Valuation of Dot-com and Intellectual Property-intensive Companies
During 1999 and the first quarter of 2000, the market's infatuation with dot.com companies created enormous market capitalizations for these companies and enormous personal wealth for their entrepreneurial owners. In fact, the statistics regarding the volume of capital market activity and the creation of shareholder wealth in this industry are record-setting. In 1999, there were 295 initial public offerings (IPOs) related to internet companies (according to IPO.com data). In the first quarter of 2000 alone, there were 91 IPOs related to Internet companies (also according to IPO.com data). Capital market funds were greatly attracted to dot.com companies, despite the extraordinarily high market capitalization pricing multiples. Private capital was also greatly attracted to dot.com companies. During 1999, approximately 39 percent of all venture capital investments went to internet companies (according to the Venture Economics and National Venture Capital Association).
During the spring and summer of this year, some of the "irrational exuberance" regarding publicly traded dot-coms abated. Pricing multiples have significantly decreased for underperforming dot.com ventures. During this recent repricing of dot.com industry stocks, investors returned to more traditional valuation metrics. In the Aug. 15, 2000, issue of Bottom Line, money manager Richard Bregman wrote, "Most investors have finally recognized that the dot.com companies that were yesterday's darlings were wildly overpriced. I believe unprofitable dot.com companies, or those with poor business models, are not going to recover."
This recent period of stock market repricing saw another type of wealth creation activity—mergers and acquisitions (M&A) transactions. The stock market is identifying unsuccessful dot.com companies and pricing their stocks accordingly. However, at the same time, successful dot-coms are acquiring unsuccessful dot.com companies at record-setting rates. The first quarter of 2000 saw more than $200 billion in Internet M&A transactions (according to WebMergers.com). In the second quarter of 2000, there were 14 Internet M&A transactions of more than $1 billion each. In this current period of performing companies buying underperforming companies, even unsuccessful dot.com entrepreneurs have become rich.
The stock market is identifying unsuccessful dot.com companies and pricing their stocks accordingly. However, at the same time, successful dot-coms are acquiring unsuccessful dot.com companies at record-setting rates.
The topic of this article is the valuation of dot.com companies that have filed for bankruptcy protection. The recent market dynamics create uncertainty for valuation analysts engaged to value dot.com companies within a bankruptcy estate. While there are numerous uncertainties regarding dot.com valuations, there appear to be at least three certainties. First, the recent erratic nature of capital market pricing multiples indicates that even the market "consensus" may not be sure how to value these companies. Second, traditional valuation methods, such as the direct capitalization of earnings or the yield capitalization of cash flow, are not particularly useful. This is because these pricing metrics result in non-meaningful results when applied to companies with negative earnings and cash flow—on either an ex-poste or ex-ante basis. Third, analysts agree that the value the market perceives in these dot.com companies is associated with their intangible assets and intellectual properties.
The valuation of dot.com companies (for bankruptcy or other purposes) is more of an exercise in intangible asset-valuation methods than in traditional business-valuation methods. Therefore, this discussion will focus on the identification and valuation of intangible assets—particularly in the context of dot.com companies and other intellectual property intensive companies.
In the discrete method of valuing dot.com intangibles, each of the individual intangible assets is separately identified and appraised. Such individual intangible assets include computer software, proprietary technology, copyrights, patents, trademarks, contracts, licenses, permits, employee relationships, supplier relationships, customer relationships, etc. Each individual intangible asset (or, at least, each individual category of intangible assets) is analyzed and its value is estimated. The estimated value of each of the intangible assets is added to the estimated values (usually deminimus) of the tangible assets and net working capital in order to estimate the dot.com business enterprise value. In this method, all of the dot.com intangibles are appraised "discretely"—i.e., individually.
In the collective method of valuing dot.com intangibles, the total intangible value of the business (from whatever economic phenomena contribute to that value) is analyzed and quantified in the aggregate. Such collective intangible value is often called goodwill. For purposes of this collective method, goodwill is defined as the total value of the dot.com business in excess of the (usually deminimus) tangible assets and net working capital. In the collective method of estimating intangible value, the conclusion is sometimes also called unidentified goodwill, unidentified intangible value or intangible value in the nature of goodwill. As these names imply, identifying the source of the intangible value is not important in the collective method. Rather, identifying the total amount of the intangible value is the only objective.
In the discrete method, dot.com intangible assets are identified and appraised. In the collective method, dot.com intangible value is identified and appraised. The distinction between intangible assets and intangible value may seem semantic, but it is an important distinction that represents the primary conceptual and practical difference between these two analytical methods. In the discrete method, it is necessary to identify which individual intangible assets create what amount of value. In the collective method, it is sufficient to identify that intangible value exists and what that total value is. The source of, or cause of, that intangible value is not especially relevant in the collective method.
As described below, there are several methods for the discrete valuation of individual intangible assets. There are also several methods for the collective valuation of total intangible value. Since these methods are not particularly useful in the valuation of a dot.com business, they will not be discussed in detail. However, for identification purposes, the following list presents the most common methods for the collective valuation of aggregate dot.com intangible value:
- capitalized excess earnings method (a direct capitalization of "excess" economic income into perpetuity model)
- present value of prospective excess economic income (a yield capitalization of "excess" economic income, based on a discrete long-term projection)
- residual from the actual transaction sale price (the values of the dot.com tangible assets and net working capital are subtracted from the dot.com business sale price)
- residual from business enterprise value (the values of the dot.com tangible assets and net working capital are subtracted from an estimated overall business value)
- build-up method (a few general components of goodwill are identified, valued and the values summed; the "build-up" components of goodwill typically include the dot.com going-concern value—often measured as the forgone economic income during the period required to recreate de novo the subject dot.com)
There are many benefits to the use of the discrete method, particularly with regard to bankruptcy-related dot.com valuations.
Benefits of the Discrete Method
First, the conclusion of the discrete method is presented in a typical balance-sheet format. The format is a comparative presentation of the dot.com's historical cost-based balance sheet and valuation-based balance sheet. This format is familiar and comfortable to lawyers, accountants and other advisors involved in bankruptcy matters.
Second, because of the balance-sheet format, the discrete method can present alternative definitions of value and premises of value. The same format, for example, can present the historical cost-based balance sheet, compared to a fair market value-based balance sheet, compared to a liquidation value-based balance sheet. This form of comparison may be particularly relevant in bankruptcy cases when the future nature of the subject dot.com as a going concern business entity is an issue.
Third, the discrete method explains the individual components of the dot.com value. Collective valuation methods that rely on capitalized expected cash flow or a multiple of expected revenues may result in an appropriate value conclusion. These collective methods, however, indicate only the total value; they do not explain why or how the dot.com has created that value. The discrete method calculates value by estimating the component values of each individual intangible asset. This information may be important to the parties to a bankruptcy matter (particularly if the issue of who was responsible for creating the value is raised). This detailed information about the dot.com value is also important to lenders, investors buying in, investors selling out, etc.
Fourth, the discrete method has many dispute resolution and litigation support benefits. For example, in a bankruptcy dispute, the value of the bankruptcy estate interest in a dot.com may be estimated by valuing the individual intangible assets associated with each lienholder. It is also possible to "date" the dot.com intangible assets—i.e., to estimate if they were created before or after a certain date (such as the date of filing).
Fifth, in the case where all or part of the dot.com business is sold as part of a reorganization, the discrete valuation method develops a ready-made sale price allocation. This may have important asset-basis considerations for federal income tax purposes.
There are also costs associated with the discrete method, particularly when the timing and expenses of the valuation are significant issues.
Costs of the Discrete Method
First, due to increased analytical rigor, this method requires considerably more time and effort than other valuation methods. Additional time is required for data collection and analysis procedures. Additional time is required in the actual valuation analysis. Additional time also is required in the valuation reporting. One offset to this additional time cost is that the analyst is much more intimately familiar with the dot.com (and particularly with the components of—and causes for—economic value) than if the collective method is used.
Second, due to the increased time required to prepare the more comprehensive analyses, the discrete method typically involves higher appraisal fees. Most parties to a bankruptcy dispute attempt to minimize appraisal and other professional fees. Nonetheless, particularly in controversial cases, the more comprehensive and rigorous the valuation analysis, the greater the likelihood of a favorable settlement or litigation judgment.
Third, the discrete method is more descriptive to the operations of the dot.com than other valuation methods. The discrete method requires that the analyst collect more documents from the dot.com, spend more time interviewing management, etc. Most dot.com owners and managers prefer to minimize any disruption associated with a valuation—particularly with a valuation prepared for bankruptcy purposes. Many times in bankruptcy cases, the debtor-in-possession will simply not be forthcoming with the necessary data to make the discrete method practical. As with all business valuation methods, the results of this method are only as good as the quality and quantity of available data.
Bundle of Legal Rights
The first step in the analysis is to identify the specified bundle of legal rights subject to appraisal. According to the bundle-of-rights theory, complete intangible asset ownership, or title in fee, consists of a group of distinct legal rights. Each of these legal rights can be separated from the bundle and conveyed by the fee owner to other parties in perpetuity or for a limited time period. When a right is separated from the bundle and transferred, a partial or fractional property interest results. It is possible to examine property interests in discrete intangible assets from several points of view. This is because the ownership, legal, economic and financial aspects of intangible assets overlap.
Ownership interests in intangible assets can take various forms. Different economic values can attach to the different ownership interests. The ownership interests related to the typical income-producing intangible assets include the following:
- fee simple interests
- term estates
- license/franchise interests and sub-license/franchise interests
- reversionary interests
- development/exploitation rights.
Valuation of Dot.com Intangible Assets
There are several methods, procedures and techniques to the economic analysis and valuation of dot.com intangible assets. All of these methods logically group into three general categories of economic analysis: the cost approach, market or sales comparison approach and income approach.
The cost approach is based on the economic principle of substitution. This principle asserts that an investor will pay no more for an asset than the cost to obtain—by either purchasing or constructing—an asset of equal utility. For purposes of this principle, utility can be measured in many ways, including functionality, desirability and so on. The availability and cost of substitute assets is directly affected by shifts in the supply and demand within the dot.com industry. Unlike fungible tangible assets, there are often no reasonable substitutes for dot.com intangible assets. Accordingly, the use of the cost approach may be limited in the case of unique dot.com intangible assets.
Intangible assets are the largest component of the value of dot.com business, and the value of these intangible assets is the only rational explanation for the sometimes irrational market valuations of dot.com companies.
The market approach is based on the economic principles of competition and equilibrium. These principles conclude that, in a free and unrestricted market, supply-and-demand factors will drive the price of an asset to a point of equilibrium. The principle of substitution also directly influences the market approach. This is because the identification and analysis of equilibrium prices for substitute assets will provide important evidence with regard to the value of the subject dot.com intangible.
The income approach is based on the economic principle of anticipation, also called the principle of expectation. The value of the subject intangible is the present value of the expected economic income to be earned from the ownership of the intangible. As the name of this principle implies, the investor anticipates the expected economic income to be earned from the asset. This expectation of prospective economic income is converted to a present worth—that is, the value of the dot.com intangible. There are numerous definitions of economic income. If properly analyzed, they all provide a reasonable indication of value. In this approach, the analyst estimates the investor's required rate of return on the asset generating the prospective economic income. This required rate of return is a function of many variables, including the risk—or uncertainty—of the expected economic income.
Analysts generally attempt to value dot.com intangibles using all three approaches. This multiple-approach analysis is performed in order to obtain a multidimensional perspective. The final value estimate is usually based on a synthesis—or reconciliation—of the various value indications. When concluding value, the analyst should realize that analysts only "estimate" the value of dot.com intangibles, while the marketplace actually "determines" the value of dot.com intangible assets.
Simplified Market Approach Example
In Example 1, the value of the dot.com trademark and trade name is estimated by reference to the economic income it could generate if it was licensed to another dot.com company (perhaps a competitor). The estimated royalty income would be based on an analysis of actual comparable dot.com trademark license transactions. Sales and licenses of dot.com trademarks is fairly common. Therefore, analysts may be able to assemble the necessary empirical transaction data. However, it is important to consider whether the comparative sale/license transactions took place at arm's length. If a sale/license transaction was from a failing dot.com to a successful competitor, the actual price may imply a liquidation value such that the transaction data may not be relevant to the analysis of an intangible used in a going-concern business (unless appropriate adjustments are made).
In this illustrative example, the value of the dot.com trademark is estimated by multiplying projected revenues by a five percent market-derived royalty rate. The direct capitalization rate is calculated as the market-derived present value discount rate minus the expected long term growth rate in the projected dot.com revenue. Capitalizing the projected royalty income by the illustrative market-derived 10 percent direct capitalization rate results in an indicated trademark value of $50 million.
In the simplified Example 2, the value of the dot.com-assembled workforce is based on the cost to recruit, hire and train replacement employees of comparable experience and technical expertise. This cost is estimated as a percent of total compensation for various categories of employees (where higher categories may represent employees with longer tenure, greater compensation, and/or higher level of responsibility).
Simplified Income Approach Example
Let's use an income approach analysis to value a dot.com's customer relationships (Example 3).
The dot.com's projected revenue is $100 million for the next fiscal year. The normalized profit margin is 12 percent, which is what the dot.com is expected to earn after it achieves a stabilized (normal growth) level of revenue. This stabilized level of revenue occurs after the dot.com has reached its break-even point.
Subtracting a fair return (sometimes called an "economic rent") on the other assets owned or used by the dot.com results in the expected economic income attributable to recurring customer relationships. Based on a statistical analysis of historical customer turnover rates, the average remaining life of the customer relationships is expected to be six years. The present value annuity factor is based on (1) the six-year estimate of the expected life of the dot.com customers and (2) an estimated market-derived present value discount rate.
Valuation Synthesis and Conclusion
Typically, the valuation of a dot.com intangible follows the process summarized above. When more than one valuation approach is used, each approach usually results in a different value indication. Within the same approach, there are often different indications of value. For example, there may be several values indicated by different income approach methods. The asset valuation synthesis procedure is an analysis of alternative indicated values—in order to arrive at the final value estimate.
The final value estimate is generally a number from the indicated range of values. The final value estimate may be one of the indicated values, or it may be the mathematical expectation (i.e., the weighted average) of the indicated values, or it may be based on another number within the indicated range of values. Generally, it is not appropriate to simply average the indicated values. A simple arithmetic mean implies that all of the value indications have equal validity and deserve equal weight. While this is sometimes appropriate, it is usually not the case in the typical intangible asset valuation. The final value estimate should be derived from the analyst's reasoning and judgment regarding all of the relevant factors and all of the available market evidence.
Intangible assets are the largest component of the value of dot.com business, and the value of these intangible assets is the only rational explanation for the sometimes irrational market valuations of dot.com companies. This article summarizes the approaches and methods generally used to value dot.com intangibles. While the methods are generic to all intangibles, the selection of the individual valuation procedures (e.g., ex ante analyses vs. ex post analyses, normalized margin analyses, etc.) are specific to dot.com intangibles. Accordingly, the valuation of dot.com intangibles—for bankruptcy or any other purpose—should be performed by an analyst familiar with current industry trends, empirical data sources and procedures derived from dot.com transactions and industry participants.