For many small businesses, intellectual property is the most significant asset on the balance sheet.
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Although an accurate appraisal of the company's intellectual property is essential, assigning a value to something that can't be seen or touched is difficult . . . But not impossible.
Like any other asset, the actual value of intellectual property is the amount someone is willing to pay for it on the open market. However, since the actual value of property can only be determined when an asset is sold, the valuation process is essentially an informed estimate of the asset's value. Since estimating value can be tricky, even for tangible assets like equipment and real estate, business owners rely on a handful of tried and true valuation methods. Here are three of the most common valuation techniques used to assign value to intellectual property.
The most accurate method for assigning value to an intellectual asset is to locate sales of comparable assets in the marketplace. Unfortunately, market-based valuations are also the most difficult to conduct. Unlike real estate, the pool of comparable sales of intellectual property is extremely limited.
Additionally, intellectual property is frequently sold as part of a larger asset (e.g. a company or business division), making it impossible to determine how much of the selling price was attributed to the intellectual property and how much was attributed to other assets. If you can locate comparable sales of intellectual property, then a market-based valuation is probably your best option. But in most cases, you will need to pursue another valuation method.
Cost-based valuation methods are popular because they are the easiest way to assign value to an intangible asset. Using either the cost of creating or the cost of replacing the asset as your basis, the process of determining an informed estimate of the asset's value shouldn't be very difficult.
However, cost-based valuations are inherently flawed because they don't tell the entire story. Even though the cost of producing or replacing an intellectual asset is a good starting point, the current market value of that asset might be much higher than the replacement value. If possible, it is always preferable to weigh a cost-based valuation against other valuation methods that are more in tune with the asset's current market value.
A third way to determine the value of an intellectual asset is a valuation based on the asset's past and future earnings potential. While the other two valuation methods rely on either comparable sales or replacement costs, this method determines value based on the asset's earning capacity.
The manner in which an appraiser can apply the income method to the valuation of an asset varies (e.g. capitalization vs. profit differentials). Given the diversity of approaches within the income valuation method, it's important to understand whether the valuation has been based primarily on historic performance or future potential. Unless you can provide a rational reason for preferring one over the other, both should be considered in the valuation of the asset.