Upon emerging from Chapter 11 bankruptcy, companies are required to apply the provisions of Accounting Standards Codification 852, Reorganizations. Under this treatment, referred to as “fresh start” accounting, companies exiting Chapter 11 are required to re-state assets and liabilities at fair value, as if the company were being acquired at a price equal to the reorganization value. As a result, two principal valuation-related questions are relevant for companies in bankruptcy:
- Reorganization Value - As noted in ASC 852, Reorganizations, reorganization value “generally approximates the fair value of the entity before considering liabilities and approximates the amount a willing buyer would pay for the assets of the entity immediately after the restructuring.” (ASC 852-05-10) Discounted cash flow analysis is the principal technique for measuring reorganization value. In certain cases, depending on the nature of the business and availability of relevant guideline companies, a method under the market approach may also be appropriate. A reliable cash flow forecast and estimate of the appropriate cost of capital are essential inputs to measuring reorganization value.
- Identifiable Intangible Assets - When fresh-start accounting is required, it may be appropriate to allocate a portion of the reorganization value to specific identifiable intangible assets such as tradenames, technology, or customer relationships. We discuss valuation techniques for identifiable intangible assets in the remainder of this article.
Measuring the Fair Value of Identifiable Intangible Assets
When valuing identifiable intangible assets, we use valuation methods under the cost, income, and market approaches.
The Cost Approach
The cost approach seeks to measure the future benefits of ownership by quantifying the amount of money that would be required to replace the future service capability of the subject intangible asset. The assumption underlying the cost approach is that the cost to purchase or develop new property is commensurate with the economic value of the service that the property can provide during its life. The cost approach does not directly consider the economic benefits that can be achieved or the time period over which they might continue. It is an inherent assumption with this approach that economic benefits exist and are of sufficient amount and duration to justify the developmental expenditures.
Methods under the cost approach are frequently used to measure the fair value of assembled workforce, proprietary software, and other technology-related assets.
The Market Approach
The market approach provides an indication of value by comparing the price at which similar property has been exchanged between willing buyers and sellers. When the market approach is used, an indication of value of a specific intangible asset can be gained from looking at the prices paid for comparable property.
Since there is rarely an active market for identifiable intangible assets apart from broader business combination transactions, valuation methods under the market approach are not commonly used to value identifiable intangible assets.
However, available market data, such as observed royalty rates in licensing transactions, is an important input in valuation methods under the income approach such as the relief-from-royalty method. Other market-derived data helps to inform estimates of the cost of capital and other valuation inputs, as well.
The Income Approach
The income approach focuses on the capacity of the subject intangible asset to produce future economic benefits. The underlying theory is that the value of the subject property can be measured as the present worth of the net economic benefits to be received over the life of the intangible asset.
Using valuation methods under the income approach, we estimate future benefits expected to result from the subject asset and an appropriate rate at which to discount these expected benefits to the present. The most common valuation methods under the income approach are the relief from royalty method and multi-period excess earnings method, or MPEEM.
- The relief from royalty method seeks to measure the incremental net profitability available to the owner of the subject intangible asset by avoiding the royalty payments that would otherwise be required to enjoy the benefits of ownership of the asset. When applying the relief from royalty method requires specification of three variables: 1) The expected stream of revenue attributable to the identifiable intangible asset, 2) An appropriate royalty rate to apply to that revenue stream, and 3) An appropriate discount rate to measure the present value of the avoided royalty payments. The relief from royalty method is most commonly used to value tradename and technology assets for which market-based royalty rates may be observed.The MPEEM is a form of discounted cash flow analysis that measures the value of an intangible asset as the present value of the incremental after-tax cash flows attributable only to the subject asset. In order to isolate those cash flows, we first develop a forecast of the expected revenues and associated operating costs attributable to the asset.
- Next, we apply contributory asset charges to reflect the economic “rent” for use of the other assets that must be in place to generate the projected operating earnings. In other words, the MPEEM recognizes that the subject identifiable intangible asset generates operating earnings only in concert with other assets of the business.
- Finally, we reduce the net after-tax cash flows attributable to the subject identifiable intangible asset to present value using a risk-adjusted discount rate. The indicated value is the sum of the present values of the “excess earnings” of the expected life of the subject asset.
Conclusion
The valuation techniques for identifiable intangible assets are rooted in the fundamental elements of business valuation, cash flow and risk, under the cost, market, and income approaches. However, when valuing identifiable intangible assets, we use valuation methods adapted to the unique attributes of those assets.
