From the August 2009 issue of Investment Advisor • Subscribe!

The Affluentialist: The Importance of Valuing the Intangible

Determining credible values can help with advanced planning strategies

As we explored in last month's column about the importance of including intangible assets (patents, copyrights, trademarks, etc.) in any comprehensive plan, valuing those assets requires an approach similar to a business valuation. The relevant experts, such as intellectual property professionals, patent attorneys, and valuation analysts can help the advanced planning team with this task.

Although each type of intangible asset is different, a handful of factors help determine a credible estimate of value. Typically the greater the breakthrough, the more valuable the intangible asset. The breakthrough can come in the form of a valuable invention that solves a problem or an asset that can create a whole market that didn't exist before. A smudged carbon copy of an unpublished novel by an unknown author may appear inconsequential at first, but then it could follow a similar fate of the highly successful A Confederacy of Dunces, mentioned in last month's column.

If a client who is an engineer/entrepreneur and trailbike enthusiast, invents a different type of bicycle chain, the patent may not prove that valuable if it's just a variation of others available.

One of the preliminary barometers of value is the price a company would pay to use or distribute a protected creation. Other factors include uniqueness, size of the market, relative strength within the market, and term of rights (such as remaining years on a patent or copyright).

Valuation as Preventative

In creating a comprehensive financial plan for a client with complex wealth, an advanced planning group may need a valuation expert for gift, estate, and income tax planning. The expert appraisal serves another purpose beyond planning. It helps prevent the IRS from poking into the client's affairs and challenging the valuation. The IRS evaluates a case against a taxpayer by looking at its costs and potential return. "A good [expert valuation] report makes it more likely that the Service will have to expend more resources to assert its case, and will have a more difficult time trying to show that the taxpayer's position is somehow wrong," state Curtis R. Kimball and Timothy J. Meinhart, in Valuation Theory and Practice: Family Business Planning, an American Bar Association publication.

Hiring an expert after the IRS has come calling with a challenge makes the task that much more difficult since the required valuation may refer to a transfer several years earlier, for example. "The IRS has, also, made significant strides over the past few years in improving the level of business valuation expertise within its valuation engineering staff," note Kimball and Meinhart. "Although there can be no guarantee that the appraisal will withstand the scrutiny of a court, it puts the family in a better position to defend a challenge against discounts for lack of control and lack of marketability." A valuation report would also provide the substantiation for a valuation discount claimed for generation-skipping transfer.

Approaches to Valuation

Whatever intangible assets the client owns, a valuation will address these goals, which may have more or less significance depending on the nature of the asset:

o Determine the estimated value of the client's intangible asset;

o Calculate the appropriate royalty, license, or other market value for a third party to acquire use or ownership rights;

o Estimate the remaining useful life of the asset, and the rate of value change over time;

o Estimate the amount of economic loss if the asset isn't commercially marketable permanently or temporarily.

While the specific asset or circumstance will dictate which method is best for the client, they typically fall into three approaches: cost, market, and income. The valuation analyst will typically use multiple methods to gain a more complete picture of the value.

The market approach uses commercial transactions with similar assets to gauge value. The valuation analyst will identify the right marketplace for relevant information and reconcile his findings with the intangible asset to assess the value. If the client's asset is dissimilar to what's being licensed or bought in the marketplace, this approach may not work. Commercial price is not necessarily the same as the value, which is the expected price.

The cost approach looks at what a buyer would pay for a similar asset. This approach assumes that no buyer would pay more than the cost to create a similar intangible asset. The availability or scarcity of similar products in the marketplace affect the cost, and external factors can cause the cost to rise or fall. Valuation experts use this technique to estimate the value of intangible assets with unique characteristics, such as computer software, procedures, designs, etc.

The income approach is based on the present value of the client's required rate of return. The analyst may use different measures of income to calculate a value such as revenues, income, operating income, and cash flow.

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