The Price is Right
To some, the legal system might seem too preoccupied with measuring the value of things–even intangibles like pain and suffering–in terms of dollars.
Valuation is, indeed, a crucial issue in a wide range of legal matters. In divorce cases, for instance, it is necessary to put some value on the marital assets to divide them equitably between the spouses. In personal injury cases, the loss to the injured plaintiff must be measured in some way. And in business or property matters, some precise value must be established for what is being bought and sold.
Valuation even drives whether an attorney will take a case, notes professor Nancy Levit of the University of Missouri-Kansas City School of Law. An essential part of evaluating a prospective case, she says, is to determine whether the value of the potential recovery makes the case viable.
But the law’s tendency to measure value in money terms isn’t simply a matter of being cold, hard and crass. To some extent, there is no other way to define value. Marriages can’t always be patched up, bodies crippled in a collision can’t always be mended, and the trust that’s shattered in a deceitful business deal can’t always be recouped. So in some cases, both law and society turn to money to make things right.
In a broader sense, Levit says, the law is engaged in an ongoing search for other ways to define value–and values.
“The law has always struggled not only with property concepts, but also people concepts, and how they intersect,” Levit says. “How the law gives value to certain interests speaks volumes about what society holds dear.”
She cites recent litigation over efforts to put a value on family pets–or companion animals, as they are starting to be called. Traditionally, the law treated pets as property, she says, “but people think of them as family members,” leading to custody fights. In tort law, more attention is being given to the concept of lost chance, the idea that some value can be put on the lost hopes and opportunities that result from catastrophic injuries.
And in the business area, courts have been looking at how valuations can be assigned to things such as stock options, which have a value that is difficult to determine in a strictly business sense.
But while the law grapples with specific issues of valuation, Levit wonders whether there is a place for the notion of limits. “In trying to value something, we do not have any concept of ‘enough,’ ” she says. “More and bigger is always better. We never have an idea of what’s enough.”
Dividing Up Is Hard to Do
Proper Valuation Is Crucial to Equitable Distribution of Marital Property
Robert D. Feder
The process of apportioning marital property can become an emotional battleground for the spouses and lead to intense arguments between them. Nevertheless, setting values on various types of marital property that must be allocated between the parties is a necessary task.
One source of difficulty for courts is that they frequently are called upon to assess the value of assets that have no ready market to confirm their value.
That is why the value of closely held businesses and professional practices is litigated frequently. These assets can have substantial value that has a major impact on the overall property division.
The unsettled nature of the law regarding valuations only adds to the tension. Two controversial issues recently addressed by the courts are whether the value of closely held businesses should be subject to discounts for minority ownership shares and lack of marketability, and how personal goodwill should be accounted for in the valuation of professional practices.
When to Discount
In a 1995 decision, the Oregon Court of Appeals defined minority and marketability discounts applicable to closely held businesses. Tofte and Tofte, 895 P.2d 1387. “A minority discount takes into account the relationship between the interest being valued and the total enterprise,” stated the court. “The primary factor in determining the value of a minority interest is the degree of control that the owner either does or does not have within the corporation. Obviously, the degree of control must be analyzed in the light of the number and size of the remaining shareholders’ total interests in the corporation. For instance, a 20 percent minority shareholder may have greater control relative to two 40 percent minority shareholders than he or she would have relative to an 80 percent shareholder.”
A marketability discount, said the court, “addresses the degree of liquidity of the interest. Such discounts compensate for the lack of a recognized market for a particular stock, lack of ready marketability, or restrictive provisions affecting ownership rights or limiting sale. A marketability discount may apply to either a minority or majority interest and may be imposed in addition to a minority discount if circumstances warrant.” The minority discount has historically ranged from a low of 11.3 percent to a high of 50 percent across the country. The marketability discount has historically ranged from a low of 10 percent to a high of 40 percent. With discounts at the upper end of these ranges, the impact on the marital estate is substantial. For a summary of divorce court decisions applying the discounts, and the size of the discount, see: Valuation Strategies in Divorce, 4th ed., vols. 1 and 2, 2005 cumulative supplement, section 15.54, pages 350-51. Recent empirical studies have caused business appraisers to rethink the size of the marketability discount. The discount usually falls in the 10 percent to 25 percent range now rather than the 30 percent to 40 percent range that was more typical in earlier reported court decisions. For a review of the empirical data, see “Deconstruct the Studies,” March 2004 Trusts & Estates.
The Alaska Supreme Court recently addressed minority and marketability discounts in Hanson v. Hanson, 125 P.3d 299 (2005). The parties owned a business that offered traffic control services to construction companies. The dispute concerned the value of the wife’s 5 percent interest in the business and whether the court should apply the discounts. Since the husband owned 95 percent of the business, it made sense that he would buy out his wife’s 5 percent share as part of an equitable distribution of the marital estate. The husband asserted, however, that the discounts should apply, thus lowering the price he would pay for his wife’s shares.
The court recognized that if the stock were placed on the open market for sale, a “hypothetical buyer would also be a minority shareholder and would thus demand a discount.” But here, the husband was buying the wife’s shares and becoming the sole owner of the business, not a minority shareholder.
The husband cited a prior Alaska Supreme Court decision on valuation discounts, Hayes v. Hayes, 756 P.2d 298 (1988), to support his contention that they are required in divorce cases. In Hayes, the court held that minority discounts can be appropriate in divorce cases. That does not mean, however, that they must be applied in all cases, stated the court in Hanson. “Rote application of minority discounts in such situations undervalues minority shares,” the court noted. The court rejected a minority discount for the wife’s 5 percent share of the business.
Hanson has important implications for cases where the parties own 100 percent of the stock between them, but one spouse owns less than 50 percent. The Alaska Supreme Court’s opinion offers persuasive reasoning for the position that minority discounts should not apply in such cases.
Because of the nature of divorce proceedings, according to this view, the minority shareholder-spouse will never actually sell his or her shares on the open market at a discount. Instead, the stock will almost always be awarded to the majority shareholder-spouse. Essentially, the discount is fictitious under these circumstances.
The marketability discount should be applied, however, if the facts warrant it. Even a 100 percent interest in a closely held business can have barriers to marketability under certain circumstances.
The Ohio Court of Appeals, 2nd District, affirmed a 75 percent discount for lack of marketability in Caldas v. Caldas, No. 20691 (Aug. 19, 2005), an unpublished opinion. This substantial discount is outside of the normal range. The court upheld the discount on the basis of the husband’s key role in the business and other special factors. As the court pointed out, the business received preferences for government contracts because of the husband’s racial/ethnic background. The preference had a limited period of nine years and was about to expire. Upon the expiration of the preferences, the business would have to compete with larger companies for government contracts. Ninety percent of the company’s existing government business was under minority contracts that could not be assigned or transferred. Therefore, the contracts were not marketable. Moreover, the company relied heavily on the husband’s security clearance to obtain the contracts, but at the time of the divorce trial, he had just received notice that he lost his security clearance. As a result, he was in the process of losing all the contracts except for one small NASA job.
The appellate court found the trial court’s decision to adopt the marketability discount to be reasonable in view of the risky nature of the husband’s business. The court cited a number of factors supporting that conclusion: Certain loan covenants prohibited the husband from selling his interest in the company, from merging with another company, from making corporate loans, and from distributing dividends or capital. The fact that the husband lost his security clearance during the trial was a major factor in convincing the court that the business had a high degree of risk.
Courts in some states, such as Connecticut, Indiana and Minnesota, sometimes decline to apply the marketability discount under certain circumstances. Their reasoning includes the following points:
• The state uses an intrinsic or fair-value standard rather than a fair market-value standard. The fair market-value standard focuses on what the asset would likely sell for on the open market, while the fair-value standard seeks to identify the value to the holder of the asset.
New Jersey does not apply discounts in divorce cases as a matter of policy based on that state’s fair-value standard. See Brown v. Brown, 792 A.2d 463 (N.J. Super. Ct. App. Div. 2002).
• In most cases, there is no realistic possibility the business interest will be sold.
• State corporation laws protect minority shareholders from having the value of their stock diluted.
Practitioners should watch for court decisions indicating any new emerging consensus on when the discounts should be applied, and at what levels.
Goodwill Gets Personal
A second hot topic in divorce valuation is how to value personal goodwill as distinguished from enterprise goodwill.
Enterprise goodwill is the value of the advantages a business entity has from its location, brand name and other characteristics. The majority view among the states is that this form of goodwill is a divisible asset upon divorce. A comprehensive list of court decisions adopting the majority view can be found in Valuation Strategies in Divorce (see citation above), section 15.73, page 461.
But there also is a majority view that personal goodwill associated with an individual’s business or professional reputation, knowledge and skills is not marital or community property subject to distribution in divorce proceedings. See May v. May, 589 S.E.2d 536 (W.Va. 2003).
A few states have held that neither personal nor enterprise goodwill is marital property. The Mississippi Supreme Court has addressed the issue twice in recent years. In Singley v. Singley, 846 So. 2d 1004 (2002), the court ruled that “goodwill should not be used in determining the fair market value of a business, subject to equitable division in divorce cases.” The court stated that the meaning of goodwill varies depending on the context in which it is being used. The court held that goodwill “is simply not property; thus it cannot be deemed a divisible marital asset in a divorce action.”
Two years later, the court clarified its holding in Singley with respect to enterprise goodwill and personal goodwill. “Neither should be included in the valuation of a solo professional practice for purposes of a division of marital assets,” the court stated in Watson v. Watson, 882 So. 2d 95 (2004). “In such cases, the two are simply too interwoven and not divisible.”
The issue arises frequently in the context of noncompetition or consulting agreements. Typically, a business owner signs such an agreement as part of a sale transaction to prevent him or her from doing business with existing customers and potential new customers of the enterprise being sold. The consulting aspect of such a contract calls for the seller to introduce existing customers to the buyer and assure them that the new owner will continue to provide the same quality of products and services that they received before the sale.
In a recent divorce case considered by Florida’s 4th District Court of Appeal, the wife’s expert valued the husband’s insurance agency assuming that, if he sold it, he would sign a noncompetition agreement preventing him from doing future business with the existing customers of the agency. Held v. Held, 912 So. 2d 637 (2005). The appellate court rejected that valuation, which had been accepted by the trial court. The appellate court ruled that personal goodwill is improperly included if the valuation assumes any type of noncompetition agreement.
“In this case, the husband’s personal relationship with his clients allowed him to obtain their repeat business,” stated the appellate court. “The trial court’s valuation method inserted into enterprise goodwill an aspect of personal goodwill, the value of the husband’s personal relationship with the 60 clients.” But, the court pointed out, that method of valuation contravened at least one earlier case, “which emphasized that to be a marital asset, goodwill ‘must exist separate and apart from the reputation or continued presence of the marital litigant.’ ”
There are, however, good reasons why the value of a noncompetition agreement should be subtracted from the value of the business in order to remove the personal goodwill. The selling owner often stays on in a consulting role to preserve the enterprise goodwill of the business for the new owner. The seller is paid to do this. The price or value of the noncompetition or consulting agreement is the cost to preserve the existing enterprise goodwill. Therefore, an appraiser should deduct that cost from the sale price. There is industry data on the terms of such consulting contracts from actual market transactions. Pratt’s Stats, for instance, is a database that can be used to calculate the present value of a hypothetical noncompete agreement to deduct from the value of the business.
Some customers will still leave the business despite the noncompetition agreement. To fully deduct for personal goodwill, an appraiser should deduct an estimate for this lost business. This requires an inquiry into what percentage of the existing customers patronize the business because of a personal relationship with the owner as opposed to other characteristics of the business, such as its location, price and brand recognition. Although the legal definition of personal goodwill is relatively clear, the proper methodology to value personal goodwill remains elusive. It may be many years before we have definitive guidance on the proper valuation methodology for this unique legal concept.
The Block’s New Big Kid
The Growing Importance of IP to Companies Puts a Premium on Effective Valuation
Donna Suchy
“Intellectual property drives commerce.” “Intellectual property is key to economic growth.” “IP represents more than half of a company’s value.” Increasingly, these statements echo through the halls and boardrooms of businesses everywhere.
Assuming the statements are true–and in today’s business world, that’s a safer bet all the time–then the process used to set and adjust the value of intellectual property is becoming more and more crucial to a company’s overall operations and financial health. Since intellectual property accounts for a large percentage of corporate assets in today’s companies, understanding IP valuation is critical.
But that doesn’t mean it’s easy.
Valuing IP assets involves more complexities than an overall business valuation. Traditional valuation methods are not always adequate to perform reliable valuations on IP assets, particularly for emerging and noncommercialized technologies. The primary reason is that traditional methods cannot adequately consider the multiple outcomes possible with the use of new technologies that have not yet been commercialized or proven in the marketplace.
Moreover, there is no single “right” valuation method for intellectual property. All IP valuation methods can be grouped into one of three general approaches: income, market or cost. The results can vary depending on the type of valuation method used, and different valuation methods are suitable to different scenarios. Accordingly, the first step in any IP valuation is to understand what IP rights are being valued–and why.
Valuation may be needed because of legal or commercial considerations. On the legal side, valuation may be required in litigation over the validity or ownership of a patent, possible patent infringement or unauthorized use of the technology. Valuation also may be required in bankruptcy proceedings.
On the business side, deal-making concerns–including mergers, acquisitions, transfers, reorganizations, spin-offs and licenses–usually are the driving force. When evaluating an asset, it is important to consider ways the IP may produce income. It may be more valuable on a stand-alone basis or as part of a larger group of assets. Unlike most tangible assets, intellectual property often needs to be packaged with other assets to maximize its value. This packaging can take place horizontally, based on the type of IP being valued (such as all trademarks and logos), or vertically, by product or business lines.
Three-Way Street
In 2004, the ABA Section of Intellectual Property Law conducted a survey of IP valuation methods used by its members. It garnered more than 500 responses from a wide variety of companies, representing incomes ranging from less than $10 million to more than $10 billion, and work forces of fewer than 100 employees to more than 10,000. Respondents indicated that most of their valuations were for asset transfers–such as sales and purchases–and joint ventures, followed by licensing, financial purposes and litigation support.
The valuation methods used by the respondents were evenly distributed between the market, cost and income approaches.
(Some of the survey results are reported in Fundamentals of Intellectual Property Valuation: A Primer for Identifying and Determining Value, published in 2005 by the ABA. The author of this article co-edited the book with Weston Anson. For more information, go to www.abanet.org/store.)
Generally, the market approach is used when comparable sales or other transactions can be identified that are very similar to the IP asset being valued. This approach uses market indicators to measure comparative value. These indicators are represented by methods such as industry standards, market comparables, ranking/rating, pricing multiples, market replacement and allocation of business enterprise value.
The cost approach often is used as a primary or secondary method to measure the cost savings as a result of owning that asset. Savings can be determined by assessing the cost to create the same or similar asset, or the costs to design around, replace or reproduce the asset.
The income approach is used where specific income levels and/or streams of real or imputed royalties can be identified for a given asset bundle. Sometimes this approach takes the form of the relief-from-royalty method, which calculates the present value of the royalties a business would have to pay for the IP if it did not own it. Methods to quantify income that will be gained or lost due to the IP asset also include discounted net cash flow, direct capitalization analysis, comparative income differential and split profits.
The relief-from-royalty method should, however, be used with some caution. While this method has been used to value IP assets for many years, in the past decade it has been widely misused (and even abused). In Minebea Co. Ltd. v. Papst, the U.S. District Court for the District of Columbia excluded royalty calculations because there was no detailed, per-patent analysis. No. Civ.A. 97-0590 (PLF) (June 21, 2005); summary judgment denied, 374 F. Supp. 2d 202 (June 24, 2005).
The problem is that too many valuations are based on theoretical market royalty rates to calculate value. It is true that some intellectual property–particularly trademarks, brands and copyrights–has established comparable market royalty rates. But in many cases, comparable royalty rates are speculative at best. Moreover, exact comparable royalty rates do not exist, so any valuation project that claims to present exact comparables is flawed in its basic logic.
Nonetheless, the relief-from-royalty approach can be a very effective valuation methodology when appropriate royalty rate comparables or calculations or both are available and properly used. See Joblove v. Barr Labs Inc. (In re Tamoxifen Citrate Antitrust Litigation), 429 F.3d 370 (2d Cir. 2005); as amended Jan. 3, 2006.
In the view of many IP valuation experts, applying more than one of these approaches–market, cost and income–to a particular IP property produces the most reliable valuation results. It also is possible to combine valuation approaches to suit the property, available information about it and the purpose of the valuation.
All three approaches can be used in many situations, and at least two of the three approaches always should be used to quantify the results. See Whelan v. Abell, Nos. 87-442 and 87-1763 (1997), where the U.S. District Court for the District of Columbia excluded expert testimony on financial valuation and damages because the plaintiffs’ expert used only one valuation method.
Shrinking Lifespan
Other issues that should be considered in relation to intellectual property valuations include the following:
IP lifespan. In both economic and legal terms, intellectual property doesn’t always have a meaningful existence that goes on forever.
IP assets with a limited legal life include patents and copyrights, while those with an indefinite legal life include trademarks and trade secrets. The legal life of an IP asset is an important consideration in the valuation process, but determining the legal life is not always a straightforward matter because the intellectual property often is part of a bundle of assets that affect one another.
IP assets that are protected in multiple jurisdictions are likely to have legal lives of varying lengths in each of the jurisdictions.
Meanwhile, economic obsolescence is an increasingly important factor as the life cycle for products becomes shorter. There is no guarantee that an IP asset will retain its value for its entire legal life. Patents on chip technology, for example, may have a remaining legal life of 15 years, but rapid advances in chip technology may limit their economic life to only two or three years. Existing contractual agreements as well as the functionality of the IP must be considered when evaluating the economic life of an IP asset.
Design-around or re-creation costs. Many protected technologies do not provide an exclusive method or product feature. Demand for the protected product gives potential competitors compelling motivation to design around the patent, copyright or trade secret to capture some of the market share. Likewise, if a branded product takes off in a particular market, competitors may try to create a similar brand product to compete and capture market share. The costs to design around or re-create will create a ceiling for the value of the IP asset.
Internal communications. The results of the survey conducted by the ABA Intellectual Property Law Section indicate that 90 percent of IP valuations are made by a dedicated IP group or another internal business unit in a company. This approach to IP valuation could result in poor communication with management regarding IP valuation methods employed and lead to valuations that are inconsistent with the company’s overall strategic objectives. IP valuation policies that are consistent with a company’s strategic objectives are critical to optimizing the management of one of the most important groups of assets a company possesses.
Best practices. A company should develop best-practice guidelines for implementing and overseeing an IP valuation strategy. A best-practice plan should:
• Involve IP counsel in the management of intellectual property.
• Assure that chief executive officers and chief financial officers are familiar with IP portfolios and the company’s valuation policy so they can make certifications of asset ownership as required by the Sarbanes-Oxley Act of 2002.
• Update IP identification and valuation methods.
• Keep board members and other key people informed.
• Make accurate and comprehensive disclosures.
The true value of an IP asset is only known at the end of its life. Thus, it is important that the relevant factors influencing the asset’s value are considered during the valuation process, and that the valuation is revisited when any one of those factors changes significantly.
James Podgers, a lawyer, is an assistant managing editor for the ABA Journal. Robert D. Feder is a partner in the family law department of Schnader Harrison Segal & Lewis in Philadelphia, where he focuses on financial aspects of divorce. Feder is the editor of Valuation Strategies in Divorce, 4th ed., vols. 1 and 2, and Valuing Specific Assets in Divorce, both published by Aspen Publishers in New York City. Donna Suchy is an intellectual property attorney at Eastman Kodak in Rochester, N.Y., where her focus is on patent protection and valuation. She chairs the IP-Related Issues Division of the ABA Section of Intellectual Property Law.
