When TTBs get valued

By A.Scott Davidson

Practical approaches to assigning value to such assets as trademarks, trade names and brands

Trademarks, trade names and brands are vital elements of profitable, growing businesses. Today there is an increasing need to assign values to such assets. Reasons include purchase transaction pricing, financial statement/purchase price allocations, annual impairment testing under GAAP and dispute related matters. And there are a number of practical approaches to the valuation of these assets.

When valuing trademarks, trade names and brands (TTB) in the context of a going concern, one typically looks to cash-flow based methods (particularly the discounted cash-flow technique, which offers the greatest precision), and market-based comparable measures of value. Both methods capture commercially transferable good-will. Cost-based measures of value (reproduction and re-creation cost) can also provide a "sanity check" and secondary perspectives in a context of a going concern.

Cash-flow based approaches to TTB value
Incremental sustainable future cash flows drive value. When valuing IP assets under a cash-flow based approach, one is typically most interested in the incremental cash flow sustainable over future years generated by the business from the deployment of the IP asset. That is to say, incremental cash flow sustainable over future years above and beyond that which might otherwise be generated in the absence of the specific IP.

Authors often refer to earnings and cash-flow methods interchangeably. While the principles applicable to both methods are very similar, the cash-flow-based methods are more precise.

The value of the incremental economic benefit from the deployment of the IP asset is a function of the following factors including:

• absolute amount of the cash flow advantage;
• duration of the benefit;
• growth rates and collateral benefits;
• relative risk and appropriate discount rates when converting the future cash flows to a present value capital sum.

In short, the value reflects a discounted cash-flow methodology based on maintainable incremental cash flows.

Essential to the valuation process is the identification and quantification of the specific annual cash-flow increments.

Three ways of quantifying that cash flow are a direct assessment of the relevant benefits; residual return on assets analysis; and relief from royalty analysis.

One can consider and directly quantify a number of types of benefits. As these benefits are quantified with direct reference to the TTBs, the direct assessment method can be described as a "bottoms up" approach. The dollar amount of each of the relevant benefits must be quantified on an annual basis over the future benefit — going forward. Simple math will allow the conversion of the present value of these future benefits to a sales-based royalty rate. Common types of benefits include:

• Premium pricing advantage:  The nature of the TTB may be such that it allows for a premium price to be charged for the subject product. That premium price is the increment in price above and beyond the price that a so-called generic product (but otherwise the same or very similar) commands in the marketplace. For example, a well-known soft drink carrying a mark may be able to be priced higher than an unknown or unbranded drink.
  
  The premium price advantage is quantified simply as the amount of the price per unit increment multiplied by the number of units sold.
  
• Volume advantage: The TTB may be such that its use in the marketplace generates incremental unit sales of the subject product. For example, consumers may choose to buy a recognizable soft drink brand carrying a mark in preference to one that is not recognized.
  
  The volume advantage benefit is quantified as the incremental volume attributable to the mark multiplied by the per unit dollar contribution earned on each unit of that volume.
  
• Economies of scale or gross profit advantage: With incremental sales volume there are opportunities to realize on economies of scale in the production process. For example, longer production runs can spread fixed costs over a larger base and thereby reduce the per unit allocation of those costs. Similarly, higher volumes can facilitate volume discounts on the purchases of raw materials. These benefits translate into increased gross profits and this benefit may be directly attributable to IP being used.
  
  This benefit is quantified as the incre-mental gross profit percentage multiplied by the dollar revenues being generated from sales of the product.
  
• Reduced costs or operating profit advantage: Additional cost efficiencies in product promotion and administrative and other costs may also be realized because of the incremental volumes being generated. These further cost savings are included in the measure of the economic benefit attributable to the IP being valued.

Chart 1 demonstrates all four types of benefits diagrammatically, assuming the IP in question was a trademark.

Another measure of the economic benefit from the deployment of the TTB is an enhanced return on the assets utilized in the business. This method, based on a re-sidual return on assets analysis, is sometimes referred to as the excess income method.

Under this methodology, the valuator makes a review of all of the assets, tangible and otherwise, that are deployed by the business in the sale of its products. Having determined appropriate returns that need to be earned on all of the tangible and other assets deployed (based on market rates of return), the remaining portion of the total profits generated can be attributed to the TTB. That residual return or excess income is then the measure of the economic benefit of the TTB.

In the context of the branded soft drink carrying a mark, the total profits earned must first be allocated to such assets as the working capital deployed in running the business and the fixed assets used in the production and bottling process. The distribution assets, and likely other assets, would also be entitled to an appropriate return. The residual profits are attributable to the mark/brand.

The relief from royalty method is another means of measuring the economic benefit that may be attributable to a particular IP asset. It uses a market-based roy-alty rate as the starting point for quantifying the economic benefit and in this sense is a "top down" method.

Under the relief from royalty method the valuator must determine what arm's length royalty would likely have been charged had the owner of the mark had to license that asset from a third party. The quantification of the benefit is the product of that royalty rate and the revenues that were generated from sales of the product.

Before settling on value based on the relief from royalty method, careful consideration should be given to the direct method and the residual return method. Significant differences may be indicative of unusually high or low profitability from the IP or the use of an external market-based royalty rate that is not appropriate or comparable.

While it is beyond the scope of this article to explore how to determine the appropriate royalty percentage or the base against which it ought to be applied, it is often very difficult to generate a market-based royalty rate or to find genuinely comparable royalty rates.

Under a discounted cash-flow analysis, in addition to measuring the present value of the annual cash flows over the forecast period, one takes into account the residual or terminal value at the end of the forecast period. A capitalized earnings/cash-flow method is typically used to determine the terminal value.

For example, if at the end of the forecast period the cash flows relevant to the IP were at a stable $3 million a year, the terminal value determined by the capitalized cash-flow method would be the product of $3 million and an appropriate multiple. The present value of this amount at the valuation date would be determined using a discount rate commensurate with the risk associated with realizing the terminal value.

Cost measures of IP asset value
The above measures predominate in determining the fair market value of IP. However, it may be appropriate to assess the cost of reproduction of the IP asset in some situations, particularly where the dollar magnitudes of the benefits are not susceptible to determination.

Reproduction cost can be assessed with reference to residual development cost and recreation cost.

The residual development cost is the portion of expenditures incurred historically in developing the IP asset that still reside in the asset at the valuation date. In effect, this approach concerns a quantification of the carryover benefit of the historical expenditure that resides in the asset at the valuation date.

Another way of conceptualizing the carryover benefit is in terms of the extent to which the past spend directed at the IP has not "depreciated" as at the valuation date. For example, in the context of advertising spend directed at the development of a trademark, it is often considered that the value of that advertising depreciates over an economic life ranging perhaps as long as five years.

The relevant expenditures can be of many types including, for example, costs of concept development, consulting, legal, consumer testing, design, advertising, traffic-building cost, start up losses and lesser profits during "runway or buildup period."

Recreation cost is dollar value of the efforts and expenditures necessary to recre-ate the IP asset. Recreation cost is based on a multiple of annual ongoing (or sustaining or retention) spend. In the context of a TTB, the value will be a multiple of the annual retention spend (advertising and other ongoing expenditures) that would otherwise be directed to the preservation (but not growth) of the TTB.

While the context of the IP valuation will often dictate the primary valuation method, careful consideration should be given to at least one or two alternative methodologies to ensure a well-balanced and market-based result. Reconciliation between different methodologies will also ensure not only greater insight into the result but will often surface input errors.