Valuation of Dot-com and Intellectual Property-intensive Companies

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Oct 2000

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During 1999 and the first quarter of 2000, the market's infatuation with dot.com companies created
enormous market capitalizations for these companies and enormous personal wealth for their
entrepreneurial owners. In fact, the statistics regarding the volume of capital market activity and the creation
of shareholder wealth in this industry are record-setting. In 1999, there were 295 initial public offerings
(IPOs) related to internet companies (according to IPO.com data). In the first quarter of 2000 alone, there
were 91 IPOs related to Internet companies (also according to IPO.com data). Capital market funds were
greatly attracted to dot.com companies, despite the extraordinarily high market capitalization pricing
multiples. Private capital was also greatly attracted to dot.com companies. During 1999, approximately 39
percent of all venture capital investments went to internet companies (according to the Venture Economics
and National Venture Capital Association).

During the spring and summer of this year, some of the "irrational exuberance" regarding publicly
traded dot-coms abated. Pricing multiples have significantly decreased for underperforming dot.com
ventures. During this recent repricing of dot.com industry stocks, investors returned to more traditional
valuation metrics. In the Aug. 15, 2000, issue of Bottom Line, money manager Richard Bregman wrote,
"Most investors have finally recognized that the dot.com companies that were yesterday's darlings were
wildly overpriced. I believe unprofitable dot.com companies, or those with poor business models, are not
going to recover."

This recent period of stock market repricing saw another type of wealth creation activity—mergers and
acquisitions (M&A) transactions. The stock market is identifying unsuccessful dot.com companies and
pricing their stocks accordingly. However, at the same time, successful dot-coms are acquiring unsuccessful
dot.com companies at record-setting rates. The first quarter of 2000 saw more than $200 billion in Internet
M&A transactions (according to WebMergers.com). In the second quarter of 2000, there were 14 Internet
M&A transactions of more than $1 billion each. In this current period of performing companies buying
underperforming companies, even unsuccessful dot.com entrepreneurs have become rich.

<blockquote><blockquote>
<hr>
<big><center>
The stock market is identifying unsuccessful dot.com companies and pricing their stocks accordingly.
However, at the same time, successful dot-coms are acquiring unsuccessful dot.com companies
at record-setting rates.
</center></big>
<hr>
</blockquote></blockquote>

The topic of this article is the valuation of dot.com companies that have filed for bankruptcy protection.
The recent market dynamics create uncertainty for valuation analysts engaged to value dot.com companies
within a bankruptcy estate. While there are numerous uncertainties regarding dot.com valuations, there
appear to be at least three certainties. First, the recent erratic nature of capital market pricing multiples
indicates that even the market "consensus" may not be sure how to value these companies. Second,
traditional valuation methods, such as the direct capitalization of earnings or the yield capitalization of cash
flow, are not particularly useful. This is because these pricing metrics result in non-meaningful results when
applied to companies with negative earnings and cash flow—on either an ex-poste or ex-ante basis. Third,
analysts agree that the value the market perceives in these dot.com companies is associated with their
intangible assets and intellectual properties.

The valuation of dot.com companies (for bankruptcy or other purposes) is more of an exercise in
intangible asset-valuation methods than in traditional business-valuation methods. Therefore, this discussion
will focus on the identification and valuation of intangible assets—particularly in the context of dot.com
companies and other intellectual property intensive companies.

In the discrete method of valuing dot.com intangibles, each of the individual intangible assets is
separately identified and appraised. Such individual intangible assets include computer software, proprietary
technology, copyrights, patents, trademarks, contracts, licenses, permits, employee relationships, supplier
relationships, customer relationships, etc. Each individual intangible asset (or, at least, each individual
category of intangible assets) is analyzed and its value is estimated. The estimated value of each of the
intangible assets is added to the estimated values (usually deminimus) of the tangible assets and net working
capital in order to estimate the dot.com business enterprise value. In this method, all of the dot.com
intangibles are appraised "discretely"—i.e., individually.

In the collective method of valuing dot.com intangibles, the total intangible value of the business (from
whatever economic phenomena contribute to that value) is analyzed and quantified in the aggregate. Such
collective intangible value is often called goodwill. For purposes of this collective method, goodwill is
defined as the total value of the dot.com business in excess of the (usually deminimus) tangible assets and
net working capital. In the collective method of estimating intangible value, the conclusion is sometimes
also called unidentified goodwill, unidentified intangible value or intangible value in the nature of
goodwill. As these names imply, identifying the source of the intangible value is not important in the
collective method. Rather, identifying the total amount of the intangible value is the only objective.

In the discrete method, dot.com intangible assets are identified and appraised. In the collective method,
dot.com intangible value is identified and appraised. The distinction between intangible assets and
intangible value may seem semantic, but it is an important distinction that represents the primary conceptual
and practical difference between these two analytical methods. In the discrete method, it is necessary to
identify which individual intangible assets create what amount of value. In the collective method, it is
sufficient to identify that intangible value exists and what that total value is. The source of, or cause of, that
intangible value is not especially relevant in the collective method.

As described below, there are several methods for the discrete valuation of individual intangible assets.
There are also several methods for the collective valuation of total intangible value. Since these methods
are not particularly useful in the valuation of a dot.com business, they will not be discussed in detail.
However, for identification purposes, the following list presents the most common methods for the
collective valuation of aggregate dot.com intangible value:

<ol>
<li>capitalized excess earnings method (a direct capitalization of "excess" economic income into perpetuity
model)

</li><li>present value of prospective excess economic income (a yield capitalization of "excess" economic
income, based on a discrete long-term projection)

</li><li>residual from the actual transaction sale price (the values of the dot.com tangible assets and net working
capital are subtracted from the dot.com business sale price)

</li><li>residual from business enterprise value (the values of the dot.com tangible assets and net working capital
are subtracted from an estimated overall business value)

</li><li>build-up method (a few general components of goodwill are identified, valued and the values summed;
the "build-up" components of goodwill typically include the dot.com going-concern value—often measured
as the forgone economic income during the period required to recreate de novo the subject dot.com)</li></ol>

There are many benefits to the use of the discrete method, particularly with regard to bankruptcy-related
dot.com valuations.

<h3>Benefits of the Discrete Method</h3>

First, the conclusion of the discrete method is presented in a typical balance-sheet format. The format
is a comparative presentation of the dot.com's historical cost-based balance sheet and valuation-based
balance sheet. This format is familiar and comfortable to lawyers, accountants and other advisors involved
in bankruptcy matters.

Second, because of the balance-sheet format, the discrete method can present alternative definitions of
value and premises of value. The same format, for example, can present the historical cost-based balance
sheet, compared to a fair market value-based balance sheet, compared to a liquidation value-based balance
sheet. This form of comparison may be particularly relevant in bankruptcy cases when the future nature of
the subject dot.com as a going concern business entity is an issue.

Third, the discrete method explains the individual components of the dot.com value. Collective
valuation methods that rely on capitalized expected cash flow or a multiple of expected revenues may result
in an appropriate value conclusion. These collective methods, however, indicate only the total value; they
do not explain why or how the dot.com has created that value. The discrete method calculates value by
estimating the component values of each individual intangible asset. This information may be important
to the parties to a bankruptcy matter (particularly if the issue of who was responsible for creating the value
is raised). This detailed information about the dot.com value is also important to lenders, investors buying
in, investors selling out, etc.

Fourth, the discrete method has many dispute resolution and litigation support benefits. For example,
in a bankruptcy dispute, the value of the bankruptcy estate interest in a dot.com may be estimated by
valuing the individual intangible assets associated with each lienholder. It is also possible to "date" the
dot.com intangible assets—i.e., to estimate if they were created before or after a certain date (such as the
date of filing).

Fifth, in the case where all or part of the dot.com business is sold as part of a reorganization, the discrete
valuation method develops a ready-made sale price allocation. This may have important asset-basis
considerations for federal income tax purposes.

There are also costs associated with the discrete method, particularly when the timing and expenses of
the valuation are significant issues.

<h3>Costs of the Discrete Method</h3>

First, due to increased analytical rigor, this method requires considerably more time and effort than other
valuation methods. Additional time is required for data collection and analysis procedures. Additional time
is required in the actual valuation analysis. Additional time also is required in the valuation reporting. One
offset to this additional time cost is that the analyst is much more intimately familiar with the dot.com (and
particularly with the components of—and causes for—economic value) than if the collective method is used.

Second, due to the increased time required to prepare the more comprehensive analyses, the discrete
method typically involves higher appraisal fees. Most parties to a bankruptcy dispute attempt to minimize
appraisal and other professional fees. Nonetheless, particularly in controversial cases, the more
comprehensive and rigorous the valuation analysis, the greater the likelihood of a favorable settlement or
litigation judgment.

Third, the discrete method is more descriptive to the operations of the dot.com than other valuation
methods. The discrete method requires that the analyst collect more documents from the dot.com, spend
more time interviewing management, etc. Most dot.com owners and managers prefer to minimize any
disruption associated with a valuation—particularly with a valuation prepared for bankruptcy purposes.
Many times in bankruptcy cases, the debtor-in-possession will simply not be forthcoming with the
necessary data to make the discrete method practical. As with all business valuation methods, the results
of this method are only as good as the quality and quantity of available data.

<h3>Bundle of Legal Rights</h3>

The first step in the analysis is to identify the specified bundle of legal rights subject to appraisal.
According to the bundle-of-rights theory, complete intangible asset ownership, or title in fee, consists of
a group of distinct legal rights. Each of these legal rights can be separated from the bundle and conveyed
by the fee owner to other parties in perpetuity or for a limited time period. When a right is separated from
the bundle and transferred, a partial or fractional property interest results. It is possible to examine property
interests in discrete intangible assets from several points of view. This is because the ownership, legal,
economic and financial aspects of intangible assets overlap.

Ownership interests in intangible assets can take various forms. Different economic values can attach
to the different ownership interests. The ownership interests related to the typical income-producing
intangible assets include the following:

<ul>
<li>fee simple interests

</li><li>term estates

</li><li>license/franchise interests and sub-license/franchise interests

</li><li>reversionary interests

</li><li>development/exploitation rights.</li></ul>

<h3>Valuation of Dot.com Intangible Assets</h3>

There are several methods, procedures and techniques to the economic analysis and valuation of
dot.com intangible assets. All of these methods logically group into three general categories of economic
analysis: the cost approach, market or sales comparison approach and income approach.

The cost approach is based on the economic principle of substitution. This principle asserts that an
investor will pay no more for an asset than the cost to obtain—by either purchasing or constructing—an asset
of equal utility. For purposes of this principle, utility can be measured in many ways, including
functionality, desirability and so on. The availability and cost of substitute assets is directly affected by
shifts in the supply and demand within the dot.com industry. Unlike fungible tangible assets, there are often
no reasonable substitutes for dot.com intangible assets. Accordingly, the use of the cost approach may be
limited in the case of unique dot.com intangible assets.

<blockquote><blockquote>
<hr>
<big><center>
Intangible assets are the largest component of the value of dot.com business, and the value of these
intangible assets is the only rational explanation for the sometimes irrational market valuations of
dot.com companies.
</center></big>
<hr>
</blockquote></blockquote>

The market approach is based on the economic principles of competition and equilibrium. These
principles conclude that, in a free and unrestricted market, supply-and-demand factors will drive the price
of an asset to a point of equilibrium. The principle of substitution also directly influences the market
approach. This is because the identification and analysis of equilibrium prices for substitute assets will
provide important evidence with regard to the value of the subject dot.com intangible.

The income approach is based on the economic principle of anticipation, also called the principle of
expectation. The value of the subject intangible is the present value of the expected economic income to
be earned from the ownership of the intangible. As the name of this principle implies, the investor
anticipates the expected economic income to be earned from the asset. This expectation of prospective
economic income is converted to a present worth—that is, the value of the dot.com intangible. There are
numerous definitions of economic income. If properly analyzed, they all provide a reasonable indication
of value. In this approach, the analyst estimates the investor's required rate of return on the asset generating
the prospective economic income. This required rate of return is a function of many variables, including
the risk—or uncertainty—of the expected economic income.

Analysts generally attempt to value dot.com intangibles using all three approaches. This
multiple-approach analysis is performed in order to obtain a multidimensional perspective. The final
value estimate is usually based on a synthesis—or reconciliation—of the various value indications. When
concluding value, the analyst should realize that analysts only "estimate" the value of dot.com
intangibles, while the marketplace actually "determines" the value of dot.com intangible assets.

<h3>Simplified Market Approach Example</h3>

In Example 1, the value of the dot.com trademark and trade name is estimated by reference to the
economic income it could generate if it was licensed to another dot.com company (perhaps a competitor).
The estimated royalty income would be based on an analysis of actual comparable dot.com trademark
license transactions. Sales and licenses of dot.com trademarks is fairly common. Therefore, analysts may
be able to assemble the necessary empirical transaction data. However, it is important to consider whether
the comparative sale/license transactions took place at arm's length. If a sale/license transaction was from
a failing dot.com to a successful competitor, the actual price may imply a liquidation value such that the
transaction data may not be relevant to the analysis of an intangible used in a going-concern business
(unless appropriate adjustments are made).

In this illustrative example, the value of the dot.com trademark is estimated by multiplying projected
revenues by a five percent market-derived royalty rate. The direct capitalization rate is calculated as the
market-derived present value discount rate minus the expected long term growth rate in the projected
dot.com revenue. Capitalizing the projected royalty income by the illustrative market-derived 10 percent
direct capitalization rate results in an indicated trademark value of $50 million.

In the simplified Example 2, the value of the dot.com-assembled workforce is based on the cost to
recruit, hire and train replacement employees of comparable experience and technical expertise. This cost
is estimated as a percent of total compensation for various categories of employees (where higher categories
may represent employees with longer tenure, greater compensation, and/or higher level of responsibility).

<h3>Simplified Income Approach Example</h3>

Let's use an income approach analysis to value a dot.com's customer relationships (Example 3).

The dot.com's projected revenue is $100 million for the next fiscal year. The normalized profit margin
is 12 percent, which is what the dot.com is expected to earn after it achieves a stabilized (normal growth)
level of revenue. This stabilized level of revenue occurs after the dot.com has reached its break-even point.

Subtracting a fair return (sometimes called an "economic rent") on the other assets owned or used by
the dot.com results in the expected economic income attributable to recurring customer relationships.
Based on a statistical analysis of historical customer turnover rates, the average remaining life of the
customer relationships is expected to be six years. The present value annuity factor is based on (1) the
six-year estimate of the expected life of the dot.com customers and (2) an estimated market-derived
present value discount rate.

<h3>Valuation Synthesis and Conclusion</h3>

Typically, the valuation of a dot.com intangible follows the process summarized above. When more
than one valuation approach is used, each approach usually results in a different value indication. Within
the same approach, there are often different indications of value. For example, there may be several
values indicated by different income approach methods. The asset valuation synthesis procedure is an
analysis of alternative indicated values—in order to arrive at the final value estimate.

The final value estimate is generally a number from the indicated range of values. The final value
estimate may be one of the indicated values, or it may be the mathematical expectation (i.e., the weighted
average) of the indicated values, or it may be based on another number within the indicated range of
values. Generally, it is not appropriate to simply average the indicated values. A simple arithmetic mean
implies that all of the value indications have equal validity and deserve equal weight. While this is
sometimes appropriate, it is usually not the case in the typical intangible asset valuation. The final value
estimate should be derived from the analyst's reasoning and judgment regarding all of the relevant factors
and all of the available market evidence.

Intangible assets are the largest component of the value of dot.com business, and the value of these
intangible assets is the only rational explanation for the sometimes irrational market valuations of
dot.com companies. This article summarizes the approaches and methods generally used to value
dot.com intangibles. While the methods are generic to all intangibles, the selection of the individual
valuation procedures (e.g., ex ante analyses vs. ex post analyses, normalized margin analyses, etc.) are
specific to dot.com intangibles. Accordingly, the valuation of dot.com intangibles—for bankruptcy or
any other purpose—should be performed by an analyst familiar with current industry trends, empirical
data sources and procedures derived from dot.com transactions and industry participants.

Journal Authors

Robert F. Reilly

Journal Date

Sunday, October 1, 2000 - 12:00