Testing the reasonableness of royalty rates in valuation

Steve Economou, managing director of Curtis Financial, got into IP valuations "by accident" about 15 years ago. He now does it for tax, transfer pricing, and purchase price allocations, generally. He brought his experience to a session on supporting royalty rate valuations to the ASA Advanced Business Valuation Conference in Phoenix this morning.

Economou reminded attendees of the essential guidance in royalty rate valuation compliance, including:

• IRS section 482--which outlines their 10 requirements on transfer pricing calculations. "I believe there is a preference to see market data rather than level 3 assumptions," Economu states.
• Georgia Pacific factors from the 1970 Georgia-Pacific v. United States Plywood Corp. decision regarding the value of intellectual property (Economu directs people to the Journal of Accountancy 2008 "Royalty Rates" article on GP for further guidance on:
  • IFRS 3, ASC 805, 350 and 820, with their emphases on highest and best uses, and hypothetical market participants; and
  • OECD 42.

"I don't want to criticize the sources of documents," he said, "but I'm always facing client, auditor, or regulator scrutiny. "So, royalty rate comps data is often easily challenged."  This is particularly challenging after Uniloc v Microsoft rejected the 25% rule of thumb," he points out. "This often means that your role is to prove that you're not wrong!"  This can even be with the help of ktMINE, or "Dave Weiler at Royalty Source."

Here are the basic questions Economou asks:

• What is each IP basket?
• How is the IP used together?
• What is the line of business?
• How much revenue and profit is generated from the product using the IP?
• What is the nature of the IP, how is it protected, and how protectable is it?
• Has the IP been defended in the past?  Outcome?
• What is the company's operating history and profits?
• Who is the peer group for operating performance, either from RMA or from guideline public companies
• And, what similar licensing transactions exist, as mentioned, from ktMINE or Royalty Source (or others)

The basic questions must be augmented by specific information on trademarks or patents, formulas, or trade secrets. "I like to ask how the technology generates a competitive advantage and improve profitability," he says. "I've had clients who argue that their technology is the best anywhere, but then admit their profitability is 5% when their peer groups are running at 20%," he joked.

Royalty rate comps do have limitations. Typically,

• They have a wide range of data;
• Closer scrutiny of underlying terms often negates nearly all compatibility;
• You often don't know much about the licensee or licensor;
• It may include inter-company transactions;
• The time period or market conditions may be completely different; and
• Early payments can have a huge impact on terms.

"As I said, there's still a preference for market data, despite these problems, so appraisers should support their conclusions both qualitatively and quantitatively," Economou concludes. He mentions a case study created by ktMINE where an entire set of comps was rejected by the IRS. "What that client failed to do was offer qualitative support, so they now have the 'null set' problem."

Economou presented a number of weighted average return analyses, looking at the fair value of elements such as cash, cash free debt free working capital, trade names, proprietary technology, customer relationships, covenants not to compete, implied goodwill, assembled workforce, and internally developed software. Several people in the audience commented that they've noticed that this kind of valuation often ends up with high allocations to customer relationships. Economou agrees that "this can be a risk and perhaps appraisers tend to overvalue this segment."

Royalty rate analyses often would make an observer question the acquisition in the first place.  In any case, sanity checks are critical, and "you can go off the rails quickly if you don't watch." There are many PPA cases where the analysis provides a price widely lower than what a private equity firm just paid, for example.  "You can end up with the sense that you have no idea why the PE firm paid zillions for IP worth a couple of hundred thousand dollars," one session participant commented. Of course there are other reasons--keeping other competitors out, for instance. But the first investors frequently seem to do pretty well, Economou agreed.

Declining royalty rates, or revenues? One other participant commented that nearly all the analyses he sees use constant royalty rates over the life of the asset, and he questions whether this makes sense. Economou said he tends to degrade the revenues rather than the royalty rate, since "we have better market data on revenues than on royalty rates." Another expert commented that few agreements have declining royalty rates, so this would be unusual. The consensus of the participants at the ASA session was that you were calculating for the correct mid-point royalty rate--and then applying it to the projected revenues or profits. No one in the room said they'd attempted to support a declining royalty rate in their appraisal work.