Two Caveats to the Relief-from-Royalty Method and the Use of License Agreements

In a recent series of articles published in QuickRead, the weekly online news channel of NACVA, Robert F. Reilly discusses the “Application of the Relief from Royalty Method” in the valuation of intellectual property. Robert is one of the masterminds in intangible asset valuation, regular author and speaker, and Managing Director of Willamette Management Consultants.

In the last part of the series released on January 19, 2022, Robert discusses a number of caveats related to the relief from royalty method and the use of license agreements. We found two of Robert’s caveats particularly worth reminding.

1.

“It is a best practice for the analyst to use several intellectual property license databases, if possible. Of course, there is a cost to using multiple databases. However, the use of several databases typically results in a more comprehensive sample of CUT license agreements.

It is telling that Robert needs to mention this caveat at all. The “best information available” principle is deeply rooted in fair value measurement and in IFRS. But when it comes to developing unobservable inputs through comparable data, some analysts become economical. Getting the valuations of intangible assets “right” is of utmost importance - or might have expensive consequences.

Of course, there is a cost to using multiple databases. But what are we talking about? About intangible assets whose value is in the millions or billions of dollars. And if the valuation exercise is not about the appropriate purchase price, it is still about 15% to 30% tax deductibility from the amortization of these expensive assets. This stands against a few dollars saved in the valuation exercise.

To reap these rewards, and to avoid expensive losses, full compliance with the best information available principle should go without saying. As Robert pointed out in part III, there are “numerous commercial data sources” that analysts may access to find arm’s-length intellectual property license agreement royalty rate data.” In accessing numerous databases, appraisers should not hide behind budget restraints (ask for more budget instead) or behind the comfort of existing subscriptions with one particular data vendor (there is small-ticket access to most databases). Rather, appraisers should argue and aim for the long-term benefits of their clients.

2.

“Analysts often use the “eliminate, adjust, and assess” procedures summarized in this discussion to reach a reasonable range of royalty rates—and a final, supportable intellectual property royalty rate conclusion. However, analysts should not use the so-called “Goldilocks” procedure. That is, analysts should not:

1.?Select a predetermined intellectual property royalty rate that is “just right” for the subject valuation and then

2. Eliminate, adjust, and assess the empirical data to justify the predetermined “just right” intellectual property royalty rate.”

Goldilock is like a furuncle. Knowing the result prior to the analysis is unethical. Typically, the bandwidth of comparable data for intangible assets is relatively wide. Such is the nature of intangible assets – they are unique. In a relief-from-royalty valuation, the professional analyst shows the whole bandwidth of comparable royalty rates and provides strong and comprehensive arguments why the subject intangible asset sits at any particular point within this bandwidth (or even outside), and eventually not in its middle (median or mean). Together with the comparable data, it is this reasoning that makes a valuation conclusion robust and defensible against challenges (from auditors, regulators, tax authorities, or courts).

In contrast, applying the the Goldilock procedure is either for missing experience, or for disregard of the fair value and/or arm’s length principles. Simply speaking, Goldilock is unprofessional. The professional analyst goes for the best information and for all comparable data available, and not only for a small extract or for a desired result.

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