The valuation of in-process research and development (IPR&D) remains a complicated issue with regard to technology companies emerging from bankruptcy protection. The valuation of IPR&D is also a complicated issue in the acquisition of technology companies, whether or not the target company is financially distressed.

Since the market correction of the Internet and dot-com company prices in the year 2000, many technology companies filed for bankruptcy protection. While many technology companies ultimately failed in the last few years, many others have reorganized and are now emerging from bankruptcy proceedings. These reorganized companies adopt the fresh-start reporting provisions of the American Institute of Certified Public Accountants (AICPA) Statement of Position 90-7 (SOP 90-7). SOP 90-7 provides for the recognition of IPR&D for the reorganized technology companies.

There are fewer technology company acquisitions (including hardware/software, Internet, and dot-com companies) today than there were in the 1990s. In addition, the acquisition prices for such companies today are lower than they were in the 1990s. Nonetheless, consolidation is still taking place in many technology industries. However, now that consolidation is motivated by economic survival strategies and not by investors' irrational exuberance. Such business combinations are accounted for using the purchase accounting provisions of the Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards 141 (SFAS 141).

Even with current technology-company acquisitions consummated at lower pricing multiples, acquirers often recognize some purchased IPR&D. This is because technology companies typically own little in the way of tangible assets. And even financially distressed technology companies have R&D projects in progress at any point in time.

This article will discuss the current issues regarding IPR&D valuation. We will explain the bankruptcy and merger and acquisition (M&A) circumstances in which IPR&D is recognized. We will describe the generally accepted IPR&D valuation methods. In the late 1990s, the Securities and Exchange Commission (SEC) investigated the purchase price allocation (PPA) of numerous technology company acquisitions. Based on these investigations, the SEC issued relevant professional guidance with regard to IPR&D valuation.

Accounting for R&D Costs Related to Business Combinations

SFAS 2, issued October 1974, remains the current GAAP for financial accounting and reporting of research and development (R&D) costs. The objectives of SFAS 2 are to (1) reduce the number of alternative accounting and reporting practices and (2) provide useful financial information about R&D costs. SFAS 2 provides the following definitions of R&D:

• Research is a planned search or critical investigation aimed at the discovery of new knowledge. Research is performed with the expectation that such knowledge will be useful in (1) developing a new product or service or a new process or technique or (2) bringing about a significant improvement to an existing product or process.
• Development is the translation of research findings or other knowledge into a plan or design for (1) a new product or process or (2) a significant improvement to an existing product or process (whether intended for sale or use).

SFAS 2 contains the following professional guidance with respect to R&D expenditures:

• The costs of purchased intangibles (1) for use in R&D activities and (2) with alternative future uses (in research and development projects or otherwise) are capitalized and amortized as intangible assets in accordance with APB Opinion 17. In 2001, APB Opinion 17 was superceded by SFAS 142.
• The costs of purchased intangibles (1) for a particular research and development project, (2) that have no alternative future uses (in other research and development projects or otherwise) and (3) that have no separate economic values are research and development costs at the time the costs are incurred.
• All research and development costs encompassed by SFAS 2 are charged to expense when incurred.

FASB Interpretation 4 (FIN 4), issued in February 1975, explains the application of SFAS 2 to the cost of tangible and intangible assets used in R&D activities when those assets are acquired in a business combination recorded as a purchase. FIN 4 contains the following professional guidance under the heading "Interpretation:"

• The intent of paragraph 34 of SFAS 2 is that the PPA to the identifiable assets of an acquired enterprise will be made in accordance with APB Opinion 16. In 2001, APB Opinion 16 was superceded by SFAS 141.
• Costs are assigned to all identifiable tangible and intangible assets, including (1) assets resulting from research and development activities of the acquired enterprise or (2) assets used in the R&D activities of the combined enterprise.
• The costs assigned under APB Opinion 16 (now SFAS 141) are determined from the amount paid by the acquiring enterprise and not from the original cost to the acquired enterprise.
• Costs assigned to assets (1) to be used in a particular R&D project and (2) that have no alternative future use should be charged to expense at the date of consummation of the business combination (i.e., the M&A transaction).

SOP 90-7 refers to APB Opinion No. 16 (superceded by SFAS 141 in 2001) regarding the recognition of intangible assets, including IPR&D, for companies adopting post-bankruptcy fresh-start accounting. Accordingly, a brief review of business combination purchase accounting is appropriate. Under SFAS 141, purchase accounting for a business combination is straightforward: The purchase price is allocated to tangible and identifiable intangible assets and to liabilities assumed, based on fair values. Any excess purchase price over the fair value of the net assets acquired is designated as "goodwill." If the total fair value of the acquired net assets exceeds the total purchase price, the "negative goodwill" is offset against the allocated fair value of certain assets, with any residual immediately taken into earnings.

Under SFAS 142, goodwill (which often represents a major component of the purchase price of a technology company acquisition) is recorded and maintained semipermanently as an asset on the balance sheet. SFAS 142 requires efforts to be made to separately identify other intangibles (such as customer lists) that, under prior GAAP, were often included in goodwill. Under SFAS 142, there are specific requirements to test the goodwill for impairment on a regular basis. When impairment is detected, goodwill should be written down, with the expense included in the results of current operations.

IPR&D Accounting in Fresh-start Reporting and Business Combinations

Under GAAP, R&D expenditures are normally expensed as incurred. However, an acquirer will often purchase a company that has previously incurred and expensed substantial sums for R&D. In some technology companies, most of the value relates to the target company's previous R&D efforts. FIN 4 clearly states that the acquirer must expense that portion of the acquisition purchase price. This is because if this amount was recorded as an acquired asset, it would create a "back door" for R&D capitalization—which is prohibited by SFAS 2.

While IPR&D should be immediately expensed, the value of this R&D may continue to play an important financial reporting role. This is because of the SFAS 142 requirement that goodwill should be regularly tested for impairment. Specifically, under SFAS 142, a determination should be made of the implied fair value of goodwill. This amount is compared to the recorded amount of goodwill for purposes of ascertaining whether, and by how much, goodwill has been impaired. The impairment testing process is identical to the PPA procedure used in a business combination purchase accounting. This process involves the allocation of the overall fair value of reporting unit to all assets and liabilities—and to unrecognized intangibles including IPR&D—as if the reporting unit was acquired as of the impairment test date.

Therefore, the value of IPR&D continues to be a financial reporting issue as long as goodwill remains a recognized asset. Only to the extent that there is an excess of (1) fair value over (2) amounts assigned to assets/liabilities will there be an implied fair value of goodwill. If this analysis is not performed in this manner, then the entire (and overstated) residual amount would be allocated to goodwill. And that goodwill amount would not be truly comparable to the recorded amount of the goodwill—thereby impeding the goodwill impairment testing. An illustration of the continuing valuation of IPR&D is presented in the following example.

Ongoing Valuation of Purchased IPR&D—A Simplified Example

Alpha Co. acquired Beta Co. on Dec. 31, 2002, for $3.4 million. The purchase price was properly allocated to assets acquired and liabilities assumed, including an allocation of $240,000 to IPR&D. This IPR&D was properly expensed as of Dec. 31, 2002. A residual value of $500,000 was assigned to goodwill. The Beta operations became a separate reporting unit within the consolidated company.

To test for goodwill impairment in 2003, Alpha management assessed the fair value of the Beta operations—using information about comparable operations and economic characteristics, including market-derived pricing multiples of earnings—at $3.15 million. As of that date, the recorded value of the Beta reporting unit net assets, excluding goodwill, was $2.4 million. The Beta goodwill remained at its original $500,000 recorded value.

Alpha management assigned a fair value of $2.6 million to net identifiable assets excluding goodwill. Alpha management estimated that the IPR&D has a fair value of $210,000. The residual fair value is $340,000 (i.e., $3.15 million less $2.6 million + $210,000). This $340,000 amount is less than the $500,000 recorded amount of goodwill. Therefore, a goodwill impairment of $260,000 (i.e., $500,000 - $340,000) must be recognized by Alpha as a 2003 operating expense.

Had the fair value of the IPR&D (i.e., $210,000) been excluded from the goodwill impairment analysis, then the residual fair value would have been computed as: $3.15 million - $2.6 million = $550,000. Since recorded goodwill was only $500,000, no goodwill impairment would have been indicated in that case. However, that impairment conclusion would be erroneous because it would have ignored a real (albeit unrecognized) intangible asset of the Beta reporting unit (i.e., the IPR&D). And that impairment conclusion would have effectively mischaracterized that IPR&D as goodwill.

Valuation of IPR&D

The income approach is the preferred approach to IPR&D valuation. Within the income approach, the yield capitalization method (also called the discounted cash flow—or DCF—method) is commonly used in the valuation of IPR&D. An important consideration in the DCF method is the availability of reliable revenue and expense projections. Preferably, such revenue and expense projections are available for each individual technology project or product/ service. The valuation analyst will typically request the following information for the IPR&D valuation:

• listing of each R&D project and apparatus
• date(s) of each R&D project initiation
• estimated date(s) of R&D project completion
• effort spent so far on each R&D project
• status of each project along the R&D technology development life cycle
• remaining effort required to complete each R&D project
• understanding of each appropriate technology and its expected evolution
• schedule of the appropriate technology development life cycle
• listing of the anticipated products/ services
• schedule of the appropriate product life cycle
• marketing and pricing strategies
• analysis of market demand
• analysis of expected market share
• analysis of expected rate of market penetration and customer acceptance, and
• analysis of competition/competing technology.

There are several economic input variables in the typical IPR&D valuation DCF model. The quantitative relationships of these economic input variables are described below:

Typical DCF Model: IPR&D Valuation Variables

Step One

current period IPR&D revenue
x technology life cycle factor
= expected next period IPR&D revenue

Step Two

expected IPR&D revenue
- cost of goods/services sold
- selling, general and administrative expenses
- ongoing R&D expense
= profit before tax from IPR&D
x 1 - effective income tax rate for subject IPR&D
= profit after tax from IPR&D

Step Three

profit after tax from IPR&D
+ depreciation and amortization expense
- capital expenditures
- capital charge on assets used in commercialization of IPR&D
= IPR&D economic income

Step Four

IPR&D economic income
x present value discount factor
= present value of IPR&D economic income

Step Five

sum of present value of IPR&D economic income for each year in expected life cycle of the IPR&D
x income tax amortization factor
= indication of value of purchased IPR&D

The following discussion summarizes the valuation variables in the typical DCF IPR&D valuation model.

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[M]any technology company acquirers of the late 1990s have to make annual tests of goodwill impairment under SFAS 142... [T]he valuation of unrecorded IPR&D is an integral procedure in the SFAS 142 goodwill impairment test.

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IPR&D Revenue

In order to prepare an IPR&D revenue projection, the analyst will typically review both revenue projections prepared by the target technology company and revenue projections prepared by the acquirer company. The revenue projections should be adjusted (if necessary) to represent the revenue-generating capacity of the IPR&D as part of an independent business enterprise—that is, without the economic influence of any post-acquisition synergies or economies of scale from the acquiring company. In reviewing IPR&D revenue projections, the analyst should consider both (1) the support for and (2) the reasonableness of such factors as: the size of potential market, the subject's ability and rate of market penetration, and the technology product/service expected.

In some cases, the analyst may only have overall target company business enterprise revenue projections available. In other circumstances, revenue projections by product/service may be available. Whether they relate to product/service line revenue or business enterprise revenue, the analyst should perform a rigorous due-diligence investigation of "hockey stick" revenue projections. These projections indicate supernormal revenue growth rates in the early years of the projection period. If the IPR&D relates to a new technology, or if the company will be first to market with a new product/service, such supernormal revenue growth rates may be appropriate. However, the analyst should thoroughly examine both the quantitative and qualitative support for the "hockey stick" revenue projections.

Technology Development Life Cycle Factor

An analysis of the technology development life cycle affects two DCF model inputs. First, the term of the technology development life cycle will influence the projection period for the IPR&D revenue and expenses. Second, the shape of the technology development life cycle will influence the rate at which the IPR&D revenue (1) increased during the introduction and maturity stages and (2) will decline during the decay stage.

Discussions with company R&D personnel and marketing personnel often provide useful information regarding (1) the subject market and (2) the competing technologies. This information provides a starting point for estimating the subject IPR&D technology development life cycle. The IPR&D technology development life cycle may be developed on either a units vs. time scale or a dollars vs. time scale. After the initial estimation, the IPR&D technology development life cycle is typically translated to a percentage to time scale (or common-sized to the maximum value scale) for ease of analysis.

The IPR&D technology development life cycle may not always be shaped like the classic bell curve. This is particularly true in cases when the IPR&D is the only significant intangible asset of the subject company. Nonetheless, the IPR&D revenue projection should generally follow the classic technology development life cycle configuration of (1) starting low, (2) growing at an increasing rate, (3) leveling off and then (4) declining to zero.

IPR&D Operating Expenses

The analyst can often obtain information to project IPR&D operating expenses from published industry data, public filings of publicly traded guideline companies and security analyst brokerage reports regarding competing technology companies. In addition, the analyst can obtain information regarding the IPR&D operating expense ratio from analyzing the historical financial statements of the subject company. The analyst should be mindful that buyer-specific synergies should not be included in the IPR&D valuation. Also, the analyst should not naively apply the subject company cost structure when projecting IPR&D operating expenses.

All of the development efforts needed to bring the IPR&D projects to the point of feasibility (and commercialization) should be included in the operating-expense projections. Ongoing R&D expenses generally relate to the continuing effort to research and develop new technologies, processes or products/services. The objective of the operating-expense projection is to consider only those expenses related to the IPR&D. Therefore, R&D expenses should not be included in the operating-expense projection beyond the new product/service introductory stage. This is because by then, the R&D efforts related to the IPR&D project will be completed. However, there may be minor ongoing R&D expenses in the operating expense projection. These expenses may relate to adapting the IPR&D to new technology development or future marketplace demands.

Capital Charge/Economic Rent

A capital charge is intended to represent a fair rate of return on—or an economic rent for the use of—the tangible and intangible assets that are used in the process of generating the projected IPR&D revenue. The purpose of the capital charge is to isolate the specific component of economic income related solely to the IPR&D. The capital charge line item in the DCF method analysis is often quantified in the form of an economic rent. This economic rent is a hypothetical expense (as compared to an actual accounting expense) that the IPR&D pays for the use of target company assets that help generate the new product/service income.

The capital charge/economic rent is typically deducted at the net income level of the DCF analysis. The capital charge is deducted in order to estimate the portion of the target company economic income that is contributed by the IPR&D. One procedure for estimating the capital charge is to multiply an appropriate rate of return by the fair market value (as of the acquisition date) of the tangible and intangible assets that contribute to the IPR&D revenue generation. Using this procedure, the product of the rate of return times the asset value is the amount of the capital charge. The capital charge may be converted into an economic rent by dividing the capital charge amount into the projected revenue (or some other projection variable). The capital charge is typically stated in the form of an economic rent simply because it is easier to use an economic rent calculation in the DCF analysis.

Present Value Discount Rate

The discount rate used to compute the present value discount factor is based on the risk associated with (1) the completion and (2) the success of the IPR&D. This risk varies inversely as the IPR&D moves along the technology development life cycle. That is, during the early stages of the technology development life cycle, the IPR&D risk is the highest. And the risk then decreases as the IPR&D successively progresses to the feasibility stage and the commercialization stage.

The discount rate used in the analysis of IPR&D in the early stage of the technology development life cycle would be much higher than the discount rate used in the analysis of similar IPR&D in a later stage of the technology development life cycle. The selected discount rate will typically decline nonlinearly to the point where the IPR&D project reaches completion or proves feasibility. At that stage, the appropriate discount rate would be only a little higher than the discount rate used in the analysis of an established intellectual property.

Income Tax Amortization Effect

Corporate taxpayers typically amortize the cost of a purchased intangible asset over a 15-year period for federal income tax purposes, under Internal Revenue Code §197. The annual amortization expense is typically recognized in the DCF analysis as an additional expense line before the estimation of pre-tax income. The annual amortization expense is then added back as a credit to expense (and as a debit to cash flow) below the income tax expense line. This add-back is made because amortization expense is a non-cash expense item (just like depreciation expense). The final value indication is then calculated in an iterative process in the DCF analysis.

Alternatively, the income tax amortization effect may be included in the DCF analysis through the use of an amortization effect "factor." This amortization effect "factor" is based on (1) the selected discount rate, (2) the effective income tax rate and (3) the appropriate amortization period. A common income tax amortization effect factor formula is presented as follows:

Amortization effect factor =

1
________________________________________________________________
1 - (income tax rate) x (present value annuity factor)
________________________________________________________________
amortization period

where the present value annuity factor is based on (1) the selected discount rate and (2) the appropriate amortization period.

SEC Concerns Regarding IPR&D Valuations

During the 1998-99 period, the Securities and Exchange Commission (SEC) identified several concerns regarding public registrant acquisitions of technology companies. The SEC expressed these concerns in comment letters to individual registrants (i.e., technology company acquirers) and in speeches delivered by SEC representatives. In particular, the SEC noted four concerns regarding IPR&D valuations. First, in IPR&D valuations, the IPR&D projects were not separated from other technology-related intangible assets. Many of the IPR&D valuations did not consider the value of the existing commercialized core technology. Many of the IPR&D valuations did not consider the contributory value added by the existing customer base, trademarks and goodwill to the marketing of the "new and improved" or "next generation" products/services.

Second, the IPR&D valuations did not consider either (1) the stage of development or (2) the amount of completion of the purchased IPR&D projects. According to the SEC, the IPR&D valuation models did not distinguish between the value of a project still in conceptual and/or design stage vs. a project that was approaching the completion and commercialization phase.

Third, the SEC was concerned that many IPR&D valuations estimated an "investment value" rather than the "fair value." According to this concern, the IPR&D value conclusions encompassed buyer-specific synergies, economies of scale and post-merger economic benefits. Since these buyer-specific value increments were not available to the typical hypothetical willing buyer, the SEC concluded that they should not be included in the IPR&D valuations.

Fourth, the proportion of the total acquisition purchase price related to IPR&D (and the amount of the immediate post-acquisition expense) was inconsistent with the announced business reasons for the acquisition. In some cases, the target technology company did not incur or disclose any R&D expenditures prior to the transaction. That lack of disclosure indicated to the SEC that the target technology company had not made any significant R&D effort.

In late 1998 and early 1999, the SEC proposed methodological guidance with regard to IPR&D valuations, including:

• The value of any other intangible assets should not be included in the value of the purchased IPR&D.
• The transaction PPA should be based on "fair value" and not on the "value to a particular buyer."
• The income approach is an acceptable IPR&D valuation approach. However, as part of the IPR&D analysis, the valuation should specifically consider: (1) the company's track record of projecting its product development efforts, (2) the amount and timing of the current future cash flow from the new products/services or releases and (3) the current market conditions and competing technologies.
• The allocation of projected cash flow to purchased IPR&D should recognize the economic contribution of (1) existing products, (2) existing core technologies and (3) other acquired tangible and intangible assets. This recognition may be based on a capital charge, an economic rent, a profit split or a similar allocation procedure.
• The projected cash flow attributable to the development of future versions of the subject product/service should be excluded from the IPR&D valuation.
• Valuation analyses that use the market approach/relief from royalty method based on "industry average" technology license royalty rates are not appropriate.
• The valuation of IPR&D should not be based on a "residual" analysis. This residual method should only be used for the valuation of goodwill.
• The fair value of (1) an existing product/service or (2) an existing technology should not be considered as part of IPR&D. This is true even if the company intends to significantly modify the product/service or the technology.
• The same procedures that the company uses to determine if internally developed products/services are in-process or complete should be used to determine if the purchased technology is in-process or complete. For example, a pharmaceutical company that considers a product to be in the R&D stage until it receives FDA approval should use the same policy in the IPR&D analysis.

Current Status of IPR&D Valuation Guidance

The FASB has decided that the accounting for R&D costs (including IPR&D) should be addressed in a comprehensive manner. The comprehensive R&D project was scheduled for 2002. However, at the time of this writing, the FASB has postponed—and not rescheduled—its consideration of the accounting for R&D. Until the FASB addresses this issue, the immediate expense of purchased IPR&D is required under GAAP.

Based on the professional guidance issued (albeit somewhat piecemeal) by the SEC in and after 1999, there is now greater consistency regarding IPR&D valuation methodologies. These revised valuation methodologies appear to produce IPR&D values that are more consistent with the SEC's implicit reasonableness tests. Of course, current technology company pricing multiples—and purchase price premiums—are greatly reduced compared to the late 1990s. When the currently depressed prices for technology company acquisitions recover, the current IPR&D valuation methodologies may again produce values that do not pass the SEC reasonableness tests.

Summary and Conclusion

The valuation of IPR&D is still an important issue for three reasons. First, many technology companies filed for bankruptcy protection in 2001 and 2002. When those companies emerge from bankruptcy protection, they will adopt fresh-start reporting under SOP 90-7. At that time, their IPR&D will have to be valued. Second, although prices are currently depressed, there are still acquisitions of technology companies. And even financially distressed technology target companies often have IPR&D projects in progress. Accordingly, that purchased IPR&D should be valued under SFAS 141 and expensed under SFAS 2. Third, many technology company acquirers of the late 1990s have to make annual tests of goodwill impairment under SFAS 142. As illustrated above, the valuation of unrecorded IPR&D is an integral procedure in the SFAS 142 goodwill impairment test.