Intellectual Property (IP) is a type of asset belonging to a business just like other assets such as cash, inventory or plant and equipment. The key difference between IP and these other type of assets is that IP is intangible rather than tangible in nature.
A cursory glance at the balance sheets for many Australian listed companies will reveal significant value disclosed under the heading of intangibles which will include a list of different types of identifiable IP. However, the balance sheet typically does not disclose the full value of all the IP belonging to the business, one key reason being that the accounting standards may not permit it to do so.
As IP is of an intangible nature, small business owners tend to focus primarily on goodwill (and rightly so) without really understanding what it is. From an accounting angle, goodwill is simply a residual concept – it is the remaining value left in the business above the sum of all the identifiable net assets. In other words, if someone pays $10 million for a business where all the identifiable net assets (both tangible and intangible) are valued at $9 million, then the value of goodwill is $1m.
However it is possible that some of the $1 million goodwill in the above hypothetical business might actually be attributable to unidentified IP – perhaps relating to patents, copyright, trademarks, brands and/or software development. IP might also include ‘know-how’, customer lists, and licenses depending on the industry the business operates in.
While obtaining values for tangible assets is relatively straightforward, valuing the IP is less so.
Conceptually the value ought to be determined by reference to the net present value of all the future cash flows attributable to IP which is usually very different from its cost. For example, it is a safe bet to assume that the rights to a Michael Jackson lyric is very different what it cost him to write it down!
The challenge for many big businesses today is to identify all its IP, protect it and manage its value. This type of thinking should be no different for smaller businesses. Using the same hypothetical example of the business sold for $10 million, lets now assume that a number of patents, which were not previously identified, have now been identified and valued at $0.5 million. The goodwill value, in this case will reduce to $0.5 million to reflect identifiable net assets of $9.5 million. However the purchaser might then take steps to more aggressively market the benefits of the patents which might translate to increased sales volume and prices, which in turn could increase the value of the patent and hopefully the goodwill of the business. Even if, the purchaser chooses not to aggressively market to realise the full potential of the patents, the identification and valuation of previously unidentified IP can potentially provide tax benefits down the track. This is another reason why small business owners need to consider identifiable and unidentifiable IP.