A deeper look at valuation of intangibles

In a recent NNBW article authored by Scott Wait, he speaks about intangible property being a significant driver of the value of a business. He gives some examples of intangible properties and indicated that they normally do not appear on financial statements the point being that assets which cannot be seen or touched are often valuable because they contribute to, or are even the major reason for, a business' profitability. Mr. Wait also gives the three approaches that are applicable to valuing intangibles, i.e. cost, market and income approaches. Since I fully agree with the contents of Mr. Wait's article, my intention is not to take issue with anything therein, but to merely expound somewhat on what he has discussed.

Frequently, the values of intangibles are not separately identified in financial statements but, instead, a value may be ascribed to goodwill, which is really a conglomeration of all the components of intangible assets. However, goodwill does not necessarily appear on balance sheets and, in fact, often it does not. If goodwill exists when a business is being valued for such purposes as a purchase or sale, gift or estate tax reporting or a divorce, then the value of the goodwill (if not segmented) will be inherent in the total value of the business enterprise. Without getting into a detailed discussion of the various valuation methodologies, an example of how the existence of goodwill value is determinable is by applying an appropriate capitalization rate to the business' cash flow, i.e. dividing a representative cash flow amount by a capitalization rate, and comparing the result to the fair market value of the business' net tangible assets (tangible assets minus liabilities). To the extent that the capitalized cash flow, i.e. the value of business, exceeds the fair market value of the net tangible assets, a goodwill value exists. Thus, the value of the business that was arrived at consists of the fair market value of the assets minus liabilities that appear on the balance sheet plus the intangible characterized as goodwill.

Mr. Wait gives examples of specific types of intangible property, such as "proprietary software, customer lists, customer loyalty and patented processes." It should be noted, however, that many of these types of intangibles, such as customer loyalty (as opposed to customer lists or contracts), stability of the work force or the location of a business are particularly qualitative in nature and are often extremely difficult, if not impossible, to meaningfully value separately. That is not to say that situations do not arise where these intangibles need to be valued. The point I want to make is that, collectively, the value of all intangibles are inherent in the value of goodwill, and that at least some intangibles cannot be specifically identified, let alone quantified. Furthermore, when valuing businesses, often there is no reason to attempt to separately quantify those components of goodwill that can be recognized or identified, as the business' earnings or cash flow, which, as under one of the valuation approaches, is capitalized to arrive at a total value for the business, actually reflects the results of the combination of the components of goodwill.

With that being said, there are certain intangible properties that can be valued in meaningful ways and, when valuing such assets individually is indicated, one or more of the three valuation approaches (cost, market and income approaches) are applied. Some examples of intangible properties that are often valued are licenses, patents, trademarks, customer lists, proprietary software, franchise agreements, various other types of agreements and contracts, etc. Many of these kinds of intangibles are characterized as intellectual property. Valuation of these assets are performed for such purposes as when damages for infringement or contact breaches are litigated, when claiming losses covered by insurance, when liquidating of a business in bankruptcy, and for certain financial statement reporting requirements under generally accepted accounting principles.

As Mr. Wait indicates in his article, there are the three approaches used in valuing intangibles (as there are in valuing businesses or real estate). Different methods exist under each approach, and more so under the income approach than under the other two approaches. The use of any one method or a combination of methods depends on the nature of the intangible and the purpose for which it is being valued. Also, among many important factors to be ascertained when valuing intangible property are: the valuation date of the intangible, as the value could value materially as of different points in time, and the useful life of the intangible, which depends on its legal life, contractual life and/or some other condition that determines the end of its viability.

When a business enterprise is being valued as a whole, the valuator needs to decide which approach or combination of approaches to use, and which method or methods under the one or more approaches to apply. If the asset-based approach is used, then besides ascribing fair market values to the individual tangible assets, a determination needs to be made as to which intangible assets can be identified, and valued as well. (As mentioned above, one or more of the three approaches are to be used to value each such intangible asset.) If the income approach or market approach is used, the benefit of the intangible property is probably inherent in the earnings of the business, at least to some extent. When arriving at a capitalization rate under the income approach or a multiple under the market approach, the degree of significance of intangibles should be reflected in the capitalization rate or multiple to the extent such benefit is not already inherent in the earnings of the business.

Recognizing the existence of intangible property is necessary when performing valuations of business enterprises, but in many if not most situations, separate valuations of these intangibles is not fundamental to the valuation process, or not even practical. However, if your business needs to be valued, then your valuation expert will need to decide which approaches and methods are appropriate under the circumstances. You should always be able to feel free to discuss with your business valuator the methodology being used by him or her.

Richard M. Teichner, a certified public accountant, is manager and sole member of Teichner Accounting Forensics & Valuations, PLLC in Reno. Contact him at 828-7474 or accountingforensics@gmail.com.