Property rites

Got the idea from hell, but worried the suits will charge you a fortune to put a price tag on it and protect it from those who would pinch it? Mark Broatch surveys your options.

Got the idea from hell, but worried the suits will charge you a fortune to put a price tag on it and protect it from those who would pinch it?

Even just defining intellectual property (IP) is no easy task. A PricewaterhouseCoopers paper says that IP “acquires its essential characteristics, from which value emanates, from the legal system”.

The law gives rights to people who create things that embody new ideas or ways of expressing ideas, or use certain distinguishing marks. The unique characteristic of legal protection causes it to be a subset of the intangible assets of a business enterprise.

Legal protection gives it value, which may be considerable if its potential earning power can be harnessed.

As PwC notes, the property may have resulted from arduous and costly research, or by simple dumb luck. Luck does play a part, for good or otherwise, and businesses should be prepared for its appearance. IP often requires hefty capital and personnel outlay to create, and many other pieces to “spit out the most cash”, as one valuation specialist succinctly puts it.

So what is IP?

PwC notes the obvious that can be protected: patents, trademarks, copyrights, industrial designs and trade secrets and know-how. Cybersquatters on an obvious web address may also be unseated. That clever software you have developed may or may not be protected by law.

Other intangible assets created by a business might typically include a trained workforce, distributor and supplier networks, customer loyalty, training materials, subscriber base, management depth and goodwill. But the trend by firms to implement customer relationship management and knowledge management systems, to more effectively capture institutional knowledge, suggest that the line between IP and other intangibles is being blurred even more than at present.

PwC vice president Zareer Pavri notes that goodwill may be accounted for under identifiable tangibles such as trademark recognisability and it may be impossible “to precisely segregate intellectual property value from goodwill”. Giving another view, a Deloitte Touche Tomatsu seminar paper separates intangibles and goodwill if the asset can be divided and sold, transferred, licensed, rented or exchanged; or control over its future economic benefits results from contractual or other legal rights.

IP and other intangible assets may have a value because they attract huge current or future revenue streams — which is why firms such as Gen-i and Axon are working actively to better exploit their IP assets — but no immediate legal protection. (Apart from intangible assets, a business has property, plant and equipment assets and working capital, which is current assets less current liabilities.)

This might indicate that as soon as practicable smart start-ups need to dot every legal “I” and cross each contractual “T”, what AJ Park partner Ken Moon calls an “IP audit”, preparing the legal way for the accountants and uncovering potential flies in the ointment like open source licences, he says.

So what comes first, protection or advice? Deloitte corporate finance associate director Brian Buss argues that identifying the strengths and weaknesses of your IP — what assets are missing for its full exploitation — should be undertaken early in the entrepreneurial process, prioritised ahead of IP protection measures like patents.

Patents give companies the right to defend, but it is better, for instance, to spend time and money getting your distribution strategy right, he says.

Chapman Tripp IP specialist Bram van Melle estimates that obtaining a local patent will cost perhaps $10,000 and a US one $50,000 to $60,000. Developers like Artisan’s Chris Chamberlain note in comparison that trademarks don’t cost much to file. Whatever the IP protection route taken, lawyers argue that money spent on legal advice early on is likely to be far less than that of a company that has to sort out problems later.

Why do you need to value IP?

Valuation of intellectual property is done for many reasons, the bulk of which in this country are probably in the event of a take-over or the pursuit of capital, taxation, or assessing as collateral and for insurance purposes. However, licensing, joint ventures, bankruptcy and litigation may also be catalysts for valuation.

Sydney-based Macquarie Bank associate director Belinda Cooney has been involved in the process as an investor, a buyer and in the task of raising capital. Valuation of IP is a “sticky” issue, she acknowledges, and not an exact science, a comment echoed by other valuers. This is the case especially if the business based on the IP doesn’t yet exist.

Buss notes that people’s ideas have no real value until they generate earnings. The valuation may therefore be driven entirely by demand and a crude analogy can be made with real estate, says Cooney: how many people are at the auction and what did the last house in the street sell for? Early-stage companies come in with an idea of what their IP is worth, and in 80% of cases there is a difference between their management and the person holding the cheque, she says.

Where do you go to get your IP valued?

The large accountancy firms and a few other valuation specialists, such as venture capitalists and merchant banks will do it for you. Such high-end advice is “not cheap”, accepts Buss, one of the few chartered financial analysts in the country. Smaller firms are likely to sort it out among the directors, as the founders of Artisan Software did, or seek advice from their lawyers or outfits like the New Zealand Computer Society or New Zealand Software Association. Screeds of information is available from outfits like BizInfo, Trade New Zealand and Industry New Zealand.

They may go to accounting firms, says Cooney, but if they are valuing for a possible sale it’ll be a waste of money. The buyer will ultimately set the price. Accepting that venture capitalists usually push the value down, she says there is a floor level of value below which the founders will no longer feel motivated to continue the enterprise.

How do valuation specialists work?

There are three accepted approaches, says PwC: cost, income and market. Cost refers to the amount of money needed to replace the “future service capability” of the IP. This does not consider directly the amount of economic benefits, and depreciation due to physical use, functional and economic obsolescence must be taken into consideration.

Critics say the cost for a successful venture must also reflect the cost of failures. (Cost estimation for IP such as software takes forms from obvious to arcane, including expert judgement, by analogy, Parkinson estimation, or algorithmic models such as COCOMO.)

The income approach assumes that value is measured by working out the present value of the net economic benefit over the life of the asset. PwC says this is best suited to IP such as patents, copyrights and trademarks, as it is difficult to ascribe value where conditions are not conducive to deriving economic benefit. This approach takes into consideration income amount, duration and risk. Hence an ability to accurately forecast (for which there are also several means) aspects such as revenue and expenses and factor in economic and political variables, availability of labour and materials, demographics and population trends becomes a vital factor in the equation.

The market approach reflects what others — in a liquid and public market — judge it to be. Because public-market pricing and other comparative information about IP is hard to come by (think of Cooney’s house in the street — two or three bedrooms?), this method is less likely to be used.

Whatever the type of IP or the valuation firm, a mixture of methods is likely to be employed.

Eric Lucas, a corporate finance partner at PwC New Zealand, says the approaches taken will depend on a client’s circumstances. “There’s no typical job.” A software business may be looking to sell, or a company may be looking at its tax structuring or the deprecation of intangible assets. It may be looking to sell rights to a product, protect its assets or quarantine an aspect of a larger asset.

Intangibles are the hardest piece of most valuations, says Lucas, and the task will typically be attacked from two or three directions, such as using a multiple of earnings or revenue, or discounted cash flow. The ultimate aim is “to say how much cash it will spit out”. Valuing the assets of a start-up venture will be completely different

to valuing an established company, which has a track record, customers and has

developed regular updates to a product.

However, there may be a “first mover” fillip to a start-up’s valuation, he says.

Those companies with a range of products will be valued differently to those with just one or two. Value and economic life have a very close relationship, says PwC. The economic life of an asset is different to its service life (installation-to-retirement, irrespective of earnings capability), and ends when it is no longer profitable to use it or more profitable to use something else. The valuer must estimate this with factors such as legislation, competitors and innovation in mind, and it will depend on the type of IP.

Valuation comes down to various analysis tools, says Buss, plus experience and “large doses of common sense”.

Lucas, who has carried out expert evidence work — a web search found his involvement in an independent valuation for the majority sale of the Singapore arm of local telco Newcall — says because some of the assessment will be opinion, there is no right answer and a pricing range will usually be offered. Different valuers might diverge, he accepts, especially if the terms of reference are not the same.

A “point estimate” might be needed for tax, he notes. The key is to recognise that each approach has a weakness and the valuers will use two or three. “With the best will in the world, nothing’s perfect.” He likens it to walking round a car to look at it from all angles, and notes that value in any case is a very transitory thing.

How do you protect your IP?

Apart from considering the usual legal protections, such as copyright, patents and trademarks, IP lawyers suggest nailing down contract issues. Contractors and employees generally accept that they are essentially selling the output of their brain, and the resulting IP belongs to the employer unless otherwise stated in one’s employment contract. A typical clause from a real contract: “All copyright, know-how, designs, trademarks, and all intellectual property rights utilised and created as part of this agreement are owned solely by the employer.”

One of the most famous cases in which “crossover” problems come about when the employee is also a programming hobbyist involved Apple co-founder Steve Wozniak. He reportedly offered the Apple computer design to HP — his then employer — but HP thought the idea was unmarketable and gave him a release to sell it on his own.

Van Melle, who is delivering a seminar on the subject of IP later this month, advises that IP should ideally never be jointly owned or “entwined”, unless there is a specific reason for it. How a firm views ownership commercially is not equal to how the law views it, he says. Most large firms are more aware of their IP legal requirements than start-ups, van Melle says, though the various seed funds now make them “jump through a few hoops”.

Get legal advice early, he recommends, as fixing things later is usually more expensive.

The default rules at law are not usually satisfactory so contracting for rights is the safest course, he says. As well as ironclad contracts with contractors, you may want warranties from employees and demands such as that they must disclose source code to the employer.

“You need to be able to sell what you’ve got,” he says, likening it to the Rugby World Cup’s need for “clean” stadiums free of advertising and litigious corporate box-holders. Investors will look at your freedom to trade, he says. If you are buying an interest or a company, lawyers will look at the IP as part of due diligence. Be specific once you have established a roadmap and development milestones, van Melle says, and don’t be afraid to ask law firms for estimates.

What about tax?

Software developed for sale forms part of a company’s trading stock and associated costs are fully deductible against taxable income, says the IRD.

The tax office says expenditure incurred in developing computer software does not need to be assessed independently, as long as adequate records are kept. However, independent assessments of work in progress are more likely to occur “where an entity carries on a business of developing computer software for sale and elects to adopt the market value option for valuing trading stock” (IRD wouldn’t say by whom, but the large accountancy firms would not be a bad bet).

IRD says some predevelop-ment R&D costs (such as a feasibility study) for software to be used inhouse are deductible in the year incurred. Subsequent costs, including the actual development of the software, must be capitalised and depreciated at the prescribed rate because they are incurred in producing an asset that provides an enduring benefit to the business.

If a business commissions software development externally or buys an off-the-shelf product, all costs are incurred in acquiring an asset with an enduring benefit, so they have to be capitalised and depreciated (see Tax Information Bulletin Volume 4, Number 10, on the IRD website).

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