AMDG
Chapter 1
Intangible Assets and The Firm
I. Intangible Assets and the Firm
This is a book about the value, or price, of the firm’s intangible assets. Generally,
intangible assets are developed, owned, and used by firms rather than
individuals. As a result, the discipline of intangible asset valuation can be
viewed as an intersection of corporate finance, business valuation, and the
economics of capital and capital formation.
Intangible capital is, obviously, not tangible. It is therefore inherently more
difficult to describe than other forms of capital that you can touch and see. This
places a premium on a thorough upfront description of what, exactly, we mean
when we refer to “intangible assets.”
In this chapter, we attempt to describe intangible assets in three ways. First, we
provide an overview of the basic economic characteristics of the firm’s intangible
capital, hopefully doing so in a complete enough way that the basic economics of
this asset category are made plain to the reader. Second, we offer a high level
discussion of the main determinants of value for intangible assets. Finally, we
offer a brief discussion of each of the main intangible asset categories.
II.
Key Economic Characteristics
The first, and most obvious, characteristic of intangible assets was noted directly
above. That is, intangible capital is, simply put, intangible. One cannot
physically touch, or see, or smell, an intangible asset. While one can touch a
product, or piece of equipment, that embodies the intangible capital, the intangible
asset itself is, at root, just an idea or a relationship. Put differently, intangible
capital is that part of the economy’s capital stock that is idea or relationship
based.1
Take, for example, a patented drug. The drug itself is a pattern, or configuration,
of compounds – perhaps delivered through a pill that includes the active
It bears noting here that in one sense, all capital contains an element that is intangible.
Obviously, virtually any form of physical capital involves the embodiment of productive ideas in
matter.
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ingredient along with other fillers. As such, the drug product is tangible – a
tangible good.
However, the fact that the drug embodies a patented, protectable, technology
(i.e., a “composition of matter”) means that the owner of the patent has
monopoly power over the sale of the drug. If the drug is valued by consumers,
this monopoly power means that the patent owner can extract a large amount of
the “consumer surplus” (i.e., value) that consumers place on the drug.
Thus, from the point of view of the market, the drug really consists of two things:
1) the tangible matter that comprises the pill, and 2) the patent right to the
specific composition of matter that changes the economic relationship between
the producer of the drug and the consumer. Obviously, the latter component of
the drug, the patent, is not something that one can touch. It is both an idea (the
composition of matter itself), and a set of human relationships (the monopoly
power conferred on the owner of the patent).
This example highlights the second key characteristic of intangible assets.
Because they are intangible, people cannot consume them directly.
Consumption, which is the realization of value, can only take place for
intangibles if the intangibles are embodied in another good that is consumed
directly. This means that intangible assets are always what economists call an
“input good.”
The economic significance of this second characteristic has to do with what
economists refer to as “derived demand.” A derived demand is a demand for a
good that results because that good is an input into another good that is
consumed directly. Labor, for example, is an input for which the demand curve
is a derived demand.
Derived demand has certain unique characteristics that are well studied. 2 These
characteristics apply to intangible assets as well as other input goods, and
include the following. First, all else equal, the “elasticity” (price sensitivity) of an
input good is determined in part by the price sensitivity of the good for which
the input is used in production. Applied to intangibles, this means that, all else
equal, if intangible capital is used in products for which demand is highly price
sensitive (which generally means that they are sold in relatively competitive
These were first uncovered by Alfred Marshall in 1890, and were refined later by John Hicks in
1932.
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markets), then the demand for the intangible asset will also be highly price
sensitive (demand for the intangible asset will be “elastic”). For example,
restaurant recipes are an intangible asset. However, the most of the restaurant
industry is highly competitive, and therefore price sensitive. Given this, the
value of recipes is, generally speaking, also price sensitive (and thus limited).
Second, all else equal, the more substitutable is the input good for other inputs,
the more price sensitive will be the demand for the input good. So, back to the
case of the pharmaceutical patent, there is typically little substitutability
associated with patented pharmaceutical compounds. As a result, the price
sensitivity of pharmaceutical patents is low (increasing their value, all else
equal). Third, all else equal, the greater are intangible asset inputs as a share of
the total cost of a directly consumed product, the more price sensitive will be the
demand for the intangible. Again, in the example of a pharmaceutical patent, if
the R&D that led to the composition of matter patent for the active ingredient
represents a large proportion of the total cost of the pharmaceutical product, then
the demand for the patent will be more elastic.
The third important economic characteristic of intangible assets is that they are
durable, and therefore they depreciate. Intangible capital, like all other capital,
produces a flow of services for its owner over a period of time. Further, that flow
generally decreases in value over time, absent continued “maintenance” of the
asset. We examine the subject of intangible property depreciation in some detail
in Chapters 2 and 4.
Fourth, like other forms of capital, intangible assets have an associated “rental
rate,” or “required rate of return.” That is, there is a “cost of capital” for
intangible capital investments, in the same way that there is a cost of capital for
other forms of capital investments.
For example, when a firm makes an investment in R&D, that investment is
associated with a required rate of return. If we assume that the firm’s R&D
investment is $100, that the R&D will be equally productive of revenue and
profit in each of the next 10 years (meaning that it will produce an “even flow of
non-decreasing and non-increasing profit over each of the next 10 years), and
finally that the required rate of return to the R&D is 10 percent, then the firm’s
required return on its R&D investment is $15.82 per year.3 In short, the firm
This is simply the annuity flow required during each of the next ten years in order for the firm
to have an expected net present value of zero on the $100 of R&D investment. $15.82 = (10%*$100
/ (1-e10%*10).
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must earn back its “principal” (R&D investment), and also realize an “interest”
payment on that investment that is determined by the riskiness of cash flow
stream that the investment is expected to generate. The required rate of return to
intangible asset investments is discussed in Chapter 3.
However, actual (as opposed to required) returns to intangible asset investments
are highly variable. This is the fifth important economic characteristic of
intangible assets. That is, the difference between the required return to
intangible capital investments and the actual return is sometimes very large.
Part of the reason for this is that intangible asset investments are inherently risky,
and sometimes prove unsuccessful. However, another important reason is that
intangible asset investments, when successful, can produce “monopoly power”
for the firm.4 By this, we mean that intangible asset investments produce
monopoly power in the classical microeconomic sense of the term. That is, they
either cause a downward sloping demand curve for the firm, or they result in a
protectable cost advantage for the firm.5
It is important to be precise here about the valuation implications of monopoly
power. In every case, intangible asset investments are ex ante expected to
generate what we define in Chapter 2 as “residual profit.” Residual profit is the
current period return to previously sunk intangible asset investments. As we
discuss in Chapter 3, residual profit is profit measured by subtracting the
required profits to routine invested capital from the firm’s operating profit. This
means that intangible assets are the assets that are the “last claimant” to profit,
after other assets have been remunerated.
The reason that we think of the returns to intangible assets in this way is that
“last claimancy” over profits is characteristic of monopoly power. That is,
monopoly power means that the firm can earn some profits over and above those
that would accrue if the firm only owned assets that are readily available in the
open market (i.e., routine assets that coincide with competitive markets).
Without non-routine intangible assets, the firm would revert to earning “normal
profits,” or a competitive rate of return. Given this (given that last claimancy is a
By this we mean that the intangible asset investments, if successful, yield pricing power or a cost
advantage.
5 In theory, a protectable cost advantage will, in the long run, also result in a downward sloping
demand curve. The reason is that the protectable cost advantage will allow the firm to price
below its competitors, increasing its market share. This market share expansion eventually
means that the firm is addressing a large enough proportion of the market that it faces a
downward sloping demand curve (it gains monopoly power through market share expansion).
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feature of monopoly power), and given that intangible assets cause monopoly
power, it follows that last claimancy (residual profit) is a feature of intangible
assets.
Importantly, the firm’s residual profit may, or may not, be greater than its
required return on its prior period intangible asset investments. In other words,
the intangible assets may or may not yield economic profit. If, for example, the
firm’s intangible asset stock produces a downward sloping demand curve, but
does so in a monopolistically competitive environment, then it is likely that ex
ante the firm’s investments in its intangible assets are expected to produce
residual profit in later periods that are equal in present value terms to the
upfront intangible asset investment cost. In other words, the intangible asset(s)
generates residual profit but not economic profit. On the other hand, if the
intangible assets produce a true barrier to entry, and thereby result in a
monopoly or oligopoly market structure for the firm, then it may very well be the
case that the residual profit flow resulting from prior period intangible asset
investments is greater than the required return to those investments. Put
differently, in this case the firm earns economic profit.
Sixth, intangible assets are often specific to a firm or a customer, implying that
intangible capital may be non-redeployable to other uses.6 The specificity of
intangible assets means that markets for intangible assets tend to be thin. This is
evidenced by the fact that attempts to create markets for intangible assets such as
patent exchanges have generally faced severe challenges, and that the most
commonly observed “governance mechanism” for intangible asset transactions is
tailored long term contracting, as opposed to spot market exchange. The
valuation implication of all of this is that market-based methods for valuing
intangible assets, while certainly possible, can at times be difficult to implement.
The customization, or specificity, of intangible capital means that finding good
market comparables for a given intangible asset can sometimes be a challenge.
Another important characteristic of intangible assets, which should be clear from
the foregoing discussion, is that investments in intangible assets are risky.
Particularly for certain types of intangible capital, failure risk is very high.
Pharmaceutical R&D is notoriously risky, as is investment related to brand
extensions.7 The valuation implication of this is that future cash flows related to
For a good treatment of asset specificity, see Hart, Firms, Contracts, and Financial Structure,
(Oxford University Press: 1995).
7 A brand extension is the extension of a core brand into another product area.
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“in process” investments, such as “in process R&D,” must be probabilistically
adjusted to account for the risk of failure.
The eighth characteristic that merits mention is that intangible assets are not
always “property,” per se. Some intangible assets, such as certain types of
customer relationships, do not have status as property under the law. Further,
those intangibles that do have such status generally do not keep it for long. For
example, patent rights expire, and trade secrets leak out into the public domain.
In short, because patents and trade secrets are ultimately just ideas, these ideas
will eventually leak into the public domain and lose their status as legally
protectable property.
This does not mean that non-property intangible capital is valueless. In fact,
certain non-property intangible assets such as production know-how or
customer relationships have very high “value in use” for the firm. The fact that
these may not be legally protected property does not necessarily limit their value
to the firm, so long as the firm can manage to protect the uniqueness of these
assets in some other way. Thus, the lack of legal protection may limit the market
value of a piece of intangible capital, but not its value in use to the firm that has
invested in the capital.8
Finally, intangible assets tend to fall into two broad categories: technology
intangibles and customer-based intangibles. Examples of the former include (but
are not limited to) patent rights, trade secrets, know-how, recipes and
formulations, engineering, and customer specific tooling. Examples of the latter
include (but are not limited to) trademarks, customer relationships, customer
lists, and rights to exclude potential competitors from exploiting market
territories or market segments.
Importantly, customer-based and technology intangibles are usually what
economists call “complements,” rather than “substitutes.” That is, the
productivity of one is enhanced by increasing the productivity of the other. For
example, compare two firms, A and B. Suppose that both firms have identical
technology, but that firm A has very deep and broad customer relationships
whereas firm B does not. Firm A will be better positioned to exploit the
This is not to say that the presence of a property right does not add value. As a general matter,
it does – at a minimum by enhancing the “tradability” of the intangible. Our point is simply that
the absence of a property right does not necessarily detract from the value of the firm’s intangible
capital.
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technology than firm B. This implies that the technology asset is more valuable
in the hands of A than B.
III.
Value Determinants – A High Level Discussion
The previous discussion leads naturally into a discussion of the primary
determinants of the value of intangible assets. By “value,” we mean the present
value of the cash flows generated by a piece of intangible capital.
Several of the economic characteristics mentioned above have direct implications
for the value of an intangible asset. Beginning with the “derived demand”
characteristics of intangible assets, the substitutability of other forms of
intangible capital for a given intangible asset decreases the value of that asset.
Similarly, as the competitiveness of the downstream market into which the
intangible asset increases, the value of the intangible decreases. Finally, as the
intangible asset investment cost comprises more of a firm’s total costs, its value
diminishes.
The rate of depreciation of an intangible asset has a clear, downward, effect on its
value. All else equal, the faster an intangible asset depreciates, the lower is its
value. As an example, it is well known that the returns to advertising-related
investments are fairly short-lived.9 This places a natural limit on the expected
future cash flows from sunk advertising investments, and thus a limit on value.
The expected rate of return on intangible capital is obviously also an important
determinant of value.10 As the rate of return to intangible investments increases,
so too does the value of the intangibles that those investments create.
Correspondingly, as the required rate of return to intangible asset investments
(i.e., the discount rate or cost of intangible capital) increases, the value of the
See for example, Ayanian (1983), Hirschey (1985), Landes and Rosenfield (1994), and Graham
and Frankenberger (2000).
10 It bears noting here that because intangible assets generate monopoly power, the expected rate
of return to intangible assets is not necessarily the same thing as the required rate of return. For
example, assume that a firm develops a patented compound after $100 of initial R&D investment,
but requires another $100 to complete the R&D on that patent. It may very well be that the firm’s
expected rate of return on the next $100 of R&D is much higher than its required return –
particularly if the market for the product that will embody the compound is a large and
profitable one.
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intangibles produced by those investments decreases. This is simply a result of
the mechanics of discounted present value.
An interesting implication of this is that as the realized rate of return to
intangible asset investments increases, the amount of residual profit in the
system rises, which in turn decreases the systematic risk of the residual profit
stream. In other words, increasing the firm’s residual profit margin (residual
profit / sales) is tantamount to decreasing the operating leverage facing the
intangible asset investments. This, in turn, decreases the riskiness of the cash
flows generated by intangible asset investments. This increases their value. In
short, there is a secondary, positive, value effect of an increase in the rate of return to
intangible asset investments – namely, it lowers the discount rate associated with the
intangible capital’s cash flows.
The specificity, or re-deployability, of an intangible asset can also affect its value,
although the effect on value depends upon what definition of value we are using.
A highly specific asset – meaning an asset that is not re-deployable into other
uses – is inherently more limited in its market value than a similarly situated asset
that has other potential uses. This is obvious – other potential uses are
embedded options, and options have value. However, a highly specific asset
may have higher value in use, meaning value to the firm that owns that asset,
because of its specificity. That is, the specificity of the intangible capital to a
given product, or a given customer, may be the very thing that produces
monopoly power for the firm. Thus, specificity has an interesting value
implication – it may decrease market value, and at the same time may increase
value in use.
While we have discussed riskiness, we did so with a focus on “systematic” risk –
that is, risk that is not diversifiable. However, the failure risk associated with
completion, or ongoing maintenance, of an intangible asset is also value-relevant.
All else equal, the higher is the risk of failure to complete, or failure to maintain,
an intangible, the lower is the value of that asset.
The property right characteristics of an intangible asset also have an influence on
value. All else equal, broader scope and greater ease of defense of property
rights surrounding intangible capital increase the value of that intangible capital.
Finally, the degree to which marketing-related and technology-related intangible
assets complement one another increases, all else equal, the value of both types
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of intangibles. As noted earlier, firms with deep and wide sales and marketing
channels can make more productive use of technology, and vice versa.
There is a famous court case, Georgia-Pacific Corp. v. United States Plywood Corp.,
that describes 15 considerations, now known as the Georgia Pacific factors, that
may have an influence the value of an intangible asset. While the Georgia Pacific
case centered on a patent dispute, and therefore some of the factors described
therein are specific to patent assets, many of the Georgia Pacific Factors have
general applicability across most or all intangible asset categories. The Georgia
Pacific factors include the following.




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The scope and strength of the property rights surrounding the asset.
The pricing or other monopoly power conveyed by the asset, and
maintained by the owner of the asset.
The economic relationship of parties transacting over the asset (i.e., are the
competitors or co-promoters?).
The complementarity of the asset with other assets and lines of business.
The duration of the asset’s usefulness, and the duration of property rights
surrounding the asset.
The asset’s profitability.
The asset’s uniqueness.
Obviously, these factors are consistent with, and in fact are implied by, the
discussion directly above.
Examples of Technology and Customer-based Intangibles
IV.
As noted earlier, we think of intangible capital as falling into two primary
categories: technology-based and customer-based. It is worth taking a moment
to describe some examples of each type.
Customer-based intangible capital may include the following.

Marketing-generated Customer Awareness. Marketing investments such
as advertising, trade show participation, and other forms of marketing
serve to increase the awareness of a firm’s products or services, thus
serving to increase revenues. These investments are durable, in the sense
that they pay off over time. Further, the revenue response to certain types
of marketing (i.e., advertising) is well studied. Thus, we can speak of a
customer awareness asset. That is, there is an asset that results from sunk
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

advertising and other marketing expenditures, and this asset is essentially
the future revenue response from previously sunk advertising
investments. It bears noting that the customer awareness asset is likely a
short-lived one, relative to certain other forms of intangible capital.11
Selling-generated Customer Relationships. Sales activities, particularly
those carried out by a trained and capable sales force, often represent an
intangible development cost.12 These investments can give rise to valuable
customer relationships. Customer relationship intangibles have at least
two important characteristics that are worth noting. First, their durability
tends to be greater than that of marketing and advertising driven
customer awareness, for the obvious reason that awareness of a firm in the
minds of customers is more transient than actual relationships with
customers. Second, customer relationship intangibles are not the same
thing as a “customer list.” It is frequently noted that “customer lists” may
have value. However, a list is just that – a list. Customer lists only have
value to the extent that customer relationships underpin the list.
Brand and Trademark. Brand and trademark capital provides customers
with an assurance of stability, and a signal of quality. These, in turn, give
rise to an expectation of future patronage by customers. Trademark assets
do not necessarily result from a single kind of intangible asset investment
(such as marketing), but rather have value because all of the firm’s
investments and capabilities combine to produce a positive image in the
minds of the firm’s customers. Nonetheless, it is fair to say that the value
of trademark and brand assets is in fact more heavily influenced by
marketing and selling activity than by other intangible development costs.
Further, trademark assets tend to be quite durable. Instances can be found
of abandoned trademarks, purchased and held for years by firms that
One interesting question is whether or not price reductions or discounts from a “standard” or
“list” price represent a marketing. In general, price reductions for existing customers are a form
of price discrimination. As such, they represent the exercise of market power by the firm (pricing
at the highest price that the market will bear, on a customer-specific basis), rather than an
investment in obtaining market power. By contrast, discounts provided in order to obtain a new
customer are real reductions in profit that produce later benefits. As such, they may represent
investments in customer-based intangibles.
12 There are certainly some industries in which selling activity is commoditized in nature.
However, in complex industries, where the sales activity is highly technical, selling activity also
gives rise to what economists call “localized market information.” Localized information, as the
name implies, is information that is non-public and difficult to obtain in the open market.
Localized information may take the form of customer-specific information (such as customer
spending patterns, preferences, and the like), or other information related to market structure
and the competitive landscape.
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specialize in investment and ownership in trademark assets, that are later
revived after a decade or more of dormancy. It is worth noting that
trademark and brand assets are similar in nature to the concept of
“goodwill,” which we discuss below.
Correspondingly, technology-related intangible assets may include the
following.


Patents. Patents are legal property rights over technology that provide
their owner (or the owner’s assignee or licensee) with exclusivity over
commercialization of the technology (i.e., the right to make and sell
products that embody the technology). Patent rights are granted by a
government body, for technology that is deemed new, useful, and nonobvious. In the United States, for example, patents can be issued for a
“process, machine, manufacture, or composition of matter, or any new
and useful improvement thereof.” The word “process” is defined as a
process, act or method, and includes industrial or technical processes.
“Manufacture” refers to articles that are made, and includes all
manufactured articles. Finally, “composition of matter” relates to
chemical compositions and may include mixtures of ingredients as well as
new chemical compounds. These classes of subject matter taken together
include practically everything that is made by man, and/or the processes
involved. The question of the economic life, or durability, of patented
technology is an important one. In some industries, the life of a patent is
the primary determinant of the economic usefulness of a technology. That
is, in some industries, the life of the patent is quite close to (if not equal to)
the economic useful life of the underlying technology. However, in other
industries patent life can either be longer, or shorter, than the useful
economic life of the patented technology.13
Trade Secrets. Trade secrets are technologies that are protected by
actively maintaining secrecy, rather than by patenting. The reason that
firms might choose to maintain a secret, rather than patenting the
underlying technology, is that the act of patenting reveals the technology
publicly. That is, in order to obtain a patent, one must file a public
document that describes the technology in some detail. Therefore, once
the patent expires, competitors can copy the technology. Moreover,
See, for example, the line of economic research extending from Mansfield (1985) through
Lemley (2009), indicating that patents in some industries may serve to provide monopoly power
for a shorter period of time than the life of the patent right.
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


before the patent expires, competitors can often develop a sufficient
understanding of the technology to develop a “work around,” which is an
alternative, but functionally similar, technology. By contrast, trade secrets
can be maintained indefinitely, so long as the technology does not leak
into the public domain. Thus, technology assets that can be kept secret
are, by definition, more likely to be trade secrets. One example is process
technology. Another example is component technology that is relatively
well hidden and is not easily backward engineered.14 The durability of
trade secrets is obviously a function of how long the secret remains a
secret. In general, trade secrets become public as the result of research or
manufacturing employee turnover. As employees move to competitors,
knowledge tends to leak to competitors.15
Know-how and Process Technology. Know-how, as the name implies, is
knowledge about how to do something technical – usually related to a
production process. Know-how can be protected by either patent or trade
secret. At one level, almost any technology can be considered know how.
However, in its common usage, know-how generally relates to production
processes, rather than specific product attributes. Put differently, under
the common distinction between “product” and “process” technology
(where “product” technology refers to the designed characteristics of a
product or service and “process” refers to the process by which that
product or service is produced), know-how falls into the “process”
category.
Product Technology. As noted earlier, product technology is the bundle
of designed characteristics of a product or service. Product technology
can be deeply technical, such as the composition of matter for a
pharmaceutical product, or the metal alloy for aircraft aluminum sheet.
However, product technology can also be fairly trivial, such as the design
elements of a window pane. Absent legal protection, product technology
often has low durability, since valuable product characteristics can be easy
for competitors to observe and replicate.
Engineering and Tooling. One sometimes sees engineering and tooling
characterized as a technology asset. For some companies, the engineering
process involves customization of products for specific clients or markets.
Engineering can thus produce pricing power by making a customer’s
assets and processes specific to a customer. Engineering is also sometimes
Posner (1998) has an excellent discussion of trade secrets versus patents.
See Edwin Mansfield’s research for an excellent treatment of the rate at which technical
knowledge diffuses into the public domain.
14
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directed at the production process, and can result in cost saving
technologies that the firm can retain for some period of time (meaning that
the firm does not pass these efficiencies immediately to its customers
through price cuts). Tooling is similar to engineering, in that it is the
physical embodiment of a tailored production process – meaning that the
production process is tailored to a very specific (often customer-specific)
product. That is, tooling is a modification of plant and equipment in a
way that is specific to a customer or product. For example, automotive
OEMs and their suppliers have tooling that customizes their assembly
lines to specific vehicles. As for durability, the economic life of
engineering and tooling is sometimes limited by the production run(s) for
the product involved. The durability of cost-related engineering is a
function of its rate of leakage into the public domain.
Certain examples exist of intangible assets that do not easily fall into the neat
categories of “technology” or “customer-based” assets. The best example of this
is goodwill. Goodwill is frequently defined as “the expectation of future
patronage.” From a valuation perspective, goodwill is the present value of the
profit stream that the firm expects to realize after the point in the future at which
currently existing assets will have amortized away.
But what kind of intangible asset, exactly, is goodwill? The answer is,
unfortunately, “all of the above.” That is, goodwill is the “asset” that results
from the combination and coordination of all of the firm’s assets and capabilities.
Goodwill is thus similar, if not identical, to the concept of “going concern.” In a
sense, goodwill is the firm itself. That is, goodwill exists when the firm exists as
a going concern, and does not when the firm does not.
The question of how goodwill relates to specific identifiable intangible assets is
an important one – particularly in the tax area. In some tax contexts, such as
transfer pricing, governments (and occasionally taxpayers) at times take the
position that there is no such thing as goodwill. That is, goodwill is really just
today’s expectation of future profit that results from today’s stock of, say,
technology. Put differently, goodwill is nothing more than the sum present
value of future profit flows resulting from future technology generations. This
position is controversial, and one that we take up later in this book.
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V.
Outline of This Book
The remainder of this book contains three sections. Section I is entitled
“Analytical Framework,” and contains six chapters. We have two objectives in
Section I. First, these chapters provide the reader with the tools to understand
and price intangible assets. Section I is heavy on analytics, and most of the
Excel™ files that accompany this book pertain to the chapters in this section.
Second, we present several analytical approaches to the pricing and valuation of
intangible assets that we believe are, in some sense, “new.” That is, some of the
models that we describe – particularly some of the analysis presented in
Chapters 4 through 7 – may represent new thinking (or at least important
advancements of current thinking) in the area of intangible asset pricing and
valuation.
Section I begins in Chapter 2, with a discussion of “residual profit,” which is the
return to, or profit generated by, intangible assets. This is foundational, since
understanding the profit that accrues to the firm because of its intangible assets
is the first step in pricing this form of capital. In addition, Chapter 2 introduces
the reader to the concept of an intangible capital stock, and the mathematical
relationships between the stock of intangible capital, and the flows of
depreciation and residual profit over time.
We then turn in Chapter 3 to the topic of discount rates. Chapter 3 first describes
a method for determining the required rate of return to intangible assets – or
more specifically, to residual profit. Chapter 3 then turns to the question of the
appropriate discount rate in a licensing context. Since the most common market
transaction involving intangible assets is licensing, it is important to understand
the systematic risk characteristics of flows of licensing income (or royalty costs),
and how these differ from the systematic risk inherent in residual profit flows.
Chapter 4 then offers a discussion of the concept of “economic life,” and presents
a new analytical treatment of the concept. We find that this topic, which is of
course fundamental to valuing intangible assets, is one that practitioners
frequently approach in a haphazard, poorly thought out, way. We therefore
attempt to put some structure around the concept of economic life. In addition,
we offer a novel approach to estimating economic life, showing that economic
life (under one definition) is a function of the rate of return to intangible asset
investments, and the amount of gross residual profit realized by the firm.
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Chapter 5 then begins our treatment of valuation and intangible asset pricing.
Chapter 5 is one of the core chapters in our book – as we call it, a “workhorse”
chapter.
Chapter 5 begins by describing a basic approach to the valuation of intangibles
that discounts to present value the intangible asset stock’s claim over gross
residual profit. That is, we show the reader how intangible development costs
generate a stock of intangible capital, the way in which that stock of capital
claims expected residual profit in future time periods, and how that residual
profit should be discounted to present value. As part of this discussion, we
describe the relationship between “gross” and “net” intangible asset profits
(residual profit). We introduce an equilibrium condition in which the available
gross residual profit attributable to an intangible asset must equal net residual
profit, in present value. We explain the assumptions under which this
equivalence is in fact an equilibrium, and we describe the valuation implications.
Chapter 5 then turns to the topic of estimation of arm’s length royalty rates. This
is a topic of great importance in contexts as varied as IP damages, tax, purchase
accounting, and third party licensing and joint venture negotiations. Chapter 5
shows how the valuation model described directly above can be extended to a
model of equilibrium, arm’s length, royalty rates. That is, we convert our
intangible asset valuation framework very naturally into a model of licensorlicensee negotiation.
In essence, Chapter 5 provides the reader with an extremely general economic
model that can be used to both to value a stock of intangible assets and to predict
royalty rates. The model is rigorous, and the relationships that it uncovers are
sometimes very surprising.16 For example, one interesting result is that, under
the assumptions of our model, the expected rate of return to intangible asset
investments predicts a unique arm’s length royalty rate, to which licensors and
licensees would negotiate.
Chapter 6 then extends our focus on licensing relationships. However, the
emphasis in Chapter 6 is on profit sharing, or “profit splitting” as it is sometimes
called, between licensors and licensees. We discuss the lineage, utility, and case
law surrounding, the profit split “rule of thumb.” To be clear, we do not
advocate the use of a profit split rule of thumb as a primary means of estimating
arm’s length royalty rates. Rather, our emphasis in Chapter 6 is to provide
16
Although we show that upon reflection our findings are quite intuitive.
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further explanation for why licensees are different from routine manufacturers /
distributors. In other words, we offer the reader an opportunity for further
exploration of the question of why licensees capture a share of the residual profit
from licensed products, and a framework for thinking about the magnitude of
the “licensee share.”
Finally, Chapter 7 forms the last chapter in Section I. The focus in Chapter 7 is on
what valuation professionals refer to as the “cost approach,” or the “work
around approach.” If a purchaser or licensee of an intangible asset has a
realistically available alternative to “make” rather than “buy” the intangible, and
making is cheaper than buying, then the highest price that the intangible asset
will fetch is in fact the cost to self develop, or replicate, the intangible property.
This is obviously just simple opportunity cost reasoning. However, as we show,
implementation of the replication cost, or work around, approach is not
necessarily straightforward. In addition to the question of how much it would
cost to replicate an intangible asset, several other tricky considerations present
themselves. For example, is a legal work around possible? If so, how much time
(and therefore market penetration) is lost by implementing a work around? The
cost of replication method is an important “test of reasonableness” for the
methodologies described in earlier chapters, but its implementation can be
complex.
It bears noting that, where appropriate, Section I provides the reader with both a
mathematical representation of the key valuation concepts and tools surrounding
the pricing and valuation of intangible assets, and an Excel™-based set of models
that implement the approaches we describe. We approach the analytical sections
of this book in this way so that the reader can use either mathematical models, or
Excel™ models, or both to put the concepts into practice.
Section II, Empirical Analysis, is an extended discussion of what we can observe
in the open market. That is, Section II provides the reader with the good sense
for what royalty rates, profit splits, intangible development costs, and residual
profit look like, by industry. Section II is not meant to be completely exhaustive
(although it is quite detailed). Rather, the intent of Section II is to prepare
professionals in the valuation, licensing, and legal community for what they will
see in the real world.
Section II contains four chapters. Chapters 8 and 9 cover royalty rates, by
industry. Chapter 8 focuses on technology royalty rates, offering the reader
empirical results for observed royalty rates across 40 industry groupings.
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Correspondingly, Chapter 9 focuses on trademark licenses, covering a similar set
of industry groupings.
Chapter 10 then takes up the question of profit splits. While we usually cannot
observe the profit sharing between licensees and licensors, there are some
contexts in which this is in fact possible. We walk the reader through the cases
where such observations can be made, and the results obtained. We also make
an attempt at testing the model developed in Chapter 5.
Finally, Chapter 11 extends a discussion that was begun in Chapter 2.
Specifically, Chapter 13 examines levels of intangible development cost by
industry, as well as residual profit levels by industry. Results from Chapter 11
are also included in the Excel™ files that accompany this book.
The final section of this book is Section III, Applications. Section III contains four
chapters.
Chapters 12 through 14 provide examples of “real life” intangible asset
valuations or licensing determinations in three industries. Chapter 12 describes
the valuation of a pharmaceutical compound. Correspondingly, Chapter 13
offers a case study involving the pricing of software intangibles. Finally, Chapter
14 provides an example of a consumer goods trademark valuation.
The final chapter of Section III, Chapter 15, is a comparison of the main features
of intangible asset valuation and pricing within the two primary “regulatory”
contexts in which intangible asset valuation is relevant. These are IP damages
and transfer pricing. We show that while the legal frameworks in which
valuations are conducted in these two contexts differ, the approaches are largely
the same. Where there are differences, we describe and explain them.
Our sincere hope is that this book provides the reader with a strong technical
and empirical introduction to intangible asset pricing and valuation. Obviously,
there are places where the book, and the accompanying Excel™ files can be
improved. We welcome your criticisms and suggestions. Comments, criticisms,
suggestions, and questions, can be e-mailed to us at timothy.reichert@gmail.com,
and icgray@gmail.com.
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