The valuation of IP & Trade Secrets

4 months ago by in Patent Management, Patent Policy, Patent Strategy, Valuation Tagged: , , , ,

Any business professor will tell you that the value of companies has been shifting markedly from tangible assets, “bricks and mortar”, to intangible assets like intellectual property (IP) in recent years. IP in its various forms is increasingly used as the basis of many business and commercial transactions.  It is fundamental for company valuations (merger, acquisition, bankruptcy); negotiations (selling or licensing); dispute resolution (fair recovery and quantification of damages); fundraising (bank loans and raising capital); assisting in decision making (corporate strategy); and reporting (tax and accounting).

Intangible Assets

An intangible asset is an asset that lacks physical substance and includes patents, copyrights, franchises, goodwill, and trademarks.

The International Accounting Standards Board standard 38 (IAS 38) defines an intangible asset as: “an identifiable non-monetary asset without physical substance.”

IAS 38 specifies the three critical attributes of an intangible asset to be …

  • identifiability
  • control (power to obtain benefits from the asset)
  • future economic benefits (such as revenues or reduced future costs)

IAS 38 contains examples of intangible assets such as customer lists, copyright, patents and franchise agreements.

The Value and Valuation of Trade Secrets

The terms value and valuation and their cognates and compounds are used in a confused and confusing but widespread way in our contemporary culture, not only in economics and philosophy but also and especially in other social sciences and humanities. Their meaning was once relatively clear and their use limited. Value meant the worth of a thing, and valuation meant an estimate of its worth.

This blog will explore the subject of the valuation of one particular form of IP, namely trade secrets.Why trade secrets? Well, IAS 38 clearly indicates that a trade secret is also an example of an intangible asset, so long as it meets the three critical attributes – identifiability, control and future economic benefit. Trade secrets are a very important part of any IP portfolio. It is no exaggeration to say that virtually every business possesses trade secrets, regardless of whether the business is small, medium or large.

Trade secrets are an important, but oftentimes an invisible component of a company’s IP portfolio of assets. However, trade secrets can also be the crown jewels within the portfolio.

Why Conduct a Trade Secret Valuation

Before delving into the details of the valuation of a trade secret, it is important to appreciate that the rationale for conducting such a valuation may vary.

  • For management information purposes
  • For strategic planning
  • For value reporting
  • For accounting purposes
  • For liquidation reasons
  • To support a legal transaction
  • For licensing
  • For litigation support
  • For dispute resolution
  • For taxation planning and compliance
  • For fundraising purposes

Transfer Pricing

Throughout this blog, one particular valuation rationale will be analyzed, namely transfer pricing. Transfer pricing is probably the most important issue in international corporate taxation. In taxation and accounting, transfer pricing refers to the rules and methods for pricing transactions between enterprises under common ownership or control.

A transfer price is the price at which members of a group transact with each other, such as the trade of goods and services between group members..

Transfer pricing also comes into play when the transaction between group members involves intangible assets and IP like trade secrets. In other words, transfer pricing is not limited to just tangible assets. Due to the rather broad the definition of intangibles for transfer pricing established by the OECD, the scope of the valuation as well as the resulting value will often differ from analyses performed for accounting and management information purposes; as stated in the OECD Guidelines (paragraph 6.7):

Intangibles that are important to consider for transfer pricing purposes are not always recognized as intangible assets for accounting purposes. For example, costs associated with developing intangibles internally through expenditures such as research and development and advertising are sometimes expensed rather than capitalised for accounting purposes and the intangibles resulting from such expenditures therefore are not always reflected on the balance sheet. Such intangibles may nevertheless be used to generate significant economic value and may need to be considered for transfer pricing purposes”.

With trade secrets being a prominent example of Intangibles that are not being reflected on the balance sheet, but which may nevertheless generate significant economic value, it is evident that trade secrets cannot be disregarded for transfer pricing purposes. Trade secrets are explicitly recognized within the OECD Guidelines in Chapter VI Section A.4.2.

Tax practitioners which fail to identify relevant trade secrets as well as to develop a clear understanding of the attributable economic value face a high degree of uncertainty in respect to the question whether their transfer prices reflect an arm’s length compensation for the intangibles contributed by individual group members. Hence, with the growing importance of intangibles as the core value drivers within highly integrated value chains, understanding how to properly cope with intangibles and IP like trade secrets in transfer pricing is one of the key challenges faced by tax practitioners. Conducting a thorough stock-tracking analysis and compiling a respective analysis will be invaluable first steps to reduce uncertainty and risks.

The Requirements for Trade Secret Valuation

Conducting an IP valuation exercise requires transparent inputs, reliable and sufficient data, and objectivity of the person conducting the valuation. This applies also if the IP in question is a trade secret. Ideally, the valuation of the trade secret should have …

  • Transparency – Qualification of the valuation inputs, assumptions, risks, sensitivity analysis, and disclosure
  • Validity – Valid inputs and assumptions as of the value date.
  • Reliability – If a valuation is repeated, it should reliably give a comparable and reconcilable result
  • Sufficiency – The valuations should be based on sufficient data and analysis to form a reliable conclusion
  • Objectivity – The appraiser should conduct the valuation free from any form of biased judgment
  • Various financial and legal parameters – When performing a monetary IP valuation, various financial and legal parameters should be taken into account

From a transfer pricing perspective observing and documenting the above requirements will greatly contribute to the defensibility of the valuation. Tax practitioners need to be aware of in this context that tax authorities are extremely sensitive about the effects of information asymmetries. The basic assumption here, whether justified or not, is that tax authorities are generally at a disadvantage when assessing transactions involving intangibles. As a result, they will frequently second guess the valuations during tax audits. The recent discussion in the context of the BEPS point towards an increased (even reversed) burden of proof for taxpayers, as the OECD explicitly stated in the implementation guidance for hard-to-value-intangibles (BEPS Action 8, Public Discussion Draft, 23. May 2017) that:

“This guidance protects tax administrations from the negative effects of information asymmetry by ensuring that tax administrations can consider ex post outcomes as presumptive evidence about the appropriateness of the ex ante pricing arrangements. At the same time, the taxpayer has the possibility to rebut such presumptive evidence by demonstrating the reliability of the information supporting the pricing methodology adopted at the time the controlled transaction took place”.

Without observing the above requirements for the valuation process, rebutting presumptive evidence (hindsight) presented by tax authorities will be challenging indeed.

Trade Secret Valuation Techniques

Let’s now delve into the details. There are a number of techniques / methods in use when conducting IP valuation exercises. Here are some of the quantitative IP valuation methodologies used.

Income approach

The income approach measures the value of the IP by reference to the present value of the economic benefits expected to be received over the remaining life of the IP

Market approach

The market approach measures value based on what other purchasers in the market have paid for assets that can be considered reasonably similar to those being valued

Cost approach

The cost approach measures the value of a IP based on the cost invested in building the IP, or its replacement or reproduction cost

Discounted cash flow

DCF analyses use future free cash flow projections and discounts them, using a required annual rate, to arrive at present value estimates.

Typically discounted cash flow is the methodology used when conducting a trade secret valuation exercise. Discounted cash flow analysis is a method of valuing an asset using the concept of the time value of money. All future cash flows associated with the asset are estimated and discounted by using cost of capital to give their present values.

When conduction a discounted cash flow analysis in the context of transfer pricing (i.e. a sale of intangible assets and / or the relocation of corresponding functions), one should be aware that the valuation should consider the perspective of the buyer as well as the perspective of the seller (i.e. at arm’s length the buyer will generally anticipate to earn higher profits from the use of the intangibles than the seller and the parties will negotiate a price within a corresponding bid-ask range).

Considerations

Here are some of the rational economic considerations when attempting to calculate the valuation of a trade secret. They may be broken down into four ‘buckets – costs, timing, benefits and risks. These are the inputs as such which feed into the discounted cash flow valuation calculation.

Associated Costs

Investment outlays. The economic outlay to create or develop the trade secret. This may include such details as the time taken to develop the trade secret, time taken to test it, labour costs involved, investment in physical capital (e.g., equipment, property, etc.) plus other related expenses.

Protection outlays: The economic outlay to provide reasonable protection to the trade secret, and may include administrative, legal and technical protection mechanisms deployed to protect the trade secret over time.

Associated Timing

Protection period: The anticipated protection period as impacted by the likelihood of a competitor discovering through reverse engineering or other proper means. Of course, the trade secret owner himself may decide to declassify the trade secret after a period of time for various reasons. Alternatives: The existence or expected development of acceptable alternatives or substitutes that could diminish or eliminate competitive advantages provided by the trade secret.

Associated Benefits

Investment returns. The economic benefits expected as a result of the trade-secret’s use in a product or service, such as greater sales, price premiums, or cost reduction. Internal capabilities: The benefits gained by the organisation possessing the trade secret in terms of its internal capabilities, and/or improved efficiency and effectiveness.

License or sale:  a trade-secret owner might also consider licensing or selling a trade secret—whether as part of a specific IP transaction or as part of a larger business transaction.

Prior User Rights: Having a trade secret in use prior to another entity filing a patent application gives the trade secret owner prior user rights. The trade secret owner does not require a license to continue to use the patent belonging to that other entity.

Recovery of damages: While typically not a preferred way of generating a ROI on a trade secret, litigation involving misappropriation can also provide investment returns through the recovery of damages.

Associated risks

The risk that the company themselves fails to treat the information as a trade secret, by not controlling access and not putting reasonable protection mechanisms in place. The risk that the trade secret is misappropriated by say a disgruntled employee, a former executive, a collaboration partner, a competitor or a hacker. The risk that an independent party either patents or publishes the information thereby putting the information into the public domain.

All of these economic considerations are also relevant for transfer pricing professionals. Having access to respective information will greatly enhance the reliability (defensibility) of respective calculations.

Trade Secret Valuation Report

A proper and professional trade secret valuation report should ideally contain the following sections.

  • position and status of the appraiser
  • purpose of the IP valuation
  • identification of the subject IP
  • details of any IP-related assets valued
  • addressed audience/addressees
  • premise of the IP value
  • approach and methods used
  • valuation date
  • value date
  • data sources used
  • key assumptions and sensitivities
  • limitations

When compiling the report, it is highly recommended to keep the Corporate Tax Department / Function and/or the external Accountancy & Tax Firm in the loop, as the contents will also be of immediate value for transfer pricing purposes. Not only does an overview (list) of the intangibles constitute a compulsory part of the required transfer pricing documentation, the so-called Master File (see OECD Guidelines, paragraph 5.19), it will also be an invaluable source of information to verify whether the trade secrets have been adequately taken into account in the context of intercompany transactions.

Final thoughts

Trade secret valuation is a challenging task that frequently fails to demonstrate transparency in terms of how it reaches conclusions on asset value. In general, trade secret valuation requires thorough analysis and deliberation, the application of complex methodologies, and good levels of business judgement.

We trust that this overview of the valuation of trade secrets is of interest and of value.

Donal O’Connell & Oliver Treidler

IPEG Intellectual Property Expert Group is an IP consultancy based in Europe