As a special feature of our blog—guest postings by experts, clients, and other professionals—please enjoy this blog entry from Donal O’Connell, Managing Director of Chawton Innovation Services Ltd., and Oliver Treidler, Managing Director of TP&C GmbH.
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.
For instance, 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).
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 clearly indicates that a trade secret is also an example of an intangible asset, so long as it meets 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.
Throughout this paper, one particular valuation rationale will be analysed, 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 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 other accounting and management information 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 Secret Valuation Techniques:
Let’s now delve into the details.
There are a number of techniques / methods in use when conducting IP valuation exercises.
DCF is one of the key methodologies used when conducting a trade secret valuation exercise. DCF analysis is a method of valuing a trade secret asset using the concept of the time value of money. All future cash flows associated with the trade secret asset are estimated and discounted by using cost of capital to give their present values.
When conducting a DCF 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).
One of the most difficult aspects in this context is often to create reliable (plausible) forecasts of the expected profits. These forecasts are inevitably based on subjective assessments and respective forecasts will often result in a rather broad range within which the taxpayer will have to identify an appropriate transfer price. Due to the subjective nature of the valuations, tax authorities are prone to challenge the arm’s length nature of the resulting transfer prices in case they feel that the price is disadvantageous from their perspective. To guard against respective challenges and to minimize the risk of adjustments, taxpayers should strive to provide a plausible documentation of their assumptions in respect to the value of the intangibles—observing the following consideration will help to ensure a defensible position:
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 DCF valuation calculation.
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, labor 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.
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.
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.
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 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.