Hard-to-Value Intangibles Sans Mystere in Transfer Pricing
In transfer pricing intangibles are an enigma, regarded as hard-to-value assets. Let’s decipher: If we let Yt represent income (profits, royalties, dividends, interest), Greek gamma γ be the discount rate, and D = 1 + γ be the discount factor, then the present value (PV) of any asset, including intangibles, can be determined by a well-known formula:
(1) K0 = ∑(0, T) Yt D−t
for the time period t = 0, 1, 2, …, T.
In valuation, we need to determine the:
i) asset portfolio generating Yt
ii) expected life of income flow, T
iii) forecasts of Yt from t = 1 (one-period ahead) to T
iv) risk-adjusted discount rate, γ
In the case of royalties Yt derived from licensing “separate and distinct” intangibles, we can forecast (subject to errors) T years ahead using a two-component formula:
(2) Yt = φ St + At
for the future time period t = 1, 2, …, T.
In income equation (2), Greek phi φ is an arm’s length royalty rate found in RoyaltyStat, St is projected net sales (revenue, turnover) of the licensee (or the forecasted incoming royalties of the owner of the intangible) and At is the additional licensing income in the form of upfront fees and milestones.
Let’s not be fascinated with PV because forecasting St and At into a long term future is very uncertain, and this uncertainty can be measured only post-factum. Unless intangibles are long commercialized and have accumulated substantial goodwill, using the perpetual inventory method (PIM) produces more reliable estimates of value. See Carol Corrado, John Haltiwanger & Daniel Sichel (eds.), Measuring Capital in the New Economy (University of Chicago Press, 2005), especially Chapter 7 (Pharmaceutical Knowledge-Capital Accumulation and Longevity).
The additional licensing income (At) can be zero in certain years, unless the contractual terms of the licensing agreement between the licensor and licensee convey a minimum annual royalty independent of the net sales of the licensee. This additional income term must be considered because it may not be negligible.
RoyaltyStat® contains over 17,107 (as of March 29, 2016) unique license agreements each with a disclosed royalty rate, so this interactive online database can be used to find comparable φ and At. RoyaltyStat’s curated data stock (which has been acumulated over the past 18 years) increases by more than 1,200 new unredacted license agreements per year, and is updated every business day. Below you can download our article providing two distinct PV formulae to determine an arm’s-length lump-sum royalty payment for the transfer of intangibles consistent with the arm’s-length standard of the OECD guidelines and the U.S. transfer pricing regulations.