Legal Issues and Valuation of Tangible Assets, Patents and CopyrightsMay 16, 2016
In this article, we will explore the methodologies for valuing general classes of tangible assets as well as those methods applied to valuing intangible assets consisting of patents and copyrights. It has become increasingly clear that legal considerations can play an important role in asset valuation. Accordingly, we will also examine the impact of legal issues upon the valuation of tangible assets, patents and copyrights.
Purposes of Valuation
Understanding the nature and value of the assets of a business is essential for a variety of reasons. In the general context of operations, asset values are an important consideration in formulating asset management and protection policies. Asset valuation can also bear upon the amount of credit that may be made available to a business. In the context of a sale or other strategic transaction, asset valuation is obviously a central consideration in structuring and pricing the transaction. Other purposes for which asset valuation may be important include, among others, financial and tax reporting, capital budgeting, litigation proceedings and purchase price allocations in connection with an acquisition transaction.
Valuation of Tangible Assets
Types—Fixed (PPE) and Current Assets
The practice of measuring assets at estimates of their current or fair value has increasingly replaced the practice of reporting assets at historical cost. While historical cost was assumed to provide "reliable" information, fair value is assumed to provide "relevant" information upon which management can rely in making its business decisions.
The meaning of "fair value" can differ substantially by asset class. Moreover, assets may be valued differently depending upon the context. For financial reporting purposes, in general, accounts receivable are reported at the amounts an entity ultimately expects to collect; inventory is reported at the lower of cost or market value, where market value is the sales price less sales costs; and investments are marked to market value each period with unrealized gains and losses being recognized.
However, for valuation purposes outside the context of financial reporting, the "fair value" of current assets and long-term fixed assets, such as property, plant and equipment (PP&E), is normally based upon one of three approaches: cost, market or income. As discussed below, the market and income approaches consider the future benefits the PP&E may provide whereas the cost approach considers the cost to obtain or reproduce the asset in its present condition.
Asset-Based or Cost Approach: The "asset-based" or "cost" approach is predicated on the assumption that a prudent buyer would pay no more for an asset than it would cost to purchase the asset (tangible or intangible) at current market prices. This approach requires estimating the individual market values of the assets to derive an adjusted value. For example, in the case of inventory, an asset-based approach may be replacement cost or net realizable value, which is the amount for which it could be sold less any sales costs.
Market Approach: This approach is predicated on an active marketplace where similar assets are actively bought and sold. Some assets are actively traded, making the determination of fair value straightforward. However, where assets are not actively bought, sold, licensed, or otherwise traded, it becomes necessary to engage an experienced valuation professional to analyze and make adjustments to identified comparable asset values in order to arrive at an appropriate value for the asset being evaluated. Of importance in the market approach is the process one uses to identify the comparable assets. The context in which the comparable asset or transaction occurred may render the asset or transaction not at all comparable. In addition, differences in significant financial variables, risks and prospects must also be analyzed. In spite of these challenges, this approach can provide a reliable method for determining fair value.
Income Approach: The income approach is based on the present value of the future earnings or cash flow expected to be generated by the assets. Under the discounted cash flows method, earnings or cash flow projections provided by the business for a future period are discounted at a rate commensurate with the degree of risk associated with the assets of the business. A residual or terminal value is also added to the present value of the earnings or cash flow to quantify value beyond the projection period.
When practical, value is determined utilizing several of the methodologies described above in order to establish greater reliability of fair value.
There are numerous legal considerations that can impact the valuation of tangible assets. In the case of fixed assets consisting of PP&E, one should consider, first and foremost, whether the assets are owned or leased. In the case of owned real estate and buildings, it is critical to understand whether there are any defects in the chain of title, any adverse interests or any consensual or statutory liens. Whether leased or owned, a review and inspection of the PP&E should be undertaken as part of the valuation process to determine the condition of the properties and whether they comply with applicable laws. To the extent manufacturing facilities have not been inspected, or are determined not to comply with all zoning, health, safety and environmental regulations, the value of those assets may be adversely impacted. For example, in valuing a facility subject to unremediated environmental conditions, estimated clean-up costs and/or liability exposure will directly affect valuation.
With respect to current assets, such as inventory, it is important to determine whether the assets are owned or held on consignment for sale and, if owned, whether the assets are subject to third party claims. Valuing inventory which is owned but subject to a third-party lien or security interest will need to take account of the amount of the obligations secured by the lien. Consigned goods may have value based upon sale margins, but, obviously, will not be valued in the same manner as inventory that is owned.
Valuation of Patents and Copyrights
Valuing intellectual property (IP) assets including patents and copyrights requires that one: (1) identify the IP assets and (2) assign a justifiable value to the identified IP assets. By their very nature, IP assets comprise intangible assets that are not as readily identifiable as a company's tangible assets.
In addition to the cost, market and income methodologies described above, IP assets may also be valued using a relief from royalty approach. In the relief from royalty approach, a hypothetical situation is created to estimate what an entity would pay to license its own intellectual property assets in an arm's-length transaction. The royalty rates used in this approach can be taken from one of several commercially available databases that accumulate terms from a multitude of licensing agreements. The value is then calculated as the present value of the avoided hypothetical royalty charges.
The approach one uses to determine fair value of IP assets is based on a consideration of the following four factors: (1) the uniqueness of the asset involved; (2) data availability and verifiability regarding the asset; (3) the context or purpose for which the valuation is performed; and (4) the experience of the analyst conducting the valuation.
Patents and copyrights are not defined by physical characteristics as in the case of tangible assets. As such, the valuation of patents and copyrights must take into account certain legal considerations that focus on three principal overlapping concerns:
- The scope and limitations of the rights represented by the patent or copyright;
- The ownership, control and enforceability of those rights; and
- The potential liability for third-party infringement claims.
Questions surrounding any of these basic points can diminish the value of a patent or copyright.
Scope and Limitations: In many ways, a determination of the scope and limitations of a patent or copyright will lead to an understanding of the breadth of a holder's right to operate under the relevant patent or copyright while, at the same time, excluding others from doing so.
Patents. Assessing the scope of a patent begins with a thorough review of all documentation evidencing the patent registration, including the underlying application and any assignments relating to the patent. Patents are registered with the United States Patent and Trademark Office. The scope of a patent is determined by the "claims" and "specification" set forth in the patent registration. In general, the broader the scope of the patent, the greater the potential value of the asset. On the other hand, patents containing numerous claims may suggest that it is easier to substitute elements of the patent to design around the invention. Furthermore, in order to determine the holders' legal rights to practice in an area without infringing the rights of others, a thorough search of similar registered patents should be undertaken.
Patents are often the subject of a third-party license, reseller or distribution agreement, either granted by, or in favor of, the relevant business. The value of a patent covered by such an agreement must be assessed in the context of the governing agreement and a complete analysis of the scope of, and rights afforded by, the agreement must be undertaken. For example, the non-exclusive license of a patent granted by a holder for a limited duration will generally have less of an impact on valuation than an exclusive license having a longer duration. Additionally, the governing agreement should be thoroughly reviewed to determine whether the parties are in compliance with its terms and conditions.
Copyrights. The scope and limitations of a copyright may be assessed generally by a review and analysis of the content of the copyright and related documents recorded with the U.S. Copyright Office. A review of the copyright documentation will reveal, for example, if a copyright claim is limited by the fact that the author did not create some of the material for the work. As in the case of patents, if there are licenses or assignments covering the copyrighted material, these need to be analyzed for content, scope, restrictions and compliance.
Ownership, Control and Validity:
Patents. In valuing a patent, it is critical to review the "chain of ownership" of the patent in order to determine that ownership and control may be clearly established. The starting point for determining ownership is to verify inventorship. In the United States, the original patent applicant is presumed to be the owner of a patent absent an agreement to the contrary.1 The file history of a patent should include a signed declaration by the inventor. If the declaration reflects an owner other than the business itself, the assignment documents in the file history must be reviewed to confirm that the patent was properly assigned to the business by the inventor. In many instances, an employee-inventor will assign inventions to an employer by a separate "work-for-hire" agreement. However, such an assignment should be properly documented and recorded. A review of the assignment records of the patent office will reflect whether the assignment was recorded and whether any other assignments were made.
In determining the validity and enforceability of a patent, it is also necessary to verify that application maintenance fees have been paid with respect to the patent. In general, fees are payable at the time of three milestone dates following the initial issuance of the patent.2 Failure to pay the required fee may result in the patent being deemed expired with the rights thereunder having lapsed.3
Patents are also subject to expiration upon the passage of time. The duration of a patent and its expiration date can be a complicated analysis requiring a careful review of the patent filing history. For example, the expiration date of a patent can vary depending upon whether the original application was filed prior to, or after, June 8, 1995.4 In any event, as the life of a patent ages, its value will likely diminish.
Copyrights. Registration of a copyright creates a presumption that the information contained therein is accurate, including the identity of the author/owner.5 In assessing the value of a copyright, ownership should be confirmed by reviewing copyright filing records. Although registration is not required to protect a creative work, it does confer certain benefits such as statutory damages for infringement of the copyright following registration.
As with patents, a copyright is subject to expiration. Calculating the term of a copyright can be complicated, depending in large part upon when the copyright was "published." Discussion of the rules governing patent and copyright expiration dates is beyond the scope of this article. However, in valuing a copyright, the potential duration of the rights afforded by the copyright will need to be considered.
Potential Infringement Liability:
The value of a patent or copyright can be adversely affected by the degree to which the asset may be subject to a third-party infringement claim. Where a patent or copyright is the subject of a legal proceeding or a warning letter from a third party, an obvious "red flag" is present which brings into question the value of the asset for the party claiming ownership rights. Intellectual property litigation can be complex, expensive and time-consuming. The resulting cloud of uncertainty will diminish the asset's value depending upon the nature of the infringement claim. Moreover, successful challenges can immediately invalidate the rights of a holder.
The complexities introduced by reference to "fair value" asset valuation increase the uncertainties that parties face when entering into agreements based on fair value. The judgment required to determine fair value may lead to a wide range of valuations. Many of the financial crises we have experienced in recent memory can be attributed, in part, to the subjective nature of some inputs used to determine fair value. Additionally, in valuing assets, irrespective of the methodologies utilized, one cannot ignore the significance of legal considerations with respect to the assets being valued.
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