Thursday 28 August 2008

Cost-based valuation: is it a live issue?

An article by Simon Rowell, "Understanding Intellectual Property Value", was published earlier this month on Reviewing IP methodology valuations, it inevitably discusses the cost-based, market-based and income-based techniques. On the cost-based methodology it says this:

"... This method looks at the historical cost incurred to develop and create the intellectual property. ...

There are many inherent problems with the cost approach. The most significant is that it fails to reflect the earnings potential of the intellectual property. The value of intellectual property is derived from its earning potential, and not its cost. ...

If the intellectual property offers significant economic advantage in an active market, the use of the cost method is likely to understate its value. If, on the other hand, development has been inefficient or lengthy, the use of the cost method might overstate its value. Also, for many identifiable intangible assets, it may not be possible to develop a replacement, or it may not be possible to estimate the replacement cost.

In its favour, the cost approach is useful as a readily calculated bottom-line valuation".

All of this is fine. But now here comes my confession of ignorance. I have never, in my admittedly limited and subjective personal experience, seen a live example of the cost approach that has ever been used for anything to do with IP rights. Does anyone in fact use it? Or does it only exist in articles and talks on IP valuation as an example of something that isn't much use?

If readers can enlighten me, perhaps referring me to examples of active use of the cost-based approach, I'd be very grateful. If it seems that no-one does use it, can we make all articles and talks on IP valuation one paragraph shorter by dropping it?


Michael F. Martin said...

In the U.S., FAS 141 goes into effect later this year. It permits R&D to be capitalized as a balance sheet asset. This is bad if you believe (as I do) that cost measures of IP-value will create perverse incentives for management.

The larger point is that cost and comparables methods are terrible because of the incentives they create. Revenue-based methodologies need to get much better. In particular, I have advocated elsewhere that we could make better use of frequency-averaged measures of revenue (such as turnover rates) in assessing the impact of new inventions on overall profitability. Not all inventions show up as obvious changes in time-averaged sales and costs of sales. But all valuable inventions should have some measurable impact on production.

Julian said...

The valuation of IP has been the subject of discussion in so many articles that I’ve (almost) stopped reading them – which may concern the publishers of LES Nouvelles!

It seems that it’s an area where lawyers and accountants will never see eye to eye and no one method is the right method in all circumstances – that’s the easy point to make. As for the cost-based approach, I’ve seen it used many times where it’s the only method available at the time in question, e.g. for assessing tax or duty on the value of an acquisition which relates to or includes IP assets. The cost-based approach, of course, is utterly irrelevant if one is looking for a true, commercial value.

At most it may be a “sanity check” and is used in commercial negotiations, perhaps:

haggling over damages for infringement – not that a court would accept it, but perhaps of some relevance if diminution in value is an issue
to justify a purchase price or licence fee (up or down)
to encourage investors, many IMs or prospectuses will include a “valuation” on this basis,
but it’s hardly reliable.

Not sure that one can discard it all together but I’d never give it any credibility.

All the best,