IFRS 13 Relief from royalty method

IFRS 13 Relief from royalty method IFRS 13 Relief from royalty method – The ‘Royalty Relief’ (also known as Relief from Royalty) method is based on the notion that a brand holding company owns the brand and licenses it to an operating company.  One method to determine the market value of Intellectual Property assets like patents, trademarks, and copyrights is to use Relief from royalty method (also known as Royalty avoidance approach or Royalty Relief approach). This approach determines the value of Intellectual Property assets by estimating what it would cost the business if it had to purchase the Intellectual Property (IP) it uses from an outsider. Other valuation methods are provide here.

This approach requires the valuator to

  1. project future sales of the products that use the technology,
  2. determine an appropriate reasonable royalty rate, and
  3. determine either a present value factor or an appropriate discount rate.

The result is the present value of the Intellectual Property to the company.

The notional price paid by the operating company to the brand company is expressed as a royalty rate. The Net Present Value (NPV) of all forecast royalties represents the value of the brand to the business.

Example – Brand valuation

The attraction of this method is that it is based on commercial practice in the real world. It involves estimating likely future sales, applying an appropriate royalty rate to them and then discounting estimated future, post-tax royalties, to arrive at an NPV.

The ‘Royalty Relief’ method is used for 2 reasons:

  1. It is favored by tax authorities and the courts because it calculates brand values by reference to documented, third-party transactions
  2. It can be done based on publicly available financial information.

Steps in the Royalty Relief brand valuation process:

  • Obtain brand-specific financial and revenue data,
  • Model the market to identify market demand and the position of individual brands in the context of market competitors,
  • Establish the notional royalty rate for each brand,
  • Calculate the notional future royalty income stream for each brand,
  • Calculate discount rate specific to each brand, taking account of its size, international presence, reputation, and Brand Rating,
  • Discount future royalty stream to a net present value (NPV), which represent the fair value of the tradename/brand.

Calculation: IFRS 13 Relief from royalty method

WARA = Weighted Average Return on Assets

Example-Patents

The valuation of a patent is similar to other intangibles, in that computations principally focus on earnings ability. There are many issues that affect patent valuation:

  1. A new patent on a new product or process has no history of earnings.
  2. A patent may have a history of earnings although the history may or may not be indicative of the future.
  3. In valuing patents, the analyst may have the following questions:
    1. Are there comparable patents?
    2. What are the royalty rates paid for comparable patents?
    3. What is the nature and scope of the license?
    4. What is the current popularity of the patented property?
    5. What are the advantages of the patented property over the old models or devices?
    6. What is the demand for the patented property?
    7. Are there acceptable non-infringing substitutes?
    8. Do manufacturing and marketing capabilities exist to exploit total demand?
    9. Should projected income be attributed to other intangible or tangible assets?
    10. What is the remaining economic life?
    11. What is the company’s financial ability to defend the patent?
  4. Method of Valuation A common method of patent valuation is to estimate the earnings a patent could realize from future royalties if the owner granted an exclusive unlimited license during the use of the patent for its remaining useful life (assume 15 years in the following example):

Calculation: IFRS 13 Relief from royalty method

Projected annual sales

€1,000,000

Royalty rate Royalty Avoidance Approach

X 5%

Projected annual royalties Royalty Avoidance Approach

€50,000

Present value factor (€1.00 annual annuity for 15 years discounted at 12% per annum = )

6.8109

Value of patent Royalty Avoidance Approach

€340,545

Because trademarks are associated with particular products and businesses, sales of trademarks are less common than licenses for their use. As such, there exists a fair amount of publicly available information on trademark licensing, often derived from financial reports filed with the SEC. This information allows a specialist to develop units of comparison for trademarks, most notably a royalty rate.

IFRS 13 Relief from royalty method makes use of the royalty rates involved in comparable uncontrolled transactions (CUT)—essentially, comparable arm’s-length trademark license transactions between willing buyers and willing sellers—to derive the value of the subject trademark.

The theory behind IFRS 13 Relief from royalty method is one of cost avoidance—that is, the value of the trademark is reflected in the trademark license royalty payments the trademark owner avoided having to pay by owning the trademark.

In this method, the analyst assumes the actual owner does not own the trademark and, therefore, must pay a hypothetical third party for a license to use it. The hypothetical trademark royalty payment is calculated as a market-derived running royalty rate multiplied by the actual owner’s projected revenue over the remaining useful life of the trademark. IFRS 13 Relief from royalty method

Because IFRS 13 Relief from royalty method depends on applying the royalty rate to the projected revenue, it overlaps with the income approach, and some analysts will characterize this method as an income approach method. IFRS 13 Relief from royalty method

The selected trademark royalty rate is determined from an analysis of the CUT trademark license royalty rates. No “true comparable” exists because trademarks are, by their nature, unique.

So, in practice, the analyst typically identifies CUT licenses based on a degree of similarity.

The degree of similarity may include an assessment of the following: IFRS 13 Relief from royalty method

  1. Product similarity (the trademark in controlled and uncontrolled transactions should be used in association with similar products or processes within the same general industry or market)
  2. Profit potential (taking into consideration growth expectations)
  3. Form of the royalty payment (e.g., lump-sum amount or running royalty)
  4. Duration of the trademark license IFRS 13 Relief from royalty method
  5. Restrictions (e.g., exclusivity, geographical area or territorial limitations, and market limitations)
  6. Stage of development
  7. Collateral transactions or ongoing business relationships between the transferor and transferee (e.g., joint venture arrangements, cross-licensing arrangements, or the exchange of other intangible property or services as part of the transaction)

Generally, comparable trademark license transactions are those involving a similar product or business to that of the subject trademark with similar license terms, particularly with regard to the structure of the royalty (e.g., a lump-sum amount versus annual royalty payments) and restrictions of use (e.g., exclusivity).

Even after identifying reasonably comparable trademark licenses, some dissimilarity can remain. So the selected royalty rate may be adjusted to fit the particular facts and circumstances surrounding the subject trademark. Some factors that analysts often consider in the adjustment of the royalty rate are:

Factors Considered in the Adjustment of the Royalty Rate

Factor

Consideration

Age, absolute

Long established or newly created trademark

Age, relative

Older or newer than competing trademarks

Use, consistency

Used consistently on related products or inconsistently on unrelated products

Use, specificity

Used on a broad range of products and services vs. narrow range

Use, geography

Has wide appeal (e.g., can be used internationally) vs. narrow or local appeal

Potential for expansion

Unrestricted vs. restricted ability for use on new and different products

Potential for exploitation

Unrestricted vs. restricted ability for licensing in new industries and uses

Associations

Trademark associated with positive vs. negative person, event, or location

Connotations

Name has positive vs. negative connotations and reputation among consumers

Timeliness

Trademark is perceived as modern vs. old-fashioned

Quality

Trademark is perceived as respectable vs. less respectable

Profitability, absolute

Profit margins on associated products is higher vs. lower than industry average

Profitability, relative

Profit margins on associated products is higher vs. lower than competitor(s)

Expense of promoting

Low vs. high cost of advertising and marketing of trademark

Means of promoting

Numerous vs. few means to promote the trademark

Market share, absolute

Associated product has high vs. low market share

Market share, relative

Associated product has higher vs. lower market share than competitor(s)

Market potential, absolute

Products are in an expanding vs. contracting market

Market potential, relative

Market for products expanding faster vs. slower than competitor(s)

Name recognition

Trademark has high vs. low recognition among consumers

IFRS 13 Relief from royalty method

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