Income Approach Valuation
Different measures of economic income may be relevant to the various income approach methodologies. Some of these measures include the following:

• Gross or net revenues;
• Gross profit;
• Net operating income;
• Pretax income;
• Net income (after tax);
• Operating cash flow;
• Net cash flow;
• Incremental income; and
• Cost savings.

Given the different measures of economic income that may be used in the income approach, an essential element in the application of this valuation approach is to ensure that the discount rate or the capitalization rate used is derived on a basis consistent with the measure of economic income used.

Although there are at least as many income approach valuation methods as there are measures of economic income, most of these methods may be grouped into several categories, all of which have similar conceptual underpinnings and similar practical applications.

Several categories of intellectual property income approach methods are listed below:

• Methods that quantify incremental levels of economic income (the intellectual property owner will enjoy a greater level of economic income by owning the property as compared with not owning the property).
  
  
• Methods that quantify lower levels of economic cost (the intellectual property owner will incur a lower level of economic cost, avoiding otherwise required investments or operating expenses), by owning the property versus not owning the property.
  
  
• Methods that estimate a relief from a hypothetical royalty or rental payment (the amount of a royalty or rental payment that the intellectual property owner would be willing to pay to a third party in order to obtain the use of, and/or rights to, the subject intellectual property he actually owns).
  
  
• Methods that quantify the difference in value of the overall business enterprise or similar economic unit as the result of owning the subject intellectual property used in the business enterprise compared with not owning the subject intellectual property (and not being able to use it in the business enterprise).

All of the various income approach valuation methods may be grouped into the following two analytical categories:

1. Direct Capitalization; and
2. Discounted Future Economic Benefits.

In a direct capitalization analysis, the valuer estimates the appropriate measure of economic income for one period (i.e., one period future to the valuation date) and divides that measure by an appropriate investment rate of return. The appropriate investment rate of return is called the capitalization rate. The capitalization rate may be derived for a perpetual period of time or a specified finite period of time, depending upon the valuer's expectations of the duration of the economic income stream.

In discounted future economic benefits analysis, the valuer projects the appropriate measure of economic income for several discrete time periods into the future. This projection of prospective economic income is converted into a present value by the use of a present value discount rate. The present value discount rate is the investor's required rate of return over the expected term of the economic income projection period.

The duration of the discrete projection period - and whether or not a residual or terminal value should be considered at the conclusion of the project period - depends upon the valuer's expectation of the duration of the economic income stream to be generated by the subject intellectual property.

The result of either a direct capitalization analysis or a discounted future economic benefits analysis will provide an indication of the value of the subject intellectual property.

Determining the Discount Rate and Capitalization Rate
In discounting available cash flow, an appropriate rate of return must be determined. The rate of return expected by an investor from an investment is related to:

• The general level of interest rates;
• A premium for perceived financial risk; and
• A premium for perceived business risk.

The appropriate rate of return for valuing an investment is the cost of capital for that investment. This rate of return is referred to as the discount rate, which is most often determined by using either the capital asset pricing model (CAPM) or the build up method. Both of these methodologies are variations of the basic summation concept.

The summation concept essentially "builds" a discount rate using the various components that comprise the total rate of return required on an investment. These components are:

1. the total return required on a long-term, risk-free investment;
2. equity risk premium; and
3. increments for risk differentials of the particular business or investment.

For the business or intellectual property, these risk differentials result from risk factors that are specific to the business and related to its advantages and disadvantages over other companies on the open market. These factors should include, but are not limited to, the following:

• The industry;
• The diversification of the licensing of the intellectual property;
• The characteristics of the intellectual property;
• The financial risks;
• The diversification of the operations;
• Lack of management depth;
• Lack of access to capital markets;
• Geographic diversification;
• Risk of assets; and
• Years in business.

Based on the factors listed above, an intellectual property's discount or capitalization rate can greatly vary. An established intellectual property widely licensed may use an industry rate of return, while an intellectual property in an emerging technology area with high obsolescence may have a rate of return similar to venture capital.

Developing a discount rate applicable to intellectual property is normally a two-step process. First, the valuer must develop the discount rate applicable to the entire business, which includes a company-specific risk premium accounting for the company's unique risk differentials. Next, the valuer must isolate the discount rate applicable to the specific asset being valued, by identifying and quantifying the relative risks of investments in the Company's various assets and in similar assets measured in the open market.

The discount rate applicable to the intellectual property should reflect the rate of return an investor would require for an investment in the asset. For any individual asset, this rate must be determined in the context of the discount rate of the business overall. Conceptually, the discount rate for the business may be viewed as a weighted average of a series of discount rates applicable to the individual assets of the business from the least risky (e.g., cash, receivables) to the most risky (e.g., goodwill).

The capitalization rate, the rate used as the divisor in the Direct Capitalization Method, is derived from the discount rate and is determined by subtracting from the discount rate the projected average annual compound growth rate of an earnings stream. The reciprocal of the capitalization rate is the valuation multiple.

An Example
One of the major characteristics of intangible assets recognized in generally accepted accounting principles is the characteristic of identifiability. Based on an analysis of the business and discussions with management, the valuer determines that an identifiable intangible asset exists in the form of intellectual property.

The valuer obtains data demonstrating the existence of this asset, and performs an analysis relying in part on an estimate of the remaining useful life of the intellectual property. The intellectual property alone could be sold to a willing buyer and such a sale would not necessarily require a transaction involving the entire business.

Let us assume a business discount rate of 17%, determined by CAPM or the build up methodology. This rate is theoretically the weighted average return on all the assets of the enterprise. The essence of the intellectual property (i.e., body of knowledge) and its potential transferability speak to the lesser risk of this asset relative to the business overall. We have thus determined that the discount rate applicable to the intellectual property is 16%.

Assuming a total business value of $7,500,000, a detailed allocation study might yield the following:

		FMV		Return
Cash & Equivalents		$700,000		5.0%
Accounts Receivable-Trade		400,000		7.0%
Prepaid and Other Expenses		100,000		7.5%
Net Fixed Assets		800,000		8.0%
Intellectual Property		3,000,000		16.0%
Goodwill		2,500,000		26.4%
Total and Weighted Average Return		$7,500,000		17.0%

The above analysis can be performed as a reasonableness check to make sure discount rates used to value intellectual property are supportable and make sense in the context of the business overall.

Conclusion
As we move into the 21st century, companies are becoming increasingly dependent on their intellectual properties. As a result, strategic decisions will continue to be increasingly dependent on understanding the economics affecting the value of these intellectual properties.

Intellectual property professionals and management with intellectual property knowledge will continue to gain influence over strategic decisions as we move totally into the information age whose primary capital will be intellectual property.