, should justify that the time spent is commensurate with work performed.
In reviewing a business valuation and reporting the results of that review, a valuator should form an opinion as to the adequacy and appropriateness of the report being reviewed and should clearly disclose the scope of work of the review process undertaken.
In reviewing a business valuation, a valuator should:
Identify the taxpayer and intended use of the opinions and conclusions, and the purpose of the review assignment.
Identify the report under review, the property interest being valued, the effective date of the valuation, and the date of the review.
Identify the scope of the review process conducted.
Determine the completeness of the report under review.
Determine the apparent adequacy and relevance of the data and the propriety of any adjustments to the data.
Determine the appropriateness of the valuation methods and techniques used and develop the reasons for any disagreement.
Determine whether the analyses, opinions, and conclusions in the report under review are appropriate and reasonable, and develop the reasons for any disagreement.
In the event of a disagreement with the report’s factual representations, underlying assumptions, methodology, or conclusions, a valuator should conduct additional fact-finding, research, and/or analyses necessary to arrive at an appropriate value for the property.
Valuators will make efforts to obtain a resolution of the case after fully considering all relevant facts.
The objective is to resolve the issue as early in the examination as possible. Credible and compelling work by the valuator will facilitate resolution of issues without litigation.
The valuator will work in concert with the internal customer and taxpayer to attempt to resolve all outstanding issues.
Arriving at Conclusions
Once the valuator has all the information to be considered in resolving the issue, the valuator will use his/her professional judgment in considering this information to arrive at a conclusion.
Valuators may not have all of the information they would like to have to definitively resolve an issue. Valuators, therefore, should decide when they have substantially enough information to make a proper determination.
Valuators will employ independent and objective judgment in reaching conclusions and will decide all matters on their merits, free from bias, advocacy, and conflicts of interest.
Valuators should prepare reports of their findings.
This section requires specific information to be included or addressed in each report.
The primary objective of a valuation report is to provide convincing and compelling support for the conclusions reached.
Valuation reports should contain all the information necessary to allow a clear understanding of the valuation analyses and demonstrate how the conclusions were reached.
The extent and content of the report prepared depends on the needs of each case.
Valuation reports should clearly communicate the results and identify the information relied upon in the valuation process. The valuation report should effectively communicate the methodology and reasoning, as well as identify the supporting documentation.
Subject to the type of report being written, valuation reports should generally contain sufficient information relating to the items in Identifying and Analyzing to ensure consistency and quality.
Reports written with respect to Reviewing shall contain, at a minimum, information relating to those items in Identifying and Analyzing necessary to support the revised assumptions, analyses, and/or conclusions of the valuator
Each written valuation report should contain a signed statement that is similar in content to the following: To the best of my knowledge and belief:
The statements of fact contained in this report are true and correct.
The reported analyses, opinions, and conclusions are limited only by the reported assumptions and limiting conditions.
I have no present or prospective interest in the property that is the subject of this report, and I have no personal interest with respect to the parties involved.
I have no bias with respect to the subject of this report or to the parties involved with this assignment.
My compensation is not contingent on an action or event resulting from the analyses, opinions, or conclusions in, or the use of, this report.
My analyses, opinions, and conclusions were developed, and this report has been prepared in conformity with the applicable Internal Revenue Service Valuation Guidelines.
Thursday, March 19, 2015
Tuesday, March 3, 2015
There are 50 ways to leave your lover and the number of ways to value IP is rapidly catching up. Already 25 acceptable methods have been identified in this fast-evolving area of valuation speciality. Here's an excellent summary from IPWatch
|25 Ways to Value IP|
Valuation analysts and IP professionals agree there are three standard methodologies to value IP:
- Cost Approach: The historical cost to develop an asset is sometimes used to determine its value. However, the cost to develop an intellectual asset is rarely representative of its ultimate value. This approach is less useful for intellectual properties used with products that have reached the market and generated revenues. Generally, the cost approach is better suited to analysis of intellectual properties and products that have not yet been developed commercially, or that could be re-created quickly, as it reflects the cost a company could avoid by purchasing, rather than duplicating, a similar development effort.
- Income Approach: The income approach calculates the present value of future income streams specifically attributable to the intellectual property asset. This method utilizes forecasted financial results based on factors such as historical financial results, industry trends, and the competitive environment.
- Market Approach: The market approach values intellectual properties by comparing the subject asset to publicly available transactions involving similar assets with similar uses. This provides a reasonable indication of value if an active market exists that can provide examples of recent arm’s-length transactions, with adequate information regarding terms and conditions.
- Relief from Royalty Approach: In the relief from royalty approach, a hypothetical situation is created to estimate what a business would pay to license its own intellectual property assets in an arm’s-length transaction. The value is then calculated as the present value of the avoided hypothetical royalty charges.
The decision of which approach to use is generally based on four factors: (i) how unique is the asset; (ii) how much data is available and verifiable; (iii) what is the context, purpose or objective of the analysis; and (iv) the judgment of the analyst which (one would hope) is based on extensive earlier experience.
In addition to the traditional methods used to value intellectual property, several alternative methods are available. Some are modifications of the orthodox approaches with which most are familiar, but many other choices exist to value these complex assets. Below is a brief summary of these; a detailed explanation of each methodology could fill websites. Instead, this serves as a brief introduction to alternative intellectual property valuation approaches.
As part of a still developing discipline, there are at least 25 alternative valuation techniques to be employed. I would encourage an interested reader to continue doing research on the methods shown here, if the details provided below are insufficient. This article is intended to serve as a cover of alternative IP valuation methods and not meant to provide a detailed explanation or how-to manual for valuing intangible assets. Some things in life offer the luxury of “one size fits all,” however, the orthodox valuation measures that most of us are familiar with — namely the income, market, and cost approach — are often modified even slightly to meet the needs of both the IP that is being measured, the data available, as well as the context of the valuation. The methods being explained below are frequently associated with a certain IP asset. An example of this is the Venture Capital Method, which is a technique that derives a value for a patent from the cash flows that arise over the asset’s life. Although it is similar to the income approach that utilizes a discount cash flow analysis (DCF), it possesses two differentiating factors: a fixed, non-market based discount rate is used and there is no explicit adjustment for the probability of success. We have broken them up into two groups: generally accepted and specialized/proprietary.
Group A – Generally Accepted
Brand Contribution Methodology: The Brand Contribution Methodology is another market-based methodology for valuing IP. The contribution made by the brand may be separated from the profit contributed from other elements of the business in multiple ways: 1) comparing costs charged by a manufacturer and distributor of the unbranded equivalent (also known as the “utility product”); 2) if one eliminates the value added by other assets, the appropriate return on capital employed with respect to the product may be deducted (this includes assets such as physical distribution systems, fixed assets, etc.); 3) the rate of return (or “profitability”) of the business can be compared with the rate of return of a comparable unbranded business (which is known as the “premium profits” method); and 4) comparing the premium price earned by the brand over the retail price of its comparable generic equivalent (known as the “retail premium” method).
Replacement Cost: When using the Cost Approach to value an intellectual asset, two separate methods under the cost approach shall be considered: the Replacement Cost method and the Reproduction Cost method. The Replacement Cost method aggregates the amount of money necessary to develop a replacement of the IP that provides the same functionality or utility, in the same stage of development as the IP being valued, as of the valuation date. It is important to note that the Replacement Cost measures the amount of money in today’s dollars, rather than the amount of money that was spent historically to develop the IP so inflation is accounted for. The logic behind this method is to calculate the amount, in today’s dollars, to provide an equivalent substitute. Finally, calculating the cost of an IP using the Replacement Cost method excludes the costs associated with any failed or ineffectual models.
Reproduction Cost: The Replication Cost method is very similar to the Replacement Cost method, but differs slightly in that it measures the aggregate costs necessary to develop an exact duplicate of the IP being valued, in the same stage of development as the IP being valued, as of the valuation date. Just like with the Replacement Cost, this calculation is done in today’s dollars to appropriately factor in for inflation. And unlike the Replacement Cost method, the Reproduction Cost method includes costs with associated prototypes.
Technology Factor Method: As the number of digital intangible assets rise, using The Technology Factor Method becomes all the more common because it is applicable only to technology. By measuring a technology’s contribution to a business’ total revenue, an asset’s value can be determined. Specifically, the Technology Factor Method is another method that is similar to the DCF method with respect to the calculation of an IP’s risk-free net present value. Once the NPV has been calculated, it can then be multiplied with an associated risk factor (what we will refer to as the “technology factor”). The Technology Factor value incorporates the intellectual property’s strengths and weaknesses associated with the related legal, market and economic risks.
Venture Capital Method: Analyzing the value of future cash flows over an asset’s life is a common technique used to value intellectual property, which is precisely how the Venture Capital method works. Although similar to the common DCF method, it is different in that a fixed, non-market based discount rate is used (generally, a rate of between 40 to 60 percent used). Additionally, no specific adjustment is made to account for the probability of success (e.g., a patent’s success). Unfortunately, the Venture Capital method’s weakness is such that it does not account well for specific risk factors associated with patents. Moreover, it assumes cash flows are static and the independent risk factors (new patent issuance, patent challenges or declared in valid, patent infringement suits, trade secrets, foreign governments’ failure to comply with Patent Cooperation Treaties, etc.) are marshaled. It is the simplicity of this method that harms its accuracy/credibility.
The Concept of Relative Incremental Value: This methodology works when one is trying to represent some percentage of value of an individual asset that is associated with a larger trademark or patent portfolio. For example, if an underlying trademark or brand has a value of $100 million, and the domain name associated with it is generating 10% of revenues (e.g.), then one can allocate a relative value of 10% of the total or, $10 million dollars for the domain name.
Decremental Cost Savings Valuation: This is the method that quantifies a decrease in the level of costs being experienced by the IP owner / operator. If, in fact, the IP owner can quantify lower levels of capital or operating costs connected directly with the ownership of the IP; then those lower costs can be a direct measurement of the value of the specific IP.
Enterprise Value Enhancement: The valuation analyst establishes the value of the IP owner’s overall business enterprise value as a result of owning the IP – and then compares that to the business enterprise value if the owner did not, in fact, have or control the IP or was not able to use it in its business enterprise. The value of the IP then would be the difference between the total business enterprise value and the business enterprise as calculated without the IP.
Imputed Income Analysis: A subset of traditional income approach methods, this imputed income analysis can be used quite effectively in valuing a domain name or sub brand attached to a trademark; or in valuing flanker patents for a core patent portfolio. In the case of a domain name, value is established by looking at the activity generated by the domain name and associated website assets, relative to the overall value of the core trademark and brand bundle. Therefore, one is able to estimate through imputation the relative value of a domain name to its parent trademark.
Income Capitalization or Direct Capitalization Methodology: This is a method sometimes used to estimate the value for intellectual property that has no predetermined statutory expiration (like trademarks) and for which net income (royalties or profit) is not expected to vary greatly over time (due to contractually-defined license fees, for example). This involves taking an estimate of expected annual royalty stream (or profit) and multiplying this amount by a factor known as the capitalization rate.
Income Differential Analysis: This particular variation simply means that a company manufacturing and selling a product with a particularly strong trademark or unique technology will receive more income than a competitive company producing the same product but without the addition of the specific IP, such as the trademark or patent.
Liquidation Value: Found most often in bankruptcy situations, as the name implies liquidation value for any piece of IP is the lowest price that the asset is virtually guaranteed to be sold in a distressed situation. Used almost solely in bankruptcy, other distressed situations or time critical contexts, litigation value scenarios arise most often in a Chapter 7 bankruptcy.
Premium Pricing Analysis: Of all the variations to the income approach, this is perhaps the most easily understood – because the value of an asset is established by looking at the difference in the price that it can command in the market, typically at wholesale, compared to the average product in the market. The difference between these two prices is the price premium. This, then, is projected out on an annual basis and a net present value established.
Profit Split Methodology: A form of the income approach, it can be tricky to apply accurately: because the profit split method attributes a share or portion of a company’s profitability to a particular intangible asset. This method requires that the valuation analyst have the ability to understand the IP to such an extent that he or she can isolate and expressly separate the intangible asset’s profit generation potential from all the other business assets – and then allocate that portion of profit split to the company’s operations and capitalize that value over a number of years.
Group B – Specialized/Proprietary
Auction Method: There are several market-based methods of valuing IP using recent comparable or similar IP transaction between independent parties (“arm’s-length transactions”). One of these methods is called the “Auction Method.” If a hypothetically perfect auction market existed, several potential buyers that each had all available information regarding the IP would compete with each other to bid on the IP. Through this auction process, a market-based price of the IP would be determined through bidding.
DTA (Decision Tree Analysis) Based Methods: While many people are familiar with the DCF methods of valuing intellectual property, it comes with inherent weaknesses because it relies on selecting discount rates appropriate to the risk associated with the various stages in a property’s life. Not only does it require calculating the possible cash flows which might occur, DCF methods do not account for the various possibilities open to project managers (for example, the levels of risk if a patent lapses or is abandoned at differing stages along the process). Unfortunately, there is no “exact science” to be applied for these and experience is necessary to influence these decisions.
Assumptions can be built into the DCF model in an attempt to account for the possible outcomes as the result of management decisions. Using what is known as Decision Tree Analysis, a limited number of such managerial decision possibilities can be accounted for. It is important to note, however, that the Decision Tree Analysis should be based on an underlying DCF analysis of each branch. The recommended way to perform such analysis is to begin with the final decisions and work backwards in time, which will result in a present value.
The Decision Tree Analysis Method offers a big advantage over the DCF analysis: it factors the value of flexibility associated with a project. However, assumptions still need to be made regarding the discount rate (as does the DCF method). It is important to use a discount rate appropriate with the level of risk involved at each stage of a managerial decision associated with the development of a brand or IP.
The Brand Value Equation Methodology (BVEQ™): In this methodology, a core value for the trademark is calculated, and then each of the individual other assets attached to the core asset have their values calculated. Therefore, the sum of the core brand value plus the incremental assets becomes a total brand value. Expressed in an equation it as follows:
BVEQ = CBV + IVE1 + IVE2… IVEn
The Competitive Advantage Technique: This technique is best used when the subject company has a complex portfolio of intellectual property and works on the supposition that the IP is giving its owner an advantage over its competitors because of proprietary patents, technology, trademarks, software or other intangibles.
Monte Carlo Analysis of Value: This is a method to evaluate how possible future outcomes can affect the decision of whether or not to use a new piece of IP based on possible value – remember that this methodology is most useful in valuing early stage, non-commercialized technology; and, in particular, where there are many unknowns and numerous scenarios about the future development of the technology.
Options Pricing Technique (The Black-Scholes): Patent licensing shares at least one attribute with all other relevant business decisions: it involves risk. Where decisions involving financial risk are concerned, sound management principles suggest considering ways and vehicles to hedge that risk. One of the central vehicles to hedge risk in modern finance is an “Option.” A patent can be seen as the right to invest in or to license (or enforce through litigation) an underlying technology or product line, during the term of the patent. Therefore, an un-commercialized patent can be valued from this “options” perspective using, for example, methods such as those derived from the famous “Black-Scholes” model.
Snapshots of Value Approach: This is similar in nature to the business enterprise value approach in that the snapshots value is based on establishing two different values for a company: one, based on the assumption that the company has full access to the ownership of the intellectual property and intangibles, and the second snapshot of value based on the fact that the company does not have these assets. Measuring the difference between the two snapshots establishes the value of the IP or intangible asset portfolio.
Subtraction Method of Value or Benchmark Method of Value: Establishing the value of a company against another company by comparing them on a so-called benchmark basis is the premise of this method of value. In one instance, the benchmark value will be a company that owns a particular trademark or patent and the second value for a comparable company that does not have that same asset.
The ValCalc Methodology: A proprietary approach employed by our firm, it is a variation on the return on assets employed approach (see above). ValCalc establishes the economic return that each intangible asset class should be earning. Calculations of adequate return are applied also to all classes of tangible assets within a company. Then the return for each intangible asset is calculated as a result.
Valmatrix Analysis Technique: This proprietary system was developed by our firm more than two decades ago and employs a matrix of the twenty most important predictors of value for a trademark, patent or piece of software. The predictors for each of these types of IP are, of course, unique. They are used in a common manner, however: To score a given IP asset against its peers on a numerical scale. Value is therefore established relative to similar trademarks or patents.
An important side note for the interested reader: whenever possible, we recommend the use of multiple valuation techniques when performing a valuation analysis. This is especially true with intangible assets because active markets may not exist and assumptions need to be relied on in making valuation conclusions. Moreover, uncertainty may develop if one depends on a single methodology to value an IP asset (especially a particularly complex family of technologies or brand assets). History has taught us that, as with any new practice, the evolution of methodologies will be ever-lasting.
Valuing and analyzing intellectual property is still at a premature stage, the field itself hardly more than a few decades old. As the process continues to evolve and experts refine a multitude of methodologies, the art of valuing IP will continue to witness developments, innovation, revision, and diligent progression of techniques to value intellectual property and intangible assets. In all probability, the techniques listed above will either be outdated or refined further to become industry standards.