INTANGIBLE ASSETS AND PRINCIPLES FOR THEIR VALUATION
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Farok J. Contractor
Rutgers University
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INTANGIBLE ASSETS AND PRINCIPLES FOR THEIR VALUATION
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Abstract
This paper provides a general set of principles, organized into a useable framework, for the valuation
of intangible assets as well as corporate knowledge, in the act of transferring, sharing, selling, or licensing it
from one company to another. It provides benchmarks for valuation to both seller and acquirer, to licensor and
licensee, and to both partners in a corporate alliance.
The paper begins by classifying the nature and attributes of different kinds of corporate knowledge. It
then focuses on the valuation framework.
Intangible assets, whether registered intellectual property such as brands, patents, copyrights, or
whether they be “knowhow”, or general corporate expertise, are increasingly separable from their
organizational context, and can be sold or shared with another firm – for compensation. As such activity
increases -- as part of a general trend towards outsourcing and modularization of business functions, aided by
codification of previously tacit or intuitive knowledge -- placing a money value on a “knowledge package” is a
crucial managerial function. Many of the principles presented in this paper can also be used when the same
firm makes its own investments in other markets, by transferring corporate knowledge to its own subsidiary.
The various benchmarks and criteria found in the literature are here, for the first time, presented in a
comprehensive valuation framework, eminently usable by managers and negotiators.
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INTANGIBLE ASSETS AND PRINCIPLES FOR THEIR VALUATION
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“When you can measure what you are speaking about, and express it in numbers, you know
something about it; but when you cannot measure it, when you cannot express it in numbers,
your knowledge is of a meager and unsatisfactory kind: it may be the beginning of knowledge,
but you have scarcely, in your thoughts, advanced to the stage of science.”
-- Lord Kelvin
The last two decades of the twentieth century saw a dramatic increase in corporate mergers,
acquisitions and alliances. These are now a permanent part of the economic landscape. In a majority of cases
what is being sought in such deals is the intangible assets held by the acquisition target or the potential ally
firm. Alliances involve acquiring, not the whole company, but only a portion of its assets, capability or
knowledge, which will be used in combination with the other firm. As such activity increases -- as part of a
general trend towards outsourcing and modularization of business functions, aided by codification of previously
tacit or intuitive knowledge -- placing a money value on a “knowledge package” is a crucial managerial
function. Whether in the context of a merger, acquisition, alliance, R&D project, or the sale of patents,
copyrights, brands, software, designs, etc. calculating a value for the intangible assets is a key issue in the
practice of management, from the point of view of both acquirer and seller of the intangible asset. . However, a
commonly accepted set of principles for such valuation has yet to be finalized (Economist, 1999; Sveiby,
1998).
This paper aims to develop a set of principles or benchmarks that can be broadly applied in a variety
of situations. It begins with outlining the many situations in which valuation of intangible assets needs to be
performed. Next, the paper describes different types of corporate knowledge and their attributes. It then
proposes valuation criteria for the transfer or sale of corporate knowledge, and the negotiating perspectives of
knowledge seller and acquirer. An example of a licensing negotiation illustrates the principles.
When Do Intangible Assets Need to be Valued?
Besides the important issue of stockmarket valuation, there are several principal business circumstances in
which intangible value needs to be measured
(1) A company sale, merger or acquisition: The acquiring company will appropriate the physical assets or
the purchased firm, but what is the injection of new knowledge worth? Accounting measures do not
coincide with economic or market-based values (Reilly, 1995). Many mergers and acquisitions are
justified on the grounds of combinatorial synergy between the knowledge base of the two companies.
However, there could also be combinatorial incompatibilities, knowledge transfer costs over many
years, and cultural compatibility problems between the merging organizations.
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(2) Sale, purchase or licensing of separable assets such as brands, patents, copyrights, data bases, or
technology. “Separable assets” are those that can be detached from the company which possesses
them and transferred, sold or licensed to another firm. This could include any transferable knowledge,
codified or teachable, and rights to intellectual property or markets. Here, only a portion of the
intangible assets of a company are spun off to another firm, by a legal transfer agreement and/or by
training the other firm in the use of the transferred knowledge. But how much should the company
licensing or acquiring these assets pay?
(3) Lawsuits involving intellectual property infringement. Here courts need to determine infringement costs
and penalties.
(4) Tax liability calculations in the context of transfer of intangible assets and technology to affiliated firms,
possibly in another nation.
(5) Corporate alliances: During negotiations over the formation of a joint venture (JV) or the many other
forms of strategic alliances such as management service contracts, franchising, co-marketing, etc. the
valuation of the knowledge contributions of each partner is a key issue. This decides the equity share
of JV partners, royalty rates and other fees.
(6) R&D management: Putting a value on prospective future knowledge generated by R&D investments is
key to selecting between competing R&D projects. Valuing each partner’s contribution in codevelopment projects, is another crucial measurement area.
The measurement problem has now become a global one, as firm-specific expertise and intellectual
property are increasingly shared across borders between joint venture partners and strategic allies, and
multinational firms spread the scope of their operations worldwide. Government authorities in each country are
concerned about the tax consequences of intangibles in international joint venture arrangements (Parnes,
1993). Monitoring of royalty rates and international transfer pricing has grown dramatically in the last five years
(Halperin and Srinidhi, 1994). Differences in effective tax rates across nations continue to distort transfer
prices. Tax authorities also wrestle with international firms over the allocation of global R&D overheads and
determination of “fair” license fees, with little theoretical grounding or empirical justification. Gravelle and
Taylor (1992) state that
“... with the current chaos in the industry, the economic issues associated with the treatment
of purchased intangibles have been largely misunderstood.”
(Page 81;emphasis added)
To help firms and tax authorities value intangibles, some consulting companies are attempting to
develop proprietary data bases of licensing and joint venture agreement terms. (For example, see Anson,
1993 or Smith and Parr, 1993) Factor analysis of industry and market variables are claimed to yield useable
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comparative benchmarks. But the information is private, and even if useful, merely supplies statistical
averages for industries and product groups. None have country or international variables. Moreover, these
analyses are not grounded in theory.
Marketing managers have evolved the notion of brand equity (Farquhar, 1990), and researchers have
also developed field measures such as “unit price premia” and “market share increments” to put a monetary
value on brand equity (Simon and Sulivan, 1993; Park and Srinivasan, 1994). But the extent to which these
measures correspond to the selling price of brandnames is not known, since, unlike patents or copyrights,
brandnames are only infrequently sold separately from the firm as a whole.
Stronger protection of intellectual property has been a centerpiece of negotiations at the World Trade
Organization (WTO) and a foundation stone of US foreign commercial policy since the 1980s. Formally
registered intellectual property is, of course, but the visible tip of a much larger iceberg of corporate expertise,
but is nevertheless crucial to economic growth and national competitiveness (Kravis and Lipsey, 1992;Conner
and Rumelt, 1991).
A Texas Instruments annual report to shareholders in 1991 said,
“We believe that appropriate valuation and compensation for the use of the company’s
intellectual property is essential to global competitiveness because it protects, rewards and
encourages investment in research and development”
In the 1990s Texas Instruments negotiated enormous sums of hundreds of millions of dollars in compensation
from overseas infringers of its patents.
Since Arrow’s (1962) work on appropriability of returns on R&D, scholars and policy makers have
been concerned with how companies can better protect the fruits of their research and increase their return. In
recent years there has been greater use of international strategic partners and licensing as a means of
capturing incremental returns on R&D and accessing foreign markets (Levin, 1988). In the midst of rapid
technological change and easy imitation, Teece (1988) proposes that companies are better equipped to
capture the rent stream on their innovations if they consciously develop “complementary capacities” in
marketing, after-sales service, and manufacturing. These complementary capacities are often developed in
partnerships and contractual relationships outside the firm, rather than in-house, because of heightened risks
and the global spread of markets (Contractor and Lorange, 1988). Indeed, the majority of joint ventures,
alliances and licenses appear to be in complementary capacities, and/or are intended to access foreign
markets, rather than in the core business of the firm.
Securities and Data Exchange Corp., a company that tracks commercial news announcements,
reported a twelvefold increase in acquisitions and alliances between 1989 and 1995. The measurement of the
value of an acquisition -- or in the case of an alliance, what each partner brings to their joint operation -- are
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key questions affecting purchase price, in structuring and maintaining the subsequent relationship, as well as
in the division of the profit stream that accrues from the joint or merged activity.
Two salient points emerge from the foregoing discussion:
(1) We are today in a commercial world where each year, hundreds of thousands of mergers,
acquisitions, licenses, franchises, equity joint ventures, brand sales, co-marketing alliances, joint
R&D projects involving more than one firm, patent sales, technology transfer agreements, and
other knowledge transfers, take place. A key issue in all such transactions or agreements is
putting a value on intangible assets or corporate knowledge.
(2) No one is yet satisfied with techniques used for valuation of intangibles.
PART I: THE NATURE AND ATTRIBUTES OF INTANGIBLE CORPORATE ASSETS
There are various types of corporate knowledge. Figure 1 distinguishes between three types. These
comprise (I) formally registered Intellectual Property Rights, such as patents or brand names. More broadly,
we can define (II) Intellectual Assets which comprise both the above registered property rights as well as
codified but unregistered corporate knowledge. Examples of the latter are drawings, software, databases,
blueprints, formulae, manuals, and trade secrets, all of which are likely to be in written form, but deliberately
not registered with government authorities. Instead, they are kept as proprietary information or trade secrets
within the firm. Finally, category (III) comprises uncodified Human and Organizational Capital, or expertise that
resides in the thinking of employees and in organizational routines.
The first category is exemplified by a bio-technology startup company whose principal asset may be a
set of patents. Its key strategy consists of quickly registering, and then fiercely defending this intellectual
property (Kogut and Zander, 1992). As an example of the second type of corporate intangible asset, consider
a firm called Precision Feeder, Inc. (not its real name) headquartered in New Jersey. Unlike the bio-technology
company, Precision Feeder has no patents or copyrights whatsoever. In fact, its expertise lies in what may be
superficially described as a low-technology area, namely designing vibrating hoppers which feed powders and
liquids on to assembly lines at a precise rate. Pulsing a feeder or hopper to precisely dispense materials would
not appear to be a very sophisticated, or complex operation. In fact it is fiendishly difficult. Because powders
and liquids exist in many granule shapes, sizes, angles of repose, surface friction, viscosity, moisture contents,
and so on, there is no standard hopper design. Too many different laws of physics apply to use a deterministic
model. When a client brings a new powder or liquid to Precision Feeder and asks them to design an assembly
line feeder at a particular output rate, one approach would be repeated trial and error experimentation. A better
alternative, used by the firm, was to put its entire history of say 75,000 jobs, covering 5,000 materials, done
over a quarter century, into a data base. “Expert systems” algorithms can be performed on this data base in
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order to mimic analogous examples from the past. This greatly cuts down on the design time for a new
material, by reducing design parameters. What is the company’s intangible asset? Merely its collective
knowledge, codified and encapsulated in a referencable data base. Incidentally, once codified, this enabled
this small New Jersey firm to “go global” by setting up licensees in several nation. This would, on first blush
appear suicidal – by giving away company secrets in the data base to foreign licensees. There is no patent
protection. What prevents the licensees from competing with each other, or ultimately with Precision Feeder
itself, in the US? Each licensee has a strict territory. See Contractor (1985) for international licensing
enforcement. In any case, was little prospect for this small firm to make its own investments to serve clients
abroad directly. Hence there was no available alternative to licensing as a means of “going global.”
Codification of its collective knowledge enabled substantial international expansion and incremental income
that otherwise would simply have to be foregone.
Figure 1 SCHEMATIC GROUPING OF CORPORATE KNOWLEDGE
(I) Intellectual Property
(Registered)
Patents
Brands
Copyrights
Etc.
(II) Codified but Unregistered Intellectual Assets
Drawings
Software
Blueprints
Written Trade Secrets
Data Bases
Formulae
Recipes
(III) Intellectual Capital
(Uncodified Human and Organizational Capital)
Collective Corporate Knowledge
Individual Employee Skills and Knowledge
“Knowhow”
Organizational Culture
Customer Satisfaction
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Of course, not all intangible assets can be codified, or even adequately described. Much of corporate
knowledge is vague and ambiguous (Simonin, 1995).Category III assets in Figure 1 can be exemplified by a
toy design and engineering firm in Hong Kong that does contract design for large toy makers. This firm has few
physical assets other than powerful CAD workstations and a modeling and die casting workshop. Its main
assets lie in the skills and experience of its artists, graphic designers, engineers and technicians. As children
are fickle, toy designs change continuously. While one can get legal protection for a particular design, or toy
character, there is no intellectual property protection for a class of toys. In any case, copyrights on each toy
design are held, not by the design firm, but by the toy manufacturer client. There is little codified expertise. The
strategic core competence of the design firm lies in the creative flair of its personnel, in its speedy collective
organizational responsiveness to urgent customer demands, and a culture of rapid execution and customer
satisfaction. Knowledge category III is this collective uncodified and tacit intellectual human capital, resident in
the firm as a whole (Zander and Kogut, 1995). The literature on intangible assets has also included in
Category III, company reputation, customer loyalty (Baltes, 1997), network links, human capital (King, 2000)
and other “goodwill” type items.
In any given firm, one or more categories of knowledge may be present in the firm. Many companies
tend to have all three types represented.
The gradation from category I to category III is analogous to the gradation shown in Figure 2 from
information to knowledge, and finally to wisdom or strategy. Information or data alone can be an intangible
asset with value within the firm, or for sale/license outside the firm. But information is not necessarily
knowledge until it is organized into a usable, codified form. This is the difference between a mere patent or
formula and an efficient manufacturing capability. Even knowledge is insufficient. For a firm to be competitive,
this knowledge must be assimilated and embedded in its personnel. Even that is not enough. Effective strategy
requires organizationally embedded knowledge plus wisdom in how to use that knowledge in the competitive
marketplace.
Figure 2 : FROM INFORMATION TO WISDOM
INFORMATION OR
DATA
KNOWLEDGE
WISDOM/STRATEGY
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Table 1: ATTRIBUTES OF KNOWLEDGE TYPES
Knowledge Category
Moving from
Category I to Category III
Attribute
Separability
Formalization
Human/Organizational Embeddedness
Ease of transfer or teachability
Valuation Difficulty
Decreases
Decreases
Increases
Decreases
Increases
The attributes of the three types of corporate knowledge are not the same. Moving from category I to
category III, separability, formalization, human/organizational embeddedness, and the difficulty of valuation of
the knowledge change.
“Separability” may be defined as the ability to identify and describe discrete bits of information or
knowledge (Mullen, 1993). In the earlier example, the bio-technology company can sell or license some of its
patents, but not all. Even “knowhow” generally referred to as uncodified but transferable technology, can be
separated and taught to an alliance partner, or licensee. But category III qualities, such as artistic flair in
designing new toys, or an organizational ethos or culture cannot be easily separated, transferred, or taught to
outsiders.
“Formalization” refers both to the degree of codification of technology or knowledge, as well as to
organizational routines (Nelson and Winter, 1982). Not all organizational routines are formally expressed. In
some companies they are deeply embedded in human or company-wide culture and assumptions. Personnel
follow these routines more or less unconsciously, without consulting charts. This is the most difficult kind of
knowledge to transfer, as it is tacit and embedded (Kogut and Zander, 1992). As we move from category I to
category III formalization tends to decrease and tacitness or organizational embeddedness increases. The
ease of transfer, or the teachability to an outsider decreases.
So does the difficulty in valuing tacit knowledge. It is difficult enough to put a value on a patent or a
software package, although several calculation methods exist, as we shall see later in this paper, to calculate
royalty and lumpsum fees. Ambiguity makes it more difficult to value uncodified knowhow (Simonin, 1999). But
a general corporate capability is the most difficult of all to value. The acquirer firm, or licensee, is sometimes
unable to even know what exactly is being acquired, or what value the acquired knowledge may have in
another country market. Such ambiguity or “bounded rationality” leads to failure in the market for knowledge
(Love, 1995). Often, when a prospective knowledge buyer is highly uncertain, an intermediate solution such as
a joint venture (JV) -- lying between the extremes of arms-length license or outright acquisition -- may be
optimum for the buyer. Involving the knowledge-possessing firm in an equity joint venture is a signal of their
own faith in the technology and the feasibility of the venture. (They are sinking their own capital into it). An
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equity JV also ensures the knowledge developer’s continuing commitment in the future, as contrasted with a
contractual technology transfer where the licensor may not render strong future assistance, and the contract is
finite.
PART II: GENERAL PRINCIPLES FOR VALUING AN INTANGIBLE ASSET
(In the Context of Its Sale, Transfer, Sharing, or License to Another Firm)
In general, the value of an intangible asset lies in its future use, and can be estimated from the
incremental profits that such use will throw off. But this generalization is tempered by several other
benchmarks, such as replacement or reproduction costs, opportunity costs and benefits available to buyer and
seller, industry norms, alternative options, and so on. An adjusted present value (APV) approach is
recommended, supplemented by “Real Options” or decision tree modeling (Luehrman, 1997).
In the following section the intent is not to merely make airy strategy statements or negotiation
recommendations. Rather, each statement can, and should, be reduced to a monetary number (in Present
Value terms). The discussion below develops principles whereby separable intangible assets (intellectual
property such as a copyright, patent, technology, or brand as well as uncodified “know-how”) can be priced
when selling or licensing them to another firm. “Separable” assets are those that can be transferred to another
firm, without having to buy or sell the company as a whole. The art of valuation then, is how to estimate a cost
or income stream associated with the intangible asset in its new use at another company. Several intangible
assets, on the other hand, are non-separable and cannot be wrenched apart from a company and transferred
to another. Examples include the talent of software programmers, toy designers, artists, and so on. In such a
case, obtaining such knowledge by contractual alliance means, such as licensing, franchising, and marketing
contracts may not work – the only way to acquire such intangible assets may be to purchase the firm as a
whole. In the latter case, one index of the purchase value of the company may be by estimating the alternative
cost (and delay) of replicating a similarly talented workforce (King, 2000).
For separable intangible assets several benchmarks of value apply. This is best explained by a
hypothetical case study. Let us suppose a US firm, called Company A, has developed a technology in the US
at a cost of $ 8.6 million -- spent on research and development, codification, and general commercialization
including legal and other fees for registering intellectual property. Company A has made successful inroads
into the US market, and has also begun to export the product to Country B. Direct exports to country B are
expected to be reasonable, but fall short of country B’s potential because Company A lacks good marketing
presence in that country. Export Sales estimates over the next 10 years are shown in the second column of
Table 2 below.
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To better exploit country B’s market potential, negotiations have begun with Company B in that nation,
with the idea of making Company B a licensee. With their own complete presence in country B, long
experience, and links there, Company B can license the same technology and achieve considerably better
sales over the 10 year product cycle, as shown in the fourth column of Table 2. By “technology license” is
meant an agreement-based package of (i) rights, (ii) restraints and (iii) services. “Rights” would typically
include some patent and copyright permissions for the assigned territory, but more importantly, also include
uncodified “knowhow” conveyed by Company A by training the prospective licensee so that they can produce
an efficient product in their country. These would be the “services” included in the agreement package.
“Restraints” most frequently included in the package restrict the sales of the licensee or ally to a particular
territory or country (in this case, Country B).
It is important to note that the valuation logic below, developed for a license, can with minor
modifications, also be applied to another alliance form such as an equity joint venture, or to an M&A scenario.
PART III: BENCHMARKS FOR VALUATION
Development Costs
Should Company A ask for $ 8.6 million from Company B to cover the development costs? This may
be a justifiable position if the development was motivated by, and amortizable over, only market B – a situation
which occasionally happens in contract research. In most cases however, R&D is motivated by the home, and
a few other principal country markets of the developer. Company A spent $8.6 million mainly with the
expectation of returns from its home in the US plus a few other major nations – although in theory at least,
Company A’s purview can be the whole world. A large company can, in theory, establish its own subsidiary,
export, or form an alliance in each of the 190 nations of the world, thereby recovering more against its R&D
expenditures for this technology. These days, development costs are motivated by, and amortized over, the
global market, or at least over several important nations.
But such costs are sunk, or irretrievable. What was spent in the past by Company A has really no
bearing on Company B’s willingness, or ability to pay. Company B moreover knows that part of the $ 8.6
million has already been recovered by Company A from its success so far in the US market – and there are
many more countries yet to exploit.
Of course, as a negotiation ploy, Company A’s representatives should harp on their large development
costs. But they know that,
Valuation Benchmark 1: R&D costs are sunk costs that usually have little bearing on the value of the
developed intangible asset outside the market purview of the developer (except in the case
of specific contract research).
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Table 2: Cash Flow Example for A Prospective Licensing Opportunity
 Development, Codification and IP Protection Cost of Technology is $ 8.6 million

Year
1
2
3
4
5
6
7
8
9
10
PVs
Projected Cash Flows Relating to License Proposal ($ Millions)
Export
Sales
Directly by
Company A
Lost Margins
on Exports (at
10%)
Company
B’s Sales
of Licensed
Item
0.5
0.6
0.8
0.8
1.0
1.1
1.1
0.9
0.5
0.2
.05
.06
.08
.08
.10
.11
.11
.09
.05
.02
0.5
1.2
1.8
2.5
4.0
4.5
4.6
5.0
5.0
5.0
PV at 12%
= 0.42
Company B’s
Incremental
Profit Margin
(at 16%)
.080
.192
.288
.400
.640
.720
.736
.800
.800
.800
PV at 17%
= 2.01
Lumpsum Fee
plus Royalty
(at 4%)
Lumpsum Fee
plus Royalty
(at 6%)
Direct Transfer,
Transaction
and Training
Costs
.10 + .020 .10 + .030
.048
.072
.072
.108
.100
.150
.160
.240
.180
.270
.184
.276
.200
.300
.200
.300
.200
.300
0.12
0.05
0.01
0
0
0
0
0
0
0
PV at 15 %
= 0.64
PV for
PV at 15%
Years
assuming non1 to 5
renewal
only
= 0.33
Note: The lumpsum fee is a one time payment of $ .10 million in Year 1.
PV at 15%
= 0.92
PV at 15%
assuming nonrenewal
PV at 12%
= 0.15
= 0.44
Transfer Costs
Let us now take the viewpoint of the prospective recipient of this knowledge to be licensed as an
intangible asset/service package. The negotiations have proceeded sufficiently far that Company A has
estimated the direct cost of the transaction in terms of its (a) incremental legal and negotiation costs (b)
training or teaching costs over years 1, 2, and 3. These “Transfer Costs” -- to transfer the technology and
capability to Company B -- are shown in Table 2 in the last column. They total $ 0.18 million over three years,
or have a $ 0.15 discounted present value.
Should Company B therefore argue that a payment of $ 0.15 to 0.18 million is adequate? No. The
knowledge supplier, Company A is most unlikely to agree. The “Transfer Cost” figure is only the absolute
minimum compensation needed to recoup only the direct incremental cost of the agreement incurred by
Company A. On top of that, Company A will want a recovery of part of its R&D costs plus some profit. Would a
software developer agree to sell a software package merely for the low marginal cost of transmitting it to a
user? Hence
Valuation Benchmark 2: The marginal cost of knowledge transfer comprises only a “floor price” or
minimum value for the knowledge.
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This is less trivial a benchmark than it would appear. The transmission costs of a developed software
package may be close to zero. However, in cases of very complex technology, the marginal or transfer costs
can be large. (In a few situations, the costs of transferring complex knowledge are so large that they may be
larger then the compensation that can be thrown off from a small or poor nation. In such a situation, there is no
way to adequately compensate the knowledge supplier for even the marginal costs of knowledge transfer).
Market Value
The most important valuation benchmark is the value of the transferred knowledge in its new market,
or field of use. Company B (the recipient of the knowledge) is expected to achieve sales of the licensed
product as shown in the fourth column on Table 2. At an expected 16 percent profit margin, Company B’s
profits shown in the fifth column, have a discounted PV (Present Value) of $ 2.01 million.
Should the knowledge developer Company A demand $ 2.01 million for transferring the
knowledge/services package top Company B? That would leave company B neither better off, nor worse off,
while all the gains of the knowledge transfer would accrue to Company A. It is unlikely that Company B would
agree to pay $ 2.01 million (unless own their sales and profit estimates greatly exceed those shown in Table
2). Here $ 2.01 million is the most or maximum that Company B can afford to pay Company A. In general,
Valuation Benchmark 3a: The profits thrown off as a result of a new knowledge transfer into a new
market, comprise a “Ceiling Price” or maximum value payable to the knowledge supplier.
Of course, not all knowledge transfers are for the purpose of developing a new market. In the case of
an existing product, where a knowledge transfer improves efficiency and reduces the costs of the knowledge
recipient, we have
Valuation Benchmark 3b: The marginal cost savings, resulting from the transfer of new knowledge to
an existing market, comprise a “Ceiling Price” or maximum value payable to the supplier.
In either case, the actually negotiated compensation will usually be considerably lower than the
maximum, because of moderating variables discussed later. Company B, as licensee, will actually want to pay
much less, so as to leave the lion’s share of the incremental market value created, to itself.
Opportunity Costs
Recall that the knowledge supplier, Company A, does have some prospects for directly exporting the
product to market B. On these exports Company A expects to earn 10 percent margins shown in column three
of table 2, whose discounted Present Value totals 0.42 million. By setting up the licensee, Company A not only
incurs Direct Transfer and Training Costs (of $ 0.15 million shown in the last column), but it will also lose the
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opportunity to export to country B and earn a profit margin totaling $0.42 million. (A licensee is often given
exclusive rights to their national territory). Company A would consider itself foolish therefore, to agree to any
compensation lower than a floor of (0.15 + 0.42) = $ 0.57 million. Hence,
Valuation Benchmark 4a: Profits on business lost by the knowledge developer, as a result of the
knowledge transfer, comprise an addition to the floor price, or minimum compensation
needed to justify the transfer.
A similar logic would apply in another common scenario. In oligopolistic situations like Korea, signing
an alliance agreement with one chaebol my spoil existing relations with another chaebol, and diminish profits
from trade with the latter. An estimate of lost business, and profits, in the existing chaebol relationship would
comprise an estimate of Company A’s opportunity costs in Korea.
Consequential Costs
A variant on the opportunity cost logic is the idea of consequential costs. For instance, in alliances,
there is the fear of misuse of intellectual property (Kay, 1993) or technology “leakage” of two sorts (Contractor,
1985). Leakage of technology to third parties, or competition from a former ally or a licensee is a potential cost
to be considered. This can occur after, but even before, the termination of an alliance agreement. Similarly, a
brand misused by a marketing ally in another country, or poor service rendered by a franchisee, can hurt the
reputation of the brand in third nations. This is not merely a strategy or negotiation abstraction. Money
damages from such consequential costs are routinely calculated by courts worldwide (Kay, 1993). Here the
negotiator may make such a calculation preemptively, assigning it some expected likelihood. More on this later
when we discuss the real options approach.
Valuation Benchmark 4b: Lost profits to the knowledge supplier, as a consequence of leakage,
increased competition, and degradation of intellectual property value, comprise a possible
addition to the floor price or minimum compensation needed to justify the transfer.
Thus the total minimum or “floor” price for transferred knowledge is the sum of
(a) Transfer costs to be incurred by the knowledge developer/owner (Benchmark 2)
(b) Profits on business lost to the knowledge developer as a result of the transfer (Benchmark 4a)
(c) Other consequential costs to the knowledge developer as a result of the transfer (Benchmark 4b)
Industry “Norms”
For better or worse, there are industry “norms” referenced by courts and the tax authorities or IRS, as
indexes of “reasonable” royalties in different product areas (Reilly, 1995). This has arisen, in part from the IRS’
14
search for arms-length equivalent benchmarks (Parnes, 1993) and the courts’ desire to impose infringement
penalties on violators that are based on industry averages.
One often-cited “norm” for calculating royalties is the so-called “25 percent criterion” (Evans, 1988).
This states that the lion’s share of the incremental profits created by the license, or about three-quarters, ought
to go to the licensee – while the licensor should receive royalties totaling 25 percent of the incremental profit.
Why? It is argued that this is because the licensee company (B in our case) makes the capital investment,
carries the heat of the marketing battle in their nation, and bears the investment risk. The licensor, it is argued,
is only the passive collector of royalties and fees, should the venture succeed, and licensor risks are limited to
receiving no royalties in the even of failure.
Based on this “25 percent norm” Company B, as prospective licensee, proposes a lumpsum of $ .10
million plus 4% royalty rate, shown in the sixth column of Table 2. This produces a discounted Present Value
(PV) of $ 0.64 million, which is in fact 32 percent of the $ 2.01 million incremental profits of Company B. This is
more than the 25 percent norm, and Company B considers this a generous offer.
However, the fact remains that such “norms’ have no economics basis. They have no theoretical
justification apart from the observation that the ally that bears the higher risk (the licensee in this story) should
be eligible for a larger share of the incremental value created by the transfer of knowledge. True. But who is to
say whether this ought to be 75 percent, or 55 percent? In actual practice, it often is less if the knowledge is
cutting edge, if the prospective licensee is very anxious to receive it, or if their market is small – in short if the
knowledge receiver is in a weak bargaining position. Even the argument that the licensee bears the bulk of the
project risk may not be true. A licensee may bear the capital investment risk, but the knowledge owner
undertook the R&D risk in the past. Alternatively, if there is an equity joint venture investment in the project by
the knowledge developer, than they are sharing in the project risk. Hence “Industry norms” merely reflect past
tradition and industry averages. They have no theoretical merit. But because they are referenced by
negotiators, courts and tax authorities, they act as benchmarks which negotiators cannot neglect.
Valuation Benchmark 5: Negotiators’ demands are often moderated by reference to “industry norms”
such as sector averages and the “25 percent criterion.”
The Bargaining Range
No economics theorist would make a normative recommendation that a knowledge developer should
be content with only 25 percent of incremental profits, especially for a highly valuable technology. The entire
bargaining range, from
15
$ 0.57 (0.15 in Direct Transfer/Training Costs + 0.42 in Opportunity Costs) as a floor price,
to
$2.01 million in total incremental profits generated in country B, as a ceiling price,
comprises the bargaining range. Company B has proposed a Lumpsum of $ 0.10 million plus 4% royalties,
amounting to compensation of 0.64 million --- not very much higher than the knowledge supplier’s floor price of
0.57 million.
Company A counter-proposes with a demand for Lumpsum of $ 0.10 million plus 6% royalties, which
would produce a discounted present value of $ 0.92 million (see second-last column in Table 2). From
Company A’s calculation, this would produce a net agreement profit of (0.92 – 0.57) = $ 0.35 million. Even this
$ 0.35 million could be posed by Company A negotiators as not really profit, but merely a needed partial
recovery of the past R&D costs of $ 8.6 million.
Options Moderating the Bargaining Range
As a general principle, the value of an intangible asset can range up to the marginal profits and/or cost
savings created by its incremental use in a new market or new field of use. However, this maximum is not
entirely appropriable by the knowledge supplier. Their demands are often moderated downward by options
available to the knowledge recipient.
In our case, Company B was in touch with Firm C, in Sweden Firm C has a similar technology claimed
to be roughly equivalent. Firm C is willing to license this at a 5% royalty. While preferring American technology
from Company A, this alternative Swedish option nevertheless enables Company B’s negotiators to put
downward pressure on Company A’s demands.
The Final Agreement: In the event, faced with this downward pressure, the US Company A reached
final agreement with Company B (not shown in Table 2). This entailed a 5% royalty payment, but a somewhat
higher lumpsum amount of $ 0.12 million (which would cover Company A’s Year 1 Direct Transfer costs, as
shown in Table 2. This compensation stream (Discounted at 15 percent) produces for Company A, a
Discounted Present Value of $ 0.80 million. At this level, both parties are in a “win-win” position, since both
companies stand to make significant net profits from the knowledge transfer: 0.80 – 0.57 = $0.23 million for
the knowledge supplier and 2.01 – 0.80 = $ 1.21 million for the knowledge recipient.
A range of options are sometimes available to a knowledge acquirer. The present value cost of each
can be estimated, and used as a negotiating lever against a prospective knowledge supplier.
Valuation Benchmark 6a: The compensation demand of a knowledge supplier can be moderated
downward by other options that may be available to the knowledge acquirer, such as (a)
16
Obtaining the expertise from another source (b) Developing the capability in-house with
their own R&D and (c) Risking deliberate patent or copyright infringement
By the same token, the knowledge supplier’s bargaining position can be affected by options they have.
Valuation Benchmark 6b: The knowledge supplier’s compensation demands can be influenced
upwards or downwards by options available to the knowledge developer/supplier, such as
(a) Compensation available from alternative alliance/JV partners in the target market (b) the
Discounted Present Value of entering the market themselves by establishing a subsidiary,
or other means
Indirect Benefits and Costs
Sometimes indirect costs and benefits to the knowledge supplier can be significant and have
substantial monetary value or consequence. Indirect benefits to the knowledge supplier may include
Valuation Benchmark 7a: (i) Profit margins on other supply/purchase side deals with the partner or
their associates, engendered by the agreement. (ii) Network externality or scale benefits in
the case of software and franchising.
The above indirect benefits have been substantial to some firms, even more than the direct cash
throw-off from the agreement itself. For example, a Detroit automobile firm formed an alliance with a Turkish
assembler of cars. Direct royalties on each vehicle were trivial -- merely a few hundred dollars per car. The
real money made by the Detroit company was in the margin on the supply of kits, sub-assemblies and parts to
the Turkish ally. Such indirect effects are sometimes mistakenly ignored by negotiators in their calculations,
because they accrue to other divisions of the company, or because their calculation is deemed to be difficult.
This is not necessarily the case. An estimate of likely component trade or other side business generated by the
agreement can be made, profits estimated thereon, and discounted present value calculated.
Similarly there could also be indirect costs (possibly accruing to other parts of the company).
Valuation Benchmark 7b: Indirect costs to the knowledge supplier, such as liability claims made by
foreign customers, poor quality control or customer service leading to diminution of brand,
service marks or reputation, should be factored into their cost calculation, together with
estimates of the probabilities of such occurrence.
Direct Compensation Paid For Knowledge
Once the terms of the agreement are finalized, one can calculate the discounted present value of
direct payments to be made for the knowledge.
17
Valuation Benchmark 8: Direct payments for knowledge made in the form of contractually-specified
fees and royalties (two examples are shown in columns six and seven of Table 2) and
returns on equity investment in case the knowledge supplier takes an equity position in the
recipient firm.
Duration of the Agreement
The last row of Table 2 shows the present value of compensation if cash flows stopped after Year 5.
Such a calculation clearly shows that a short agreement would yield insufficient return to the knowledge
supplier, even with a high royalty. Prospective licensees stoutly maintain that they will renew for another 5 year
term. But can they be trusted? If not, alternatives such as a joint venture (of theoretically indefinite life) or
acquisition, or “greenfield” entry in to the market by the knowledge supplier, should be considered.
Benchmarks in the Case of Equity Joint Ventures or Acquisitions
It is important to reiterate that the same valuation principles apply in the case where the knowledge
supplier takes an equity position in the recipient (in lieu of, or in addition to receiving royalty income stream).
Dividends may be regarded as merely another channel (besides lumpsums and royalties) whereby the
knowledge developer is compensated. Similarly, in the case of an acquisition or merger, many of the same
valuation benchmarks, such as alternative real options, market value, and knowledge transfer costs apply.
PART IV: A COMPREHENSIVE FRAMEWORK FOR THE VALUATION OF TRANSFERRED INTANGIBLE
ASSETS – THE NEGOTIATING PERSPECTIVES OF KNOWLEDGE SELLER AND ACQUIROR
We can now summarize the above Valuation Benchmarks into a comprehensive framework.
The whole objective of this paper is not merely to provide tips to negotiators, nor is it merely to air strategic
concepts, important though they may be. Rather, it is to reduce each valuation concept to a measured
monetary figure – in short, to put a discounted present value number to several valuation benchmarks, and
then provide an overall bargaining framework, shown in Figure 3.
Benchmark 8 is shown in two versions in Figure 3. B8b is (the present value of) direct compensation
paid by the knowledge recipient. However, because of withholding and other cross-border taxes in the
international arena, the (present value of) the amount received by the knowledge supplier is less, B 8a. B8b >
B8a.
18
Figure 3: AN OVERALL KNOWLEDGE VALUATION FRAMEWORK
KNOWLEDGE
SUPPLIER
Calculate Discounted Present Value of
BENEFITS
COSTS
B8a: Direct Compensation Received as
B1: R&D costs
part of knowledge transfer or agreement
_____________________________________
B2: Marginal cost of knowledge transfer
B7a: Indirect benefits
B4a: Opportunity costs (Profits on business lost
as a result of the knowledge transfer)
B4b: Consequential costs
KNOWLEDGE
RECIPIENT
MODERATING
FACTORS FROM
THE EXTERNAL
ENVIRONMENT
B3a: Incremental Profits from use of
knowledge in new market
B7b: Indirect Costs
B8b: Direct compensation paid for knowledge
acquisition
B3b Efficiency/Cost Savings on existing
items from use of new knowledge
B5: industry “norms”
B6a: Other acquisition options available to the knowledge acquirer
B6b: Alternative market entry options available to knowledge supplier
Axioms For Negotiating
Each negotiating side should calculate all the relevant benchmarks for benefits and costs shown
above. From this follows axiomatic conclusions:
1) B8b << B3a + B3b.
From the knowledge recipient’s perspective the direct payments they make to acquire knowledge
should, preferably, be much less than the incremental benefits created by the transfer of this knowledge in
their territory or field of use.
2) (B8a + B7a) - (B2 + B4a + B4b + B7b) >> 0
From the knowledge supplier’s perspective the direct plus indirect benefits of the transfer minus all
relevant costs should greatly exceed zero. Otherwise, this proposed agreement is not worth it. Notice that in
the above expression, R&D costs B1 have been ignored, on the grounds that they are sunk costs. However,
this may not be appropriate in case of contract research, or when the number of nations/markets/fields of use
over which the R&D is to be amortized is small. In general, a better approach for a knowledge supplier would
be to target,
(B8a + B7a) > (B2 + B4a+ B4b+ B7b) + B1(pi/pg)
19
where pi is the expected sales in the assigned territory (or field of use) and pg is the expected global sales for
the world as a whole – both over the expected life of the arrangement (specified by agreement in the case of a
license, or theoretically indefinite in case of an equity joint venture or acquisition). The factor p i/pg then prorates
the amortization of the R&D cost in proportion to the share of each market in the global total. These days,
fewer companies are comfortable with treating R&D as a sunk cost on the assumption that amortization need
occur only over the home market or principal markets of the developer. With escalating R&D costs, companies
are increasingly seeking returns from every foreign market. R&D costs therefore cannot always be treated, in a
negotiation, as sunk costs. Having said that, they and the other negotiating side know that under severe
negotiating pressure, the R&D component can indeed be ignored. The compensation could still be
incrementally acceptable, with the following criteria:
3) (B2 + B4a+ B4b + B7b) comprises the “floor price” or absolute minimum for the knowledge.
4) (B3a + B3b) constitutes the “ceiling price” or absolute maximum, and
5) (B2 + B4a+ B4b + B7b) < B8a < B8b < (B3a + B3b). That is to say, the actual compensation finally
agreed upon will fall between the bargaining range between the floor and ceiling. There is no deterministic
model which specifies where B8 will fall within the bargaining range. That depends on the relative negotiating
power of the parties, which in turn, flows from the desirability of the knowledge, its newness, the reputation of
the knowledge supplier, the size and affluence of the target market (and other variables that are not covered in
this paper). We do know however that the final size of B8 will be influenced by
6) B5 or B6a or B6b, as moderating factors from the external environment.
PART V: ADJUSTED PRESENT VALUE AND OPTION PRICING
The general consensus of finance specialists is that in situations where different levels of risks and
opportunity costs impinge on the various benefits and costs of a complex investment proposal, that a single
discount rate is inappropriate for discounting heterogeneous cash flows (Luehrman, 1997; Arthur Andersen,
1992). In any case, the two negotiating companies will use different discount rates. Even within the same firm,
different cost and income streams should be discounted at different rates as shown in Table 2. This is the
adjusted present value approach. A discounted cash flow (DCF) analysis, illustrated above, should be
supplemented by an options approach to investment (Dixit and Pindyck, 1995). This is a complicated
technique, but its foundation is a comprehensive mapping of strategic alternatives in a decision tree similar to
that shown in Figure 4. At the least, such an exercise serves to highlight neglected options to the negotiator or
strategist, and the final calculation is a cross-check against the investment/negotiating recommendations
which flow from the DCF analysis.
20
Figure 4: STRATEGIC OPTIONS
Increase Export Push and Sales
No Change
Other company (refused ally) licenses from
another firm
Negotiations
Collapse;
Continue to
Export
Refused ally makes their own investment
Licensee renews
Strong
Market
Scenario
Form
Licensing
Alliance
Former licensee
controls market
Does not renew
Former licensee
competes worldwide
Licensee renews
Weak
Market
Scenario
Does not renew
Strong market scenario
Former ally
controls market
JV
continues
JV terminates
Former ally
competes
worldwide
Equity Joint Venture
Weak market scenario
JV continues
Other company (would be ally) folds
Fully-owned subsidiary
Other company (would be ally) provides
entrenched competition
Figure 2 shows the licensing alliance option detailed in our case, together with other alternatives to
reach the foreign market, such as continued export, forming an equity joint venture or a fully-owned subsidiary.
The essential point of the options approach is not to wait and see if the negotiations succeed or fail, before
considering alternatives. Instead, even before the negotiations begin, the negotiators and strategists should
21
draw an options map such as the one illustrated. Calculating the value of each branch will reveal the preferred
path, and reveal whether a license is the most desirable in the first place, compared with other options. In any
event, the discounted cash flow (DCF) approach works in all cases, and the valuation framework in Figure 3
can be used for a joint venture negotiation or other alternatives as well.
PART VI: CONCLUSION -- WHAT THIS VALUATION FRAMEWORK PROVIDES MANAGERS
This paper has provided a general set of principles, organized into a useable framework, for the
valuation of intangible assets as well as corporate knowledge, in the act of transferring, sharing, selling, or
licensing it from one company to another. It provides benchmarks for valuation to both seller and acquirer, to
licensor and licensee, and to both partners in a corporate alliance. Many of the same benchmarks or criteria
also apply to acquisitions and mergers.
Intangible assets, whether registered intellectual property such as brands, patents, copyrights, or
whether they be “knowhow” or general corporate expertise, are increasingly separable from their
organizational context, and can be sold or shared with another firm for compensation. As such activity
increases -- as part of a general trend towards outsourcing and modularization of business functions, aided by
codification of previously tacit or intuitive knowledge -- placing a money value on a “knowledge package” is a
crucial managerial function. Many of the principles presented in this paper can also be used when the same
firm makes its own investments in other markets, by transferring corporate knowledge to its own subsidiary.
The various benchmarks and criteria found in the literature are here, for the first time, presented in a
comprehensive valuation framework, eminently usable by managers and negotiators.
22
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