Valuation of Technology Companies

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Jul/Aug 2003

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The valuation of in-process research and development
(IPR&D) remains a complicated issue with regard to technology companies
emerging from bankruptcy protection. The valuation of IPR&D is also a
complicated issue in the acquisition of technology companies, whether or not
the target company is financially distressed.

Since the
market correction of the Internet and dot-com company prices in the year 2000,
many technology companies filed for bankruptcy protection. While many
technology companies ultimately failed in the last few years, many others have
reorganized and are now emerging from bankruptcy proceedings. These reorganized
companies adopt the fresh-start reporting provisions of the American Institute
of Certified Public Accountants (AICPA) Statement of Position 90-7 (SOP 90-7).
SOP 90-7 provides for the recognition of IPR&D for the reorganized
technology companies.

There
are fewer technology company acquisitions (including hardware/software,
Internet, and dot-com companies) today than there were in the 1990s. In
addition, the acquisition prices for such companies today are lower than they
were in the 1990s. Nonetheless, consolidation is still taking place in many
technology industries. However, now that consolidation is motivated by economic
survival strategies and not by investors' irrational exuberance. Such
business combinations are accounted for using the purchase accounting
provisions of the Financial Accounting Standards Board (FASB) Statement of
Financial Accounting Standards 141 (SFAS 141).

Even
with current technology-company acquisitions consummated at lower pricing
multiples, acquirers often recognize some purchased IPR&D. This is because
technology companies typically own little in the way of tangible assets. And
even financially distressed technology companies have R&D projects in
progress at any point in time.

This
article will discuss the current issues regarding IPR&D valuation. We will
explain the bankruptcy and merger and acquisition (M&A) circumstances in
which IPR&D is recognized. We will describe the generally accepted
IPR&D valuation methods. In the late 1990s, the Securities and Exchange
Commission (SEC) investigated the purchase price allocation (PPA) of numerous
technology company acquisitions. Based on these investigations, the SEC issued
relevant professional guidance with regard to IPR&D valuation.

<h3>Accounting for R&D Costs Related to Business Combinations</h3>

SFAS
2, issued October 1974, remains the current GAAP for financial accounting and
reporting of research and development (R&D) costs. The objectives of SFAS 2
are to (1) reduce the number of alternative accounting and reporting practices
and (2) provide useful financial information about R&D costs. SFAS 2
provides the following definitions of R&D:

<ul>
<li>Research is a planned search or critical investigation aimed at the discovery
of new knowledge. Research is performed with the expectation that such
knowledge will be useful in (1) developing a new product or service or a new
process or technique or (2) bringing about a significant improvement to an
existing product or process.

</li><li>Development
is the translation of research findings or other knowledge into a plan or
design for (1) a new product or process or (2) a significant improvement to an
existing product or process (whether intended for sale or use).

</li></ul>

SFAS 2 contains the following professional guidance with respect to R&D
expenditures:

<ul>
<li>The costs of purchased intangibles (1) for use in R&D activities and (2)
with alternative future uses (in research and development projects or
otherwise) are capitalized and amortized as intangible assets in accordance
with APB Opinion 17. In 2001, APB Opinion 17 was superceded by SFAS 142.

</li><li>The costs of purchased intangibles (1) for a particular research and
development project, (2) that have no alternative future uses (in other
research and development projects or otherwise) and (3) that have no separate
economic values are research and development costs at the time the costs are
incurred.

</li><li>All
research and development costs encompassed by SFAS 2 are charged to expense
when incurred.
</li></ul>

FASB
Interpretation 4 (FIN 4), issued in February 1975, explains the application of
SFAS 2 to the cost of tangible and intangible assets used in R&D activities
when those assets are acquired in a business combination recorded as a
purchase. FIN 4 contains the following professional guidance under the heading
"Interpretation:"

<ul>

<li>The intent of paragraph 34 of SFAS 2 is that the PPA to the identifiable assets
of an acquired enterprise will be made in accordance with APB Opinion 16. In
2001, APB Opinion 16 was superceded by SFAS 141.

</li><li>Costs are assigned to all identifiable tangible and intangible assets,
including (1) assets resulting from research and development activities of the
acquired enterprise or (2) assets used in the R&D activities of the
combined enterprise.

</li><li>The costs assigned under APB Opinion 16 (now SFAS 141) are determined from the
amount paid by the acquiring enterprise and not from the original cost to the
acquired enterprise.

</li><li>Costs
assigned to assets (1) to be used in a particular R&D project and (2) that
have no alternative future use should be charged to expense at the date of
consummation of the business combination (i.e., the M&A transaction).
</li></ul>

SOP
90-7 refers to APB Opinion No. 16 (superceded by SFAS 141 in 2001) regarding
the recognition of intangible assets, including IPR&D, for companies
adopting post-bankruptcy fresh-start accounting. Accordingly, a brief review of
business combination purchase accounting is appropriate. Under SFAS 141,
purchase accounting for a business combination is straightforward: The purchase
price is allocated to tangible and identifiable intangible assets and to
liabilities assumed, based on fair values. Any excess purchase price over the
fair value of the net assets acquired is designated as "goodwill."
If the total fair value of the acquired net assets exceeds the total purchase
price, the "negative goodwill" is offset against the allocated fair
value of certain assets, with any residual immediately taken into earnings.

Under
SFAS 142, goodwill (which often represents a major component of the purchase
price of a technology company acquisition) is recorded and maintained
semipermanently as an asset on the balance sheet. SFAS 142 requires efforts to
be made to separately identify other intangibles (such as customer lists) that,
under prior GAAP, were often included in goodwill. Under SFAS 142, there are
specific requirements to test the goodwill for impairment on a regular basis.
When impairment is detected, goodwill should be written down, with the expense
included in the results of current operations.

<h3>IPR&D Accounting in Fresh-start Reporting and Business Combinations</h3>

Under
GAAP, R&D expenditures are normally expensed as incurred. However, an
acquirer will often purchase a company that has previously incurred and expensed
substantial sums for R&D. In some technology companies, most of the value
relates to the target company's previous R&D efforts. FIN 4 clearly
states that the acquirer must expense that portion of the acquisition purchase
price. This is because if this amount was recorded as an acquired asset, it
would create a "back door" for R&D capitalization—which
is prohibited by SFAS 2.

While
IPR&D should be immediately expensed, the value of this R&D may
continue to play an important financial reporting role. This is because of the
SFAS 142 requirement that goodwill should be regularly tested for impairment.
Specifically, under SFAS 142, a determination should be made of the implied
fair value of goodwill. This amount is compared to the recorded amount of
goodwill for purposes of ascertaining whether, and by how much, goodwill has
been impaired. The impairment testing process is identical to the PPA
procedure used in a business combination purchase accounting. This process
involves the allocation of the overall fair value of reporting unit to all
assets and liabilities—and to unrecognized intangibles including
IPR&D—as if the reporting unit was acquired as of the impairment test
date.

Therefore,
the value of IPR&D continues to be a financial reporting issue as long as
goodwill remains a recognized asset. Only to the extent that there is an excess
of (1) fair value over (2) amounts assigned to assets/liabilities will there be
an implied fair value of goodwill. If this analysis is not performed in this
manner, then the entire (and overstated) residual amount would be allocated to
goodwill. And that goodwill amount would not be truly comparable to the
recorded amount of the goodwill—thereby impeding the goodwill impairment
testing. An illustration of the continuing valuation of IPR&D is presented
in the following example.

<h3>Ongoing Valuation of Purchased IPR&D—A Simplified Example</h3>

Alpha
Co. acquired Beta Co. on Dec. 31, 2002, for $3.4 million. The purchase price
was properly allocated to assets acquired and liabilities assumed, including an
allocation of $240,000 to IPR&D. This IPR&D was properly expensed as of
Dec. 31, 2002. A residual value of $500,000 was assigned to goodwill. The Beta
operations became a separate reporting unit within the consolidated company.

To
test for goodwill impairment in 2003, Alpha management assessed the fair value
of the Beta operations—using information about comparable operations and
economic characteristics, including market-derived pricing multiples of
earnings—at $3.15 million. As of that date, the recorded value of the
Beta reporting unit net assets, excluding goodwill, was $2.4 million. The Beta
goodwill remained at its original $500,000 recorded value.

Alpha
management assigned a fair value of $2.6 million to net identifiable assets
excluding goodwill. Alpha management estimated that the IPR&D has a fair
value of $210,000. The residual fair value is $340,000 (i.e., $3.15 million less $2.6 million + $210,000). This
$340,000 amount is less than the $500,000 recorded amount of goodwill.
Therefore, a goodwill impairment of $260,000 (i.e., $500,000 - $340,000) must be recognized by Alpha as
a 2003 operating expense.

Had
the fair value of the IPR&D (i.e., $210,000) been excluded from the goodwill impairment analysis, then the
residual fair value would have been computed as: $3.15 million - $2.6 million =
$550,000. Since recorded goodwill was only $500,000, no goodwill impairment
would have been indicated in that case. However, that impairment conclusion
would be erroneous because it would have ignored a real (albeit unrecognized)
intangible asset of the Beta reporting unit (i.e., the IPR&D). And that impairment conclusion would
have effectively mischaracterized that IPR&D as goodwill.

<h3>Valuation of IPR&D</h3>

The
income approach is the preferred approach to IPR&D valuation. Within the
income approach, the yield capitalization method (also called the discounted
cash flow—or DCF—method) is commonly used in the valuation of
IPR&D. An important consideration in the DCF method is the availability of
reliable revenue and expense projections. Preferably, such revenue and expense
projections are available for each individual technology project or product/
service. The valuation analyst will typically request the following information
for the IPR&D valuation:
<ul>
<li>listing of each R&D project and apparatus

</li><li>date(s) of each R&D project initiation

</li><li>estimated date(s) of R&D project completion

</li><li>effort spent so far on each R&D project

</li><li>status of each project along the R&D technology development life cycle

</li><li>remaining effort required to complete each R&D project

</li><li>understanding of each appropriate technology and its expected evolution

</li><li>schedule of the appropriate technology development life cycle

</li><li>listing of the anticipated products/ services

</li><li>schedule of the appropriate product life cycle

</li><li>marketing and pricing strategies

</li><li>analysis of market demand

</li><li>analysis of expected market share

</li><li>analysis of expected rate of market penetration and customer acceptance, and

</li><li>analysis of competition/competing technology.
</li></ul>

There
are several economic input variables in the typical IPR&D valuation DCF
model. The quantitative relationships of these economic input variables are
described below:

<h3>Typical DCF Model: IPR&D Valuation Variables</h3>

Step One

current period IPR&D revenue 
x technology life cycle factor 
= expected next period IPR&D revenue

Step Two

expected IPR&D revenue 
- cost of goods/services sold 
- selling, general and administrative expenses 
- ongoing R&D expense 
= profit before tax from IPR&D 
x 1 - effective income tax rate for subject IPR&D

= profit after tax from IPR&D

Step Three

profit
after tax from IPR&D 
+ depreciation and amortization expense 
- capital expenditures 
- capital charge on assets used in commercialization of IPR&D 
= IPR&D economic income

Step Four

IPR&D economic income 
x present value discount factor 
= present value of IPR&D economic income

Step Five

sum of present value of IPR&D economic income for each year in expected life cycle of the
IPR&D

x income tax amortization factor 
= indication of value of purchased IPR&D

The
following discussion summarizes the valuation variables in the typical DCF
IPR&D valuation model.

<blockquote><blockquote>
<hr>
<big><center>
[M]any
technology company acquirers of the late 1990s have to make annual tests of
goodwill impairment under SFAS 142... [T]he valuation of unrecorded IPR&D
is an integral procedure in the SFAS 142 goodwill impairment test.
</center></big>
<hr>
</blockquote></blockquote>

<h3>IPR&D Revenue</h3>

In order to prepare an IPR&D revenue projection, the analyst will typically
review both revenue projections prepared by the target technology company and
revenue projections prepared by the acquirer company. The revenue projections
should be adjusted (if necessary) to represent the revenue-generating capacity
of the IPR&D as part of an independent business enterprise—that is,
without the economic influence of any post-acquisition synergies or economies
of scale from the acquiring company. In reviewing IPR&D revenue
projections, the analyst should consider both (1) the support for and (2) the
reasonableness of such factors as: the size of potential market, the
subject's ability and rate of market penetration, and the technology
product/service expected.

In
some cases, the analyst may only have overall target company business
enterprise revenue projections available. In other circumstances, revenue
projections by product/service may be available. Whether they relate to
product/service line revenue or business enterprise revenue, the analyst should
perform a rigorous due-diligence investigation of "hockey stick"
revenue projections. These projections indicate supernormal revenue growth
rates in the early years of the projection period. If the IPR&D relates to
a new technology, or if the company will be first to market with a new
product/service, such supernormal revenue growth rates may be appropriate.
However, the analyst should thoroughly examine both the quantitative and
qualitative support for the "hockey stick" revenue projections.

<h3>Technology Development Life Cycle Factor</h3>

An
analysis of the technology development life cycle affects two DCF model
inputs. First, the term of the technology development life cycle will influence
the projection period for the IPR&D revenue and expenses. Second, the shape
of the technology development life cycle will influence the rate at which the
IPR&D revenue (1) increased during the introduction and maturity stages
and (2) will decline during the decay stage.

Discussions
with company R&D personnel and marketing personnel often provide useful
information regarding (1) the subject market and (2) the competing
technologies. This information provides a starting point for estimating the
subject IPR&D technology development life cycle. The IPR&D technology
development life cycle may be developed on either a units vs. time scale or a
dollars vs. time scale. After the initial estimation, the IPR&D technology
development life cycle is typically translated to a percentage to time scale
(or common-sized to the maximum value scale) for ease of analysis.

The
IPR&D technology development life cycle may not always be shaped like the
classic bell curve. This is particularly true in cases when the IPR&D is
the only significant intangible asset of the subject company. Nonetheless, the
IPR&D revenue projection should generally follow the classic technology
development life cycle configuration of (1) starting low, (2) growing at an
increasing rate, (3) leveling off and then (4) declining to zero.

<h3>IPR&D Operating Expenses</h3>

The
analyst can often obtain information to project IPR&D operating expenses
from published industry data, public filings of publicly traded guideline
companies and security analyst brokerage reports regarding competing technology
companies. In addition, the analyst can obtain information regarding the
IPR&D operating expense ratio from analyzing the historical financial
statements of the subject company. The analyst should be mindful that
buyer-specific synergies should not be included in the IPR&D valuation.
Also, the analyst should not naively apply the subject company cost structure
when projecting IPR&D operating expenses.

All
of the development efforts needed to bring the IPR&D projects to the point
of feasibility (and commercialization) should be included in the
operating-expense projections. Ongoing R&D expenses generally relate to the
continuing effort to research and develop new technologies, processes or
products/services. The objective of the operating-expense projection is to
consider only those expenses related to the IPR&D. Therefore, R&D
expenses should not be included in the operating-expense projection beyond the
new product/service introductory stage. This is because by then, the R&D
efforts related to the IPR&D project will be completed. However, there may
be minor ongoing R&D expenses in the operating expense projection. These
expenses may relate to adapting the IPR&D to new technology development or
future marketplace demands.

<h3>Capital Charge/Economic Rent</h3>

A
capital charge is intended to represent a fair rate of return on—or an
economic rent for the use of—the tangible and intangible assets that are
used in the process of generating the projected IPR&D revenue. The purpose
of the capital charge is to isolate the specific component of economic income
related solely to the IPR&D. The capital charge line item in the DCF method
analysis is often quantified in the form of an economic rent. This economic
rent is a hypothetical expense (as compared to an actual accounting expense)
that the IPR&D pays for the use of target company assets that help generate
the new product/service income.

The
capital charge/economic rent is typically deducted at the net income level of
the DCF analysis. The capital charge is deducted in order to estimate the
portion of the target company economic income that is contributed by the
IPR&D. One procedure for estimating the capital charge is to multiply an
appropriate rate of return by the fair market value (as of the acquisition
date) of the tangible and intangible assets that contribute to the IPR&D
revenue generation. Using this procedure, the product of the rate of return
times the asset value is the amount of the capital charge. The capital charge
may be converted into an economic rent by dividing the capital charge amount
into the projected revenue (or some other projection variable). The capital
charge is typically stated in the form of an economic rent simply because it is
easier to use an economic rent calculation in the DCF analysis.

<h3>Present Value Discount Rate</h3>

The
discount rate used to compute the present value discount factor is based on the
risk associated with (1) the completion and (2) the success of the IPR&D.
This risk varies inversely as the IPR&D moves along the technology
development life cycle. That is, during the early stages of the technology
development life cycle, the IPR&D risk is the highest. And the risk then
decreases as the IPR&D successively progresses to the feasibility stage and
the commercialization stage.

The
discount rate used in the analysis of IPR&D in the early stage of the
technology development life cycle would be much higher than the discount rate
used in the analysis of similar IPR&D in a later stage of the technology
development life cycle. The selected discount rate will typically decline
nonlinearly to the point where the IPR&D project reaches completion or
proves feasibility. At that stage, the appropriate discount rate would be only
a little higher than the discount rate used in the analysis of an established
intellectual property.

<h3>Income Tax Amortization Effect</h3>

Corporate
taxpayers typically amortize the cost of a purchased intangible asset over a
15-year period for federal income tax purposes, under <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=I…
Revenue Code §197</a>. The annual amortization expense is typically
recognized in the DCF analysis as an additional expense line before the
estimation of pre-tax income. The annual amortization expense is then added
back as a credit to expense (and as a debit to cash flow) below the income tax
expense line. This add-back is made because amortization expense is a non-cash
expense item (just like depreciation expense). The final value indication is
then calculated in an iterative process in the DCF analysis.

Alternatively,
the income tax amortization effect may be included in the DCF analysis through
the use of an amortization effect "factor." This amortization
effect "factor" is based on (1) the selected discount rate, (2) the
effective income tax rate and (3) the appropriate amortization period. A common
income tax amortization effect factor formula is presented as follows:

Amortization effect factor = 
1 
________________________________________________________________

1 - (income tax rate) x (present value annuity factor) 
________________________________________________________________ 
amortization period

where the present value annuity factor is based on (1) the selected discount rate and (2)
the appropriate amortization period.

<h3>SEC Concerns Regarding IPR&D Valuations</h3>

During
the 1998-99 period, the Securities and Exchange Commission (SEC) identified
several concerns regarding public registrant acquisitions of technology
companies. The SEC expressed these concerns in comment letters to individual
registrants (i.e., technology company
acquirers) and in speeches delivered by SEC representatives. In particular, the
SEC noted four concerns regarding IPR&D valuations. First, in IPR&D
valuations, the IPR&D projects were not separated from other
technology-related intangible assets. Many of the IPR&D valuations did not
consider the value of the existing commercialized core technology. Many of the
IPR&D valuations did not consider the contributory value added by the
existing customer base, trademarks and goodwill to the marketing of the
"new and improved" or "next generation"
products/services.

Second,
the IPR&D valuations did not consider either (1) the stage of development
or (2) the amount of completion of the purchased IPR&D projects. According
to the SEC, the IPR&D valuation models did not distinguish between the
value of a project still in conceptual and/or design stage vs. a project that
was approaching the completion and commercialization phase.

Third,
the SEC was concerned that many IPR&D valuations estimated an
"investment value" rather than the "fair value."
According to this concern, the IPR&D value conclusions encompassed buyer-specific
synergies, economies of scale and post-merger economic benefits. Since these
buyer-specific value increments were not available to the typical hypothetical
willing buyer, the SEC concluded that they should not be included in the
IPR&D valuations.

Fourth,
the proportion of the total acquisition purchase price related to IPR&D
(and the amount of the immediate post-acquisition expense) was inconsistent
with the announced business reasons for the acquisition. In some cases, the
target technology company did not incur or disclose any R&D expenditures
prior to the transaction. That lack of disclosure indicated to the SEC that the
target technology company had not made any significant R&D effort.

In
late 1998 and early 1999, the SEC proposed methodological guidance with regard
to IPR&D valuations, including:

<ul>
<li>The value of any other intangible assets should not be included in the value of
the purchased IPR&D.

</li><li>The transaction PPA should be based on "fair value" and not on the
"value to a particular buyer."

</li><li>The income approach is an acceptable IPR&D valuation approach. However, as
part of the IPR&D analysis, the valuation should specifically consider: (1)
the company's track record of projecting its product development
efforts, (2) the amount and timing of the current future cash flow from the new
products/services or releases and (3) the current market conditions and
competing technologies.

</li><li>The allocation of projected cash flow to purchased IPR&D should recognize
the economic contribution of (1) existing products, (2) existing core
technologies and (3) other acquired tangible and intangible assets. This
recognition may be based on a capital charge, an economic rent, a profit split
or a similar allocation procedure.

</li><li>The projected cash flow attributable to the development of future versions of
the subject product/service should be excluded from the IPR&D valuation.

</li><li>Valuation analyses that use the market approach/relief from royalty method
based on "industry average" technology license royalty rates are
not appropriate.

</li><li>The valuation of IPR&D should not be based on a "residual"
analysis. This residual method should only be used for the valuation of
goodwill.

</li><li>The fair value of (1) an existing product/service or (2) an existing technology
should not be considered as part of IPR&D. This is true even if the company
intends to significantly modify the product/service or the technology.

</li><li>The same procedures that the company uses to determine if internally developed
products/services are in-process or complete should be used to determine if the
purchased technology is in-process or complete. For example, a pharmaceutical
company that considers a product to be in the R&D stage until it receives
FDA approval should use the same policy in the IPR&D analysis.
</li></ul>

<h3>Current Status of IPR&D Valuation Guidance</h3>

The
FASB has decided that the accounting for R&D costs (including IPR&D)
should be addressed in a comprehensive manner. The comprehensive R&D
project was scheduled for 2002. However, at the time of this writing, the FASB
has postponed—and not rescheduled—its consideration of the
accounting for R&D. Until the FASB addresses this issue, the immediate
expense of purchased IPR&D is required under GAAP.

Based
on the professional guidance issued (albeit somewhat piecemeal) by the SEC in
and after 1999, there is now greater consistency regarding IPR&D valuation
methodologies. These revised valuation methodologies appear to produce
IPR&D values that are more consistent with the SEC's implicit reasonableness
tests. Of course, current technology company pricing multiples—and
purchase price premiums—are greatly reduced compared to the late 1990s.
When the currently depressed prices for technology company acquisitions
recover, the current IPR&D valuation methodologies may again produce values
that do not pass the SEC reasonableness tests.

<h3>Summary and Conclusion</h3>

The
valuation of IPR&D is still an important issue for three reasons. First,
many technology companies filed for bankruptcy protection in 2001 and 2002.
When those companies emerge from bankruptcy protection, they will adopt
fresh-start reporting under SOP 90-7. At that time, their IPR&D will have
to be valued. Second, although prices are currently depressed, there are still
acquisitions of technology companies. And even financially distressed
technology target companies often have IPR&D projects in progress.
Accordingly, that purchased IPR&D should be valued under SFAS 141 and
expensed under SFAS 2. Third, many technology company acquirers of the late
1990s have to make annual tests of goodwill impairment under SFAS 142. As
illustrated above, the valuation of unrecorded IPR&D is an integral
procedure in the SFAS 142 goodwill impairment test.

Journal Authors

Robert F. Reilly

Journal Date

Tuesday, July 1, 2003 - 12:00

Bankruptcy Rule

2003