Fresh-Start Accounting: The Valuation of Intangible Assets

By Paul Dionne

During bankruptcy proceedings, the value of the debtors’ intangible assets, including its intellectual property (IP), can arise as a central issue in the case. Among other items, intangible assets may serve as collateral for secured debt or may require valuation as part of a § 363 sale. Intangible assets might also require valuation for financial-accounting purposes, specifically a debtors’ “fresh start” accounting on its emergence from bankruptcy. Under fresh-start accounting, the fair value of the debtors’ assets (both tangible and intangible) is determined to reflect the debtors’ balance sheet on its emergence from bankruptcy.

This article discusses the methodologies that are typically used to value intangible assets, including IP. Generally, there are three methods for valuing intangible assets: (1) income approach; (2) market approach; and (3) cost approach. A previous ABI Journal article detailed the use of the income approach to value IP (specifically patents).1 This article focuses on the use of the market approach to value intangible assets, and provides an overview of the methodology, things to consider when implementing the approach, and challenges that valuation professionals may face when utilizing this methodology.

The Income Approach

In the income approach, the value of an intangible asset is derived from the expected cash flow earned from the ownership or operation of a specific intangible asset.2 When utilizing this methodology, there are several variables considered by the valuation professional, which include — but are not limited to3 — (1) projected income to be earned by the intangible asset; (2) an estimate for how long the intangible asset will be earning income (e.g., the useful life of a patent); (3) any specific risk factors attributable to the subject intangible asset; and (4) a discount rate.4

The Market Approach

The market approach determines the value of an intangible asset by analyzing the price at which similar assets are exchanged in the open market.5 This approach determines the present value of the future economic benefits of the subject intangible asset, by observing what the market has determined it to be for similar assets.6 Implementing the market approach requires identifying comparable transactions that are (1) part of an active, public market and for which the price and terms are known; (2) contemporaneous with the valuation date of the subject intangible assets; and (3) between parties dealing at arm’s-length.7

The Cost Approach

The cost approach utilizes the cost required to develop a specific intangible asset (e.g., a patent) as an indication of value. This approach typically is considered when valuing certain types of IP. Generally, there are three methodologies for applying this approach: (1) historical cost; (2) replication cost; and (3) replacement cost.

The historic-cost method quantifies the amount of money spent to develop the subject intangible asset at the time that it was originally developed. The replication-cost method quantifies the money required, in current cost terms, to develop the intangible asset in the same manner and to achieve its current state, including the cost of inefficient prototypes created during development.8 The replacement-cost method quantifies the money required, in current-cost terms, to develop the intangible asset in the same manner and to achieve its current state, but excluding the cost of inefficient prototypes while in development.9 If there is insufficient information to utilize these three methodologies, the cost approach might not be reliable.

Overview of the Market Approach10

Implementing the market approach to value intangible assets (such as IP) requires a thorough and rigorous analytical process. A general summary of the steps to apply the market approach is shown in Exhibit 1.

The first step in applying the market approach to value intangible assets is to obtain market information on asset sales or transactions involving intangible assets comparable to the subject assets. Characteristics to screen for include — but are not limited to — (1) the type of intangible asset or IP; (2) the permitted use of the intangible asset; (3) the industry in which the intangible asset operates; and (4) the date of the transaction. There are numerous databases that can be utilized to identify comparable asset sales or transactions, which include such general financial data providers as S&P Capital IQ, Bloomberg and FactSet, as well as IP-specific databases like ktMINE or RoyaltyStat.

Given the uniqueness of certain intangible assets, it might be necessary to perform multiple separate screens. Potential comparable transactions screened for in these databases must be reviewed thoroughly to assess comparability to the subject intangible assets and to identify relevant information about the transactions.

The second step in applying the market approach is to confirm that the information (e.g., purchase price) of the identified guideline transactions is accurate and that the transactions are arm’s-length. If a transaction is not arm’s-length, it might not be comparable to the subject company’s intangible assets, or adjustments might be required. Reviewing the information of the guideline transactions might lead a valuation analyst to confirm whether the market conditions at the time of the guideline transaction are comparable to the market conditions at the time of the valuation of the subject intangible assets. If the market conditions at the time of a guideline transaction are different from the market conditions at the time of the valuation of the subject intangible assets, the transaction might be rejected for lack of comparability.

Once guideline transactions are identified, the valuation analyst will determine, if available, the relevant comparison units and perform a comparative analysis. The comparison units might vary depending on the type of intangible asset or IP being valued. For example, if a valuation professional is valuing a customer list, they might use such comparison units as transaction price per customer. Again, a valuation professional will have to confirm that the information used in the comparative analysis is accurate and can be used to determine the value of the subject intangible asset.

After the guideline transactions are identified and the comparison units are determined, a valuation professional performs an analysis comparing comparison units of the guideline transactions to the subject intangible asset based on the selected comparison units, adjusting as necessary. If a given guideline transaction does not have sufficient information to compare to the subject intangible asset, that guideline transaction might be rejected due to lack of information. The valuation professional will then analyze the comparison units (e.g., transaction price per customer) from the comparison analysis and determine a single value indicator or a range of value indicators to apply to the subject intangible asset.

Challenges with the Market Approach

While a valuation professional will often attempt to apply the market approach to determine the fair value of a debtor’s intangible assets for fresh-start accounting purposes, it is not always possible. Typically, the most common challenges with implementing the market approach to value intangible assets include (1) there might be an inability to identify transactions that involve intangible assets sufficiently comparable to the subject intangible assets; (2) even if sufficiently comparable transactions are identified, the transactions might not be contemporaneous with the valuation date of the subject intangible assets; and (3) there might be insufficient information to be able to perform the analysis.

One challenge that a valuation professional might face is finding transactions that are sufficiently comparable to the subject intangible assets. Unlike publicly traded companies, intangible assets (such as patents) typically do not have a readily available market and are not bought or sold frequently.

Therefore, identifying transactions involving intangible assets potentially comparable to the subject intangible asset might prove difficult. Moreover, given the uniqueness of different types of intangible assets, it might be challenging for a valuation professional to identify transactions involving intangible assets sufficiently similar to the subject asset. One example is a patent, which is one type of intangible asset that is, by definition, unique.

Therefore, if valuing a patent, it could be challenging for a valuation professional to use the market approach and identify transactions involving intangible assets like the subject patent. A valuation professional might want to query the company on whether the subject intangible asset has been bought, sold or licensed in the past. It could be the case that prior transactions of the subject intangible asset might be the best indication of its fair value.

Even if a valuation professional can identify sufficiently comparable transactions, it might be difficult to find transactions that are contemporaneous with the valuation date. Typically, a valuation professional will screen for transactions within three to five years prior to the valuation date. Finding transactions contemporaneous with the valuation date is important, as market conditions are constantly changing, which is especially true in the biotechnology industry, where there is constant innovation and where IP can represent most of the asset value of these companies.

As an example of the importance of using contemporaneous transactions, consider the market conditions in the biotechnology industry (specifically vaccines) following the COVID-19 pandemic. In 2020 and 2021, in response to the COVID-19 pandemic, “Operation Warp Speed” was enacted by the U.S. government, and biotechnology companies were pushed to discover a vaccine. As a result, valuations of companies developing COVID-19-related vaccines dramatically increased. If one were valuing IP related to vaccine technology today, transactions during the 2020-21 “COVID boom” might not be meaningful, since the COVID-19 pandemic has subsided, along with the demand for COVID-19 vaccines.

In addition, it might be difficult to find information on comparable transactions. As most transactions involving intangible assets and IP are private transactions, the details of the transaction might not be publicly disclosed. It might be necessary to use multiple sources to collect all relevant information for the transaction, as a single source might not contain all the required data. Therefore, while a transaction may involve assets that are very similar to the subject intangible asset, a valuation professional might be unable to use it in the valuation because there is insufficient information on the transaction.

Conclusion

The valuation of intangible assets can often arise as a central issue in bankruptcy proceedings. Among other issues, debtors’ intangible assets might have to be valued as part of the company’s fresh-start accounting. Generally, there are three valuation approaches a valuation professional might consider to determine the fair value of the debtors’ intangible assets.

Using the income approach, the value of the intangible asset is derived from the expected cash flow earned from ownership or operation of a specific intangible asset. The cost approach utilizes the cost required to develop a specific intangible asset as an indication of value. The market approach determines the value of an intangible asset by analyzing the price at which similar assets were exchanged in the open market. All three methodologies could be used to value the debtors’ intangible assets as part of its fresh-start accounting.

Paul Dionne is a director with The Michel-Shaked Group and manages the firm’s New York office.