Attributes of an Effective Intangible-Asset Valuation Report
Intangible-asset valuation (and related economic analysis) reports are often prepared within a corporate bankruptcy. Intangible-asset valuations are often relevant to controversies involving (1) the solvency or insolvency of the debtor corporation; (2) the identification of license, spinoff or joint venture opportunities; (3) the assessment of DIP financing collateral; (4) the value of secured creditors' interests; and (5) the analysis of proposed reorganization plans, among others. Of course, every bankruptcy financial advisor attempts to make every intangible asset valuation report clear, convincing and cogent, particularly when valuation is likely to be controversial.
First, this discussion summarizes the common attributes of the effective intangible-asset valuation report. Second, this discussion summarizes common errors to avoid in the preparation of the intangible-asset valuation report. Finally, this discussion summarizes the basic quality control procedures that bankruptcy financial advisors should perform before issuing the written intangible-asset valuation opinion report. Each topic is discussed from a bankruptcy negotiation and/or litigation support perspective.
Valuation Reports Within a Bankruptcy Controversy
Bankruptcy-related controversies regarding intangible-asset value are often decided by a judicial finder of fact. In this litigation environment, an effective intangible-asset valuation report should be both well-written and well-organized. In addition, an effective intangible-asset valuation report should satisfy (1) all of the analyst's professional standards and (2) all of the client's engagement requirements.
This discussion reviews the attributes of an effective intangible-asset valuation report within the bankruptcy context. However, this discussion of effective valuation report attributes also applies to intangible-asset valuation reports that are (1) prepared for any controversy/dispute purpose and/or (2) subject to a contrarian review.
Effective Intangible-Asset Valuation Report Attributes
A clear, convincing and cogent intangible-asset valuation report should demonstrate several effective writing attributes. These attributes include:
1. Thoroughness. The written report should include (a) all relevant quantitative/qualitative data and (b) all relevant quantitative/qualitative analyses that affect the intangible asset value conclusion. The valuation report should disclose (a) the purpose and objective of the valuation and (b) the analyst's client. In addition, the valuation report should adequately describe (a) the subject intangible asset, (b) the bundle of legal rights subject to analysis, (c) the owner and operator (if different) of the subject intangible asset, (d) the valuation assignment standard of value, premise of value, valuation date, etc. and (e) any contracts, agreements or licenses that may affect the ownership, use or transferability of the subject intangible asset.
2. Objectivity. The written report should discuss both the positive and the negative factors affecting the subject intangible-asset value. Although the analyst's client will presumably have an interest in the subject intangible-asset value conclusion, the analyst should remain unbiased and objective. Accordingly, the intangible-asset valuation report should manifest that objectivity by presenting an impartial discussion of all relevant facts and factors affecting the subject intangible asset.
3. Understandability. The judicial or other reader of the intangible-asset valuation should be able to follow and understand (a) the data analyzed, (b) the analyses performed and (c) the value conclusions reached. The valuation report should be written in a clear and concise style. The narrative should avoid technical jargon whenever possible. When technical appraisal or economic jargon is necessary, it should be adequately defined. Any empirical data and/or analytical assumptions presented in the report should be adequately described so that the valuation report readers can understand them.
4. Coherence. The valuation report content should logically flow from the empirical data presented to the final value conclusion. Also, the intangible-asset valuation report conclusions and analyses should be internally consistent. The valuation report should present a narrative story that logically leads the report reader from the initial description of the valuation assignment to the analyst's value conclusion.
5. Documentation. The intangible-asset valuation report should adequately document (a) each valuation approach, method and procedure performed and (b) each value indication reached. An adequate level of documentation generally implies (a) the presentation of all quantitative and qualitative analyses and (b) the identification of all empirical data sources relied on. That way, a finder of fact (or another analyst) can (a) recreate the particular procedures performed and (b) reach a similar value conclusion.
6. Composition. The analyst should follow all of the report composition guidelines below with respect to the intangible-asset valuation report:
a. Stick to the point; avoid discussion of extraneous topics not related to the subject valuation.
b. Make the report prose coherent; clearly link related ideas; distinguish unrelated ideas.
c. Support the report statements with specific evidence; use facts and statistics to support statements and conclusions.
d. Use lists to display facts; use charts, graphs, tables and diagrams to display data.
e. Make the point of view consistent; maintain consistent verb tenses; make verbs consistent in mood and voice.
f. Untangle the grammatical structure; straighten out the logical connections.
g. Use a variety of sentence structures; use a variety of sentence openings.
h. Avoid wordy sentences; eliminate redundancies; avoid the unnecessary repetition of words.
i. Eliminate pretentious language; simplify sentence structure; reduce clauses to phrases and phrases to single words.
j. Use the active voice (unless there is a good reason to select the passive voice).
Common Errors in Intangible-Asset Valuation Reports
Within the bankruptcy litigation context, it is very common for two (or more) intangible-asset valuations to be prepared by two (or more) analysts. This can occur, for example, when the debtor and creditors disagree on the valuation approach/method, analytical assumption or value conclusion. Differences among the parties in interest to the bankruptcy may require the court to judicially determine the intangible-asset value based on two (or more) different valuation reports.
Courts (and other finders of fact) may appropriately disregard an intangible-asset valuation report that has obvious deficiencies. Before issuing the final written report, the analyst should review the intangible-asset valuation report for one or more of the following common errors.
1. Failure to follow the defined standard of value. Generally accepted valuation terminology is used in most valuation reports to inform the report reader as to how the intangible asset value was concluded. The stated standard of value—or definition of value—is an important disclosure in any valuation report. This statement of the defined standard of value is because the subject's value can vary significantly depending on which definition of value is selected for the valuation engagement (e.g., fair value vs. fair market value vs. investment value vs. use value, etc.).
One of the common errors in an intangible-asset valuation report is the analyst's failure to consistently follow the standard of value defined in the report. This error may cause the finder of fact to assign little or no weight to the intangible asset valuation report. Therefore, analysts should (a) carefully define the selected standard of value in the report and (b) ensure that the defined standard is applied consistently throughout the valuation report.
2. Analytical internal inconsistencies. All of the valuation data, analyses, calculations and conclusions should be internally consistent throughout the report. Some common examples of analytical internal inconsistencies include:
•Application of the selected valuation pricing multiples to the wrong economic income measure (e.g., applying an after-tax pricing multiple to a pre-tax measure of intangible asset royalty income).
•Failure to match the selected direct capitalization rate or present value yield capitalization rate to the corresponding economic income measure (e.g., applying a net cash-flow discount rate to an incremental or residual income measure based on net income).
• Failure to use a consistent expected growth rate throughout the various valuation methods (e.g., using a different growth rate in an excess earnings analysis than the rate used in a profit-split analysis).
•Comparison of current intangible-asset operating data to comparative data for a different time period without making appropriate adjustments (e.g., for changes in market conditions or for changes in the owner/operator's accounting methods).
•Normalizing the financial statements for the intangible asset owner/operator without normalizing the corresponding financial data for the selected guideline companies (i.e., companies with/ without guideline intangible assets).
•Use of inconsistent extraordinary assumptions or hypothetical conditions (e.g., estimating the intangible asset income assuming the existence of contributory tangible and intangible assets
—but without allowing for a capital charge or economic rent on those contributory assets).
•Failure to perform (or to report on the performance of) a highest and best-use analysis with regard to the subject intangible asset.
3. Arithmetic errors in the analysis. One of the easiest valuation errors to prevent is one of the most common valuation report errors. All mathematical calculations should be reviewed for accuracy, and all mathematical rounding conventions should be reviewed for consistency. An obvious (and easily correctable) mathematical error may make the finder of fact question the reliability of an otherwise well-supported intangible asset valuation report.
4. Insufficient support for selected valuation variables. Inadequately documented valuation reports are an easy target for contrarian analysts during the bankruptcy litigation. Depending on the professional reporting standards applicable to the subject report, intangible-asset valuation reports should adequately document (a) the data used, (b) the procedures performed and (c) the value conclusions reached. The data used in quantitative analyses should be able to be traced to the intangible asset owner/operator financial statements or to other empirical data sources. In addition, the finder of fact/report reader should be able to trade the value conclusions presented in the report schedules and exhibits to the value conclusions presented in the report narrative.
5. Reliance on industry or other rules of thumb. Industry or other rules of thumb are not generally accepted as an intangible-asset valuation method. Transactional rules of thumb (e.g., dollars per line of code for computer software or dollars per cable TV subscriber/customer relationship) may be used to provide confirmatory evidence of a more rigorous valuation analysis. In other words, analysts may sometime use rules of thumb as a "sanity check" on their value indications. However, values indicated by rules of thumb should not be assigned significant weight in actually reaching the intangible asset value conclusion.
6. Insufficient data and inadequate market research. Some intangible asset analysts cut corners either (a) because of engagement fees and time budget constraints or (b) because of their lack of familiarity with publicly available sale/license/royalty rate transactional data sources. The intangible-asset valuation report should make it clear to the finder of fact that the analyst considered all relevant data that may significantly affect the value conclusion.
7. Inadequate due diligence procedures. Some examples of inadequate due-diligence procedures in the preparation of the intangible asset valuation report include:
a. failure to consider all three generally accepted intangible asset value approaches,
b. failure to review relevant contractual or other documentation regarding the subject intangible,
c. failure to inquire about recent sales and/or licenses involving the subject intangible,
d. failure to consider the highest and best use of the subject intangible,
e. failure to consider the owner/ operator's actual use of the subject intangible, and
f. failure to consider the specific bundle of legal rights encompassed in the subject intangible-asset analysis.
Summary and Conclusion
Particularly within a bankruptcy litigation context, the intangible-asset valuation report should be clear, convincing and cogent. The objectives of such a valuation report are to (1) educate the finder of fact and (2) persuade the finder of fact as to the concluded value for the subject intangible asset. In addition, intangible-asset valuation reports must comply with any applicable valuation professional standards.
When the analyst invests the time and effort to prepare a well-written and well-documented valuation report, that report should be able to (1) withstand a contrarian review and challenge and (2) convince the finder of fact of the concluded intangible-asset value. Also, with the appropriate analyst investment of time and effort, the same results will occur with regard to bankruptcy-related effective intangible asset analysis reports that conclude a fair royalty rate, an arm's-length transfer price, an RUL estimate, a lost profits/economic damages conclusion or a transactional fairness assessment.