Background

In today's knowledge economy, intellectual property rights (IPRs) are often the most important assets a company owns. Intellectual capital is now widely appreciated to be the foundation for the market dominance and continuing profitability of leading corporations. According to Interbrand, Apple's brand – the world's most valuable – was worth USD 234.2 billion in 2019.

The value of IPRs in Western economies is undisputed. The September 2019 study IPR-intensive industries and economic performance in the European Union by the European Union Intellectual Property Office found that IPR-intensive industries generated 29.2% of all jobs and almost 45% of total economic activity in the EU, worth €6.6 trillion, during the period 2014-2016.

IP-driven companies will have an increasing role in M&A activity, backed by acquisition finance.

Growth of IP-rich businesses

Investment in IP makes a significant contribution to the UK economy. The UK IPO's Innovation and Growth Report 2018-19 revealed that in 2016, domestic firms invested an estimated £134.3 billion in knowledge assets, of which £63.8 billion was protected by IPRs. This equates to 6.8% and 3.2% of total GDP respectively.

The UK is an IP success story. For example, our games industry is the largest in Europe and generates £2 billion in exports every year, while our publishing sector is worth £5 billion.

Lending to IP-rich SMEs

Securing sustainable finance is essential for the development and growth of any business. Commercial lending usually favours those businesses rich in tangible assets, such as real estate, which then provides security for those loans. However, for many businesses, IPRs constitute their single most valuable asset and can equally be used as a lever to secure debt finance.

IPRs are generally not formally valued in the banking sector. The general consensus is that IP is too risky to be used as collateral for traditional loans. The final report from the Expert Group on Intellectual Property Valuation (EU Commission, 2013) comments on the "growing number of SMEs who have difficulties in securing bank loans".

In order to bridge this funding gap, Creative England has launched, in partnership with Triodos Bank, a £24 million Creative Growth Finance Debt Fund, which will provide loans of up to £500,000 to IP-rich firms already generating revenue with potential for growth and scaling. This is intended to assist creative industry SMEs to scale up; at present, 72% of these SMEs suffer from lack of growth capital. The fund will offer one of the most competitive interest rates on the SME lending market, with each loan's repayment structure being individually tailored.

Quantitative valuation

IPR valuation is a process to determine the monetary value of IP. This improves the accuracy of a company's worth and allows businesses to recognise previously uncapitalised assets and guide strategic and budgetary decisions. While multinational corporations increasingly value their IPRs, SMEs are often reluctant to do so. This is often due to the costs involved and the apprehension of a complicated process.

However, the importance of IPR valuation is significant to newer businesses – an accurate and substantiated valuation of IPRs is statistically likely to increase outside investment.

There are a wide range of situations in which a business may require its IPRs to be valued. These include:

• the sale or purchase of a business or its assets
• assessing damages in the context of IP infringement; lending or borrowing, and
• for tax purposes.

The value of any IP asset is subject to change. Therefore, it is difficult to measure the value of an IP asset when giving security. However, if IP assets are to be used for raising debt finance, then any lender will require an accurate IPR valuation, to demonstrate the value of the IPRs and how they support the future cash flow of the business.

IPR valuation recognises three distinct approaches to the appraisal or valuation of any asset. These are usually described as the cost, market and income approaches. Each has its limitations and no method is appropriate in every case. Indeed, they are often used in combination.

Cost approach

The cost approach measures the value of an IP asset by calculating the cost of developing and creating the IPR. It also evaluates what the costs would be for recreating a similar IP asset. The costs incurred in developing IP could include any or all of the following:

• labour hours
• materials and equipment
• research and development
• creating a prototype
• testing and trials
• regulatory approval and certification
• registering the IP, and
• overheads for utilities, accommodation and support staff.

This method assumes that a potential buyer can avoid these costs by buying the IP, which affords the buyer relief from the following risks:

• Expenditure – spending at least as much time and money attempting to recreate the IP or develop a similar IP asset.
• Success – being unsuccessful in developing the IP.
• Protection – being unable to protect the IP.

While frequently used in valuing investment companies and capital-intensive firms, this approach is not necessarily an appropriate method of valuation. Future revenue, a standard by which value is traditionally calculated, is not taken into account at all. The sole focus on costs rather than profit results in a failure to recognise market potential.

Market approach

The market approach measures the value of an IP asset through the analysis of market transactions of comparable IP. Market valuations provide a realistic and more objective value to IPRs.

However, in practice difficulties are encountered when applying this method, as it can be very challenging to obtain published data on IP transactions, which are usually confidential.

IP transactions are hard to generalise and no transaction is exactly the same to allow for a valid comparison. Varying circumstances in IP transactions include differences in relation to economic climate, market conditions, territory and exclusivity. Businesses trading in niche markets are very often unable to locate any comparative information for their IPRs.

Income approach

An income-based valuation estimates a fair value of the IPRs by looking at expected future earnings and benefits, discounted to the present. Measuring the value of IPRs by the present value of their future economic benefits accounts for the future income which the IPR may generate, and the costs of generating that income. The result of this, which is then discounted to allow for risk and cost of capital, is the net present value (NPV). Buyers can then consider investment based on whether the NPV is positive or negative.

However, although the NPV is a useful tool, it is important to remember that the income method is based on an appraisal of likely future events rather than past performance. There are a number of problems with an income-based valuation, which include the following:

• it is difficult to estimate the economic life of IPRs
• it is not realistic to forecast income beyond five years; in any event, it is very difficult to estimate the income of early stage technology
• establishing a fair and reasonable discount rate can be problematic, and
• many factors such as the potential market for the IPR, the nature of the competition, the economic climate and enforcing and defending the IPR need to be taken into account.

All of these approaches typically result in a monetary value and are quantitative in nature. As mentioned previously, no method is complete in encompassing all variables that factor into a valuation.

Qualitative valuation

Alternatively (but much less commonly), qualitative methods of valuation can be employed. These methods of valuation attempt to provide a non-monetary estimate of the value of IPRs by rating them on the basis of their strategic impact, impact on the company's future growth, brand loyalty held by consumers and other intangible metrics that do not rely solely on numbers.

One method of qualitative valuation assesses the competitive advantage afforded by the IPRs in comparison to similar companies in the market. After all, the overarching principle guiding IPR valuation is the extent to which a company's IPRs provide a competitive advantage over others in the industry.

Qualitative methods are often used for internal and/or strategic purposes because of their non-monetary nature.

Conclusion

IP-rich companies straddle many market sectors: fintech, biotech, pharmaceuticals, gaming, and online retail, to name a few.

UK fintech start-ups reached a record level of USD 2.9 billion of funding in the first half of this year. Boris Johnson has said he wants the UK in the number one global slot for biosciences. We have a stable and respected IP regime.

For these reasons, IP-rich companies are, and will continue to be, a feature on the UK's acquisition finance landscape.