SPE 1031

VALUATION OF INTANGIBLE PROPERTY ASSETS AND ITS BENEFIT IN SECTION 1031 EXCHANGES

Intangible Property (I.P.) assets can be rightly considered one of the most important assets in commerce today. I.P. assets include assets such as patents, trade secrets, copyrights, trademarks/trade dress, and intangibles that are specified in a contract between the contracting parties. Since these assets are intangible and are, by nature, not capable of being weighed or measured physically, the process of valuation is a little more difficult for the Company owning the asset.

Why should we bother to value such elusive assets? The proper management and commercial exploitation of these assets by the Company depend upon the value of these assets to the Company. Valuations are used for a variety of reasons including accounting purposes, financing and securitization, and the purchase or sale of assets or litigation. Each I.P. asset owned by the Company must compete for scarce capital and resources, R&D funding, human resources, and legal, accounting and financial support.

I.P. Assets and 1031 Exchanges. In addition, owners of I.P. assets can benefit from the deferral of taxation on the gains from the sale or exploitation of these assets when properly structured as a Section 1031 Exchange. This deferral creates a further competitive advantage for the Company, since 100% of the proceeds can be reinvested in new Intellectual Property assets. This significantly boosts the internal rate of return earned for the Company and its investors on these assets.

Barriers. The major stumbling block in Section 1031 exchanges for I.P. assets is the failure to properly identify the I.P. assets to be exchanged and the failure to properly value the properties exchanged.

We Can Help. The purpose of this newsletter is to provide a brief description of several methods used to compute the value of I.P. assets, and to discuss the benefits derived from a firm understanding of the value of these assets in various settings.

1. Comparable Market Transactions. In a perfect world, fair market value can be determined by reference to comparable market transactions. However, due to lack of comparability, the failure to segregate the value on a asset by asset basis, and confidentiality of transaction details, this is difficult to derive.
2. Cost-Based Methodologies. These methodologies, including “cost to create" or the “cost to replace" a given asset, assumes that there is some relationship between cost and value. This could be used where the cost of the asset can be predicted and the assets itself does not produce a value, such as an automobile dealer network.
3. Discounted Stream of Income. Computation of I.P. asset value can be based on the discounted stream of income produced by the asset. This can take a combination of:
   • historic profits
   • separation of the excess profit margins produced over generic competitors, if available
   • separation of profit margins attributable solely to tangible assets
   • the amount a purchaser would be willing to pay for a license of the I.P. asset

Computation of I.P. Asset Value. This process should include an overall assessment of the enduring nature of the asset, marketability, and residual value. This should also include the shortest of the following lives: physical, functional, technological, economic and legal.1

1 This summary is taken from The Valuation and Exploitation of Intangible Assets, by Kelvin King, published by EMIS in June, 2003.