Intangible property drives business value

Growing business value may be interpreted in many ways depending on one's point of view. To a business owner, it may mean increasing cash in the bank for a "rainy day fund" while keeping top employee talent busy and productive. To such outsiders as bankers or investors, growing business value is based on drivers that increase cash flow from operations. Short-term financial buyers or strategic buyers look for return on investment and payback time. From the perspective of bankers ... investors or ... prospective buyers, intangible property drives the business' value up or down.

Common examples of intangible property include the proprietary software, customer lists, customer loyalty and patented processes of a business. Other intangible assets that seldom surface in a business' financial statements include its brand image, sales processes and product know-how. The common element among valuable intangibles: They differentiate the company and drive up earnings.

Holland & Hart patent attorney Robert Ryan emphasizes the importance of intangible property based on the Ocean Tomo 2006 research on intangibles. In a recent presentation, Mr. Ryan observed that intangible property as a percent of cost (book value) in 1975 averaged 2 percent. By 2005, intangible property as a percent of cost (book value) had risen to 43 percent. In 1975, IP accounted for some 16 percent of market capitalization (public company value) on average. This figure rose to 80 percent by 2005. Wow!

In an Entrepreneur.com article, many business owners admitted that they did not have a good understanding of how intangible assets contribute to their companies' value to potential buyers. As a refresher, intangibles can be valued using three methods:

* The cost approach values the sum of actual costs the company incurred to develop the intangible asset, including development costs, patent application costs and prototyping costs.

* The market approach compares the company's intangible asset values to those of similar assets offered in the market. These market methods are similar to the real estate model of finding asset comparisons. The challenge presented by the market approach (and it can be a big one) is identifying relevant matches in the industry that also are comparable on the basis of the size of the marketplace in which the intangible asset is used.

* The income method to valuing intangibles estimates the revenue and earnings that the intangible asset will generate over time in order to establish the intangible asset's value. The income method takes a similar approach to the internal rate of return computation used to value investments. Internal rate of return is defined as a rate of return used in capital budgeting to measure and compare the investment's profitability.

The income approach takes a few steps in computing the value of the intangible property. The first step is to determine the current income stream produced by the intangible property. Next, the intangible property's income is projected conservatively for five to 10 years into the future. The total projected income then is discounted monthly, quarterly or annually to the present. With such intangible property as brand names and customer loyalty, the approach compares the annual income stream to unbranded business, or to a company that has intangible property that is considered to be an industry median value standard.

Once the intangible property is analyzed by one method or another, the business owner may be pleasantly surprised to learn how to increase its value, or at least gain a better understanding as to how much that intangible property contributes to the company's overall value.

Scott T. Wait, CPA, is a shareholder in RS Wait of Reno and a managing director of The McLean Group LLC. Contact him at 825-7337 or at scott@rswait.com.