intavnaluatiogn of ibles - markables · the profit-split method remains an essential tool for...

4 VALUATION STRATEGIES July/August 20154 VALUATION STRATEGIES

The profit-split method remains an essential tool for valuing intangibleassets when it is refined with case-specific facts and data, including

data that is available from purchase accounting. and Intangibles

Valuation of

VALUATION STRATEGIES 5July/August 2015 VALUATION STRATEGIES 5

CHR ISTOF B INDER AND ANKE NESTLER TrademarksDo Not Miss Out On the Advantages ofthe Profit-Split Method DespiteUniloc

Based on this asset-specific profit, itsvalue can be calculated. Despite theadverse Uniloc decision of the U.S.Court of Appeals for the Federal Cir-cuit in 2011,1 profit split is an impor-tant if not essential element in thevaluation of intangibles. In the wakeof Uniloc, the method needs not only avindication, but also a refinementbased on case-specific facts and data.Purchase accounting data reported infinancial statements can provide both.

Profit-Split In a NutshellThe profit-split method is one of theoldest and most frequently appliedmethods for the valuation of intangi-ble assets . Basica l ly, profit-spl itattempts to allocate the total profit ofa business to the different assets thatcontribute to it, including the subjectintangible. The key element of the prof-it-split method is the derivation of anappropriate or reasonable profit-splitpercentage based on which a part ofthe total profit is apportioned to thesubject intangible.

Overall profit-split Method. Text-books on IP valuation suggest threedifferent variants of the method toarrive at a profit-split percentage.2

According to the overall profit-splitmethod or contribution profit-splitmethod, the combined profits earnedby two parties from a transaction (e.g.,a licensing transaction) are divided

between the two based on some allo-cation principle.

Analysis of Comparable Businesses.

Under the comparable profit-splitmethod (CPSM), the profitability ofcomparable businesses with compara-ble IPs is analyzed and applied to thesubject business. Comparable profitsdescribe the typical profitability ofcomparable businesses, including thefull cost or expenses for the IP. Thesubject business calculates its prof-itability before charges for the subjectIP, and then adds an IP charge to arriveat a comparable profitability.

Residual Profit. The residual profit-split (RSPM) is a stepwise approachto profit allocation of different cate-gories of assets. It starts with routinecontributions to assets that are easy tovalue, i.e. tangibles or intangibles witha typical return rate. Thereafter, theresidual profit is al located to theremaining “special” IP assets of thesubject business.

Complications. These three methodsmay sound simple, but in practice theyare much more complicated. First,availability of data is limited. It is hardto find financial reporting data forcomparable businesses with compara-ble IP, let alone accounting data abouttheir IP. Further, there are no typicalreturn rates for different classes ofassets, at most for typical ranges ofsuch return rates. Another restrictionof the method is that it is a typical

chicken-and-egg phenomenon. Theconcept of dividing profits amongassets is both the crux of the problemand its solution. If the value of the dif-ferent assets and IPs was known, aprofit allocation would not be need-ed. And if the profit-split to differentassets was known, it would be easy tocalculate their values. But it is an equa-tion with two unknown variables. So,valuing IP by comparables or by resid-uals—as the profit-split method sug-gests—is easier said than done.

Having said that, how can it beexplained that the profit-split methodis one of the most frequently appliedmethods to value IP? Well, this isbecause valuation practice found twoways out of this dilemma. One is sim-plification, the other sophistication.

Simplification. The problem of non-availability of data was circumventedby simplification, or the so-called rulesof thumb. As case-specific profit-splitdata was not available, valuation prac-tice came up with some universal per-centage figures presumed to be typicalor average profit-split ratios for intan-

6 VALUATION STRATEGIES July/August 2015 PROFIT-SPL IT METHOD

CHRISTOF BINDER, PhD, MBA, is an expert in trademark transactions, licensing, and valuation. He is CEO ofTrademark Comparables AG in Switzerland, and MARKABLES, an online database providing comparable data fromover 6,500 published purchase valuations of business combinations with a particular focus on trademarks. ANKENESTLER PhD, MBA, CVA, CLP, is owner of Valnes GmbH, an independent valuation boutique based in Frank-furt, Germany, specializing in the valuation of companies and intangible assets. Prior to establishing Valnes, she waswith PricewaterhouseCoopers and Oppenhoff Radler Corporate Finance. Her expertise includes M&A, asset con-tributions, squeeze-outs, tax disputes, arbitration, and succession and legacy issues.

A profit-split analysis for a trade-mark or other intangible assetattempts to quantify what shareof the profit of a business isattributable to the subject asset.

gibles. In its early version, the rule ofthumb said that 25% of the profit of abusiness is attributable to its IP. Dur-ing the course of time, the rule wasextended to different ranges extendingfrom 10% to 35%. Further, the profit-split method was often downgradedto a secondary method used to cor-roborate or “sanity check” the resultsof other primary valuation methods.The good thing with this simplificationwas that—once the percentage rangewas commonly accepted—its resultswere easy to comprehend for unin-

volved recipients like auditors, judges,or bankers.

More Sophisticated. On the otherhand, the profit-split method becamemuch more sophisticated through finan-cial modeling. Financial modeling is atool to solve a valuation problem withdifferent unknown variables and differ-ent assets to be valued within one and thesame model. Typically, such models havesome fixed limitations, for example enter-prise value, total profit, and WACC. Themodel simulates—within such limits—the unknown variables such that the out-come is most plausible. As amathematical method, financial model-ing is some sort of dynamic program-ming, where different parts of a problem(subproblems) are solved independent-ly and then combined to reach an over-all solution. Computer software greatlyfostered the diffusion of financial mod-eling in valuation. However, its com-plexity results in reduced transparency;uninvolved recipients have problems tofully comprehend the results of such val-uations. Therefore, financial modelingis the preferred method for internal use.

Profit-Split—From its Origins to UnilocThe profit-split method was pioneered50 years ago by Robert Goldscheider,one of the early masterminds in tech-nology transfer.3 At the time, Gold-scheider worked as special counsel intechnology transfer and licensing issuesfor Philco Corporation, a consumerelectronics company based in Philadel-phia. Outside North America, Philcosold its products in 18 countr iesthrough licensing arrangements withlocal companies. The license agree-ments included various product tech-nologies and patents, trade secrets andknow-how, and a set of marketingintangibles including trademarks, pho-tos, drawings, and other copyrightedmaterials. Further, Philco supplied keycomponents under favorable terms toits licensees. For this bundle of IP andsupply rights, each licensee paid a roy-alty rate of 5%. All licensees operatedsuccessfully in their local markets.

After guiding the business andworking with the licensees for twoyears, Mr. Goldscheider observed that

VALUATION STRATEGIES 7PROFIT-SPL IT METHOD July/August 2015

1 Uniloc USA, Inc. v. Microsoft Corp., 632 F.3d1292 (CA-F.C., 2011).

2 Smith and Parr, Valuation of Intellectual Propertyand Intangible Assets, 3rd ed. (John Wiley &Sons, 2000) pages 401-403; Llinares and Mert-Beydilli, “How to Determine Trade MarksRoyalties,” 32 International Tax Review 12(December 2006) pages 29-30; Zyla, Fair ValueMeasurement: Practical Guidance andImplementation, 2nd ed. (John Wiley & Sons,2012), pages 288-293; Reilly and Schweihs,Guide to Intangible Asset Valuation (AICPA, 2013)pages 311-312.

3 For a detailed description see Goldscheider, “TheClassic 25% Rule and The Art of IntellectualProperty Licensing,” 46 Les Nouvelles 148(September 2011), pages 151-153.

the pre-tax prof itabi l i t y of eachlicensee was approximately 20%. Mr.Goldscheider concluded that “5 per-cent was a healthy royalty rate, and Iwas interested to note that it usuallyconstituted about 25 percent of theprofitability ultimately achieved by thevarious licensees.” This finding wasthe starting point for Goldscheider toinvestigate the influence of actual orpotential profitability of licensingtransactions on the setting of royaltyrates. He observed similar patternsfrom later technology transfer andlicensing arrangements. A revenuetreatment ratio of 3:1 between thelicensee’s and the licensor’s interestsproved to be workable in a number ofdifferent transactions in unrelatedindustries.

These early empirical observationsled toward the formulation of a prag-matic 25:75 baseline working method-ology which generated businesslikeresults in the negotiation of licenseagreements, and were the starting pointof the profit-split method. The 25%(or any other percentage resulting froma particular royalty rate) is the part ofthe profit of a business which relates tothe IP used by it.

Refinement. Later, the method wasrefined by the “next best alternative”available to the licensee. Starting fromthe basel ine 25% rat io, a ser iouslicensee would also consider the cost ofthe next best available alternative (e.g.,development of the IP in-house, licens-ing other comparable IP, etc.) and com-pare it to the cost (royalty rate) at the25% baseline profit-split ratio, even-tually resulting in a lower or higherprofit-split. Over time, the empirical25% ratio of the early days was extend-ed to a range from 10% to 35%, basedon either net or gross profits, howev-er with its center point always remain-ing at 25%.

In the course of time, the methodwas frequently applied by valuationprofessionals in various situations forits simplicity, for example: • For the negotiation of royalty rates

in IP licensing.

• By many courts to corroborate thedetermination of reasonable roy-alty rates to compensate for IPinfringements.

• In transfer pricing to check theremaining profitability of a busi-ness after applying arm’s-lengthroyalty rates for the licensed IP.

• In financial valuations of IP tocross-check the feasibility of mar-ket comparables with businessprofitability.

• In accounting and auditing forquick checks of IP on the balancesheet. Uniloc. In 2011, the U.S. Court of

Appeals for the Federal Circuit broughtan abrupt termination to the applica-tion of the 25% profit-split rule ofthumb. In its rul ing in a patentinfringement dispute between Unilocand Microsoft, it held that:

the 25 percent rule of thumb is afundamentally flawed tool fordetermining a baseline royalty ratein a hypothetical negotiation. Evi-dence relying on the 25 percentrule of thumb is thus inadmissibleunder Daubert and the FederalRules of Evidence, because it failsto tie a reasonable royalty base tothe facts of the case at issue.4

The Cour t of Appeals fur therexplained that this rejection is notmeant to be a limit to general valuationprinciples, but only to the applicationof flat-rate schemes.

This court’s rejection of the 25 per-cent rule of thumb is not intendedto limit the application of any ofthe Georgia-Pacific factors. In par-ticular, factors 1 and 2—lookingat royalties paid or received inlicenses for the patent in suit or incomparable licenses—and factor12—looking at the portion of prof-it that may be customarily allowedin the particular business for theuse of the invention or similarinventions—remain valid andimportant factors in the determi-nation of a reasonable royalty rate.However, evidence purporting toapply to these, and any other fac-tors, must be tied to the relevantfacts and circumstances of the par-

ticular case at issue and the hypo-thetical negotiations that wouldhave taken place in light of thosefacts and circumstances at the rel-evant time.

The rejection of the 25% rule ofthumb underscores the importance ofusing facts of a particular case in cal-culating the reasonable value of IP.Having been widely accepted prior tothis court decision, the 25% rule’srejection is felt across the valuationprofession in all different applicationsof the profit-split method. Valuatorsare now expected to provide compa-rable profit-split data for their subjectcase, which almost always does notexist, and the lack of which was one ofthe reasons to apply the simple butcomprehensive “rule of thumb” per-centage ranges.

The Limitations of the Classic Profit-Split MethodIrrespective of the specific reasons thatled to the rejection of the 25% rule inthe Uniloc case, there are—and alwayshave been—a number of conceptuallimitations to the classic profit-splitmethod: 1. Bundle of rights. The license agree-

ments in the original Philco exam-ple comprised a bundle of differentIP r ights , including patents ,knowhow, trademarks, copyrights,and sourcing rights, at a royalty rateof 5% and a profitability of 20%.Each IP individually would havehad a lower royalty rate, and a low-er profit-split ratio. Thus, the actu-al profit-split ratio depends on thescope of the licensed rights.

2. No market price. According to thepr inciples of the profit-spl itmethod, the licensed IP does nothave a typical market price. Its price(royalty rate) is determined by thecost and revenue structure of thelicensee and the resulting prof-itability, but not by the price thatother licensees might have paid forsimilar IP, or that the licensor hadachieved for similar IP in previous


licensing negotiations. In realityhowever, the price for IP is some-times what the licensor asks for—irrespective of the profitability ofthe licensee.

3. No actual profits. The negotiation ofroyalty rates—and the resultingsharing of profits—is based on prof-it expectations of the licensee, butnot on actual profits which mightdiffer from expectations. Often, alicense agreement relates to the sub-sequent launch of a new product orbusiness. Depending on the sourceand the definition of failure, the floprate of new product launches isbetween 40% and 80%. Obviously,actual profitability often does notmatch original expectations. Ex-post, it is likely that numerousunsuccessful licenses were overpaidwith excessively high royalty rates.

4. No stable profits. Typically, thelaunch of a new (licensed) businessrequires some initial investment andexpenses in the early stage. Averageprofitability varies from the start of

a licensed business until the end ofits contract term. Thus, the licenseehas to consider average expectedprofitability over the term of theagreement when negotiating theroyalty rate.

5. Profit and benefit base. There hasalways been some degree of dis-agreement on the profit base for theprofit-split method. The suggestedprofit base ranges from fully loadedprofit (net profit) over gross profitto marginal or incremental profit.The benefits of a license may beattributed to the products sold thatincorporate the IP, or to componentsor manufacturing processes only.

6. International expansion. The ori-gins of the profit-split method—asdescribed by Robert Goldschei-der—go back to internat ionallicensing in an age of import restric-tions, tariffs, and entry barriers. Fora company to expand internation-ally there was often no alternative tolicensing. The licensed property wasgranted on an exclusive basis in thelicensed territory. Today, licensing isoften an approach within the same

territory, for example via non-exclu-sive patents or brand extensions. Itis not clear how this shift affectsprofitability and profit-split.

7. Value of IP increasing. As is wide-ly known, intangibles make up foran increasing share of enterprisevalue. Today, intangibles accountfor an average of 80% of enterprisevalue while 50 years ago this per-centage was in the area of 25%. Inparallel with the structure of assetsand value drivers, the sources ofprofit changed over time. Profitsgenerated by intangibles increasedat the same rate. Today, 80% ofprofits5 come from intangibles. Atthe origin of the profit-split con-cept, the 25% of profits generatedby IP were allocated to IP. Today,the 25% profit-split rule allows onlya fraction of IP-related profits tobe allocated to IP. Maybe these—and other—incon-

sistencies have been the reason for theextension of the classic profit-split con-cept from the initial 25% ratio to alarger range from 10% to 35%. But themajor source of criticism of the prof-


4 Uniloc, note 1, supra, page1055.

The method needs notonly a vindication, but

also a refinement.

it-split method has always been itsmiss ing empir ica l ev idence. Themethod has never been proven andconfirmed—except by Robert Gold-scheider’s description of the Philcocase and the fact that it was widelyused and accepted.

Empirical HistoryThere have been a few attempts to pro-vide empirical evidence for the gener-al validity of the classic profit-splitrule. The first attempt was made byRobert Goldscheider himself in 2002 torebut the often stated criticism.6 Gold-scheider and his co-authors tried tocompare royalty rates from thousandsof actual licensing transactions withexpected long-run profit margins ofthe products that embody the subjectIP. However they admit right away thatthey were unable to undertake a directcomparison of product profit and roy-alty rates because they had no access tosuch data.

In a first step, Goldscheider et al.selected 1,533 license agreements withrunning royalty rates on sales, groupedthem into 15 industries, and identifiedmedian royalty rates per industry. In asecond step, they ident if ied 347licensees from the 1,533 agreementsthat report and disclose their financialstatements. Taking the total operatingincome of these companies, the authorscompute an average operating profit

margin for the 15 industries over aperiod of 10 years. Then, they com-pare the 15 median industry royaltyrates with the 15 average profit marginsand find an average ratio of 27%.7 Theyconclude that the empirical analysisprovides “some support” for the use ofthe 25% profit-split rule, but they alsoadmit “that there is quite a variation inresults for specific industries,” rangingfrom an 8.5% split for the semicon-ductor industry to an 80% split in theautomotive industry (see Exhibit 1).8Likely, these variations would be evenlarger at the level of the 347 individualcompanies. The empirical test showsthat on average the 25% split ratio is agood overall approximation, but thestat ist ical variance is too high toexplain the split ratios at an industrylet alone company or licensed businesslevel.

Second Study. A second attempt toanalyze the relation between prof-itability and royalty rates was pub-lished by Kemmerer and Lu in 2008.9They used average industry royaltyrates for 14 industries compiled from3,015 license agreements, and prof-itability from a fully separate sample of3,887 companies mapped into the same14 industries. As profitability measuresthey test operating profit, EBIT, andgross profit. Interestingly, the averageroyalty rate in their sample is 7.0%,which is substantially higher than themedian rate of only 4.3% observed by

Goldscheider et al. On average theyfind that royalty rates account for 15%of gross, 41% of EBITDA, and 53% ofEBIT margins. They confirm earlierfindings that these overall ratios varyat industry level. Finally, they providesome limited support for the validity ofthe 25% rule based on operating prof-its assuming a (hypothetical) forcedlinear fitting between royalty rates andoperating margins.

In a specification of his first study,Lu conducted a pro forma analysisbased on corrected “pre-royalty” prof-itability data.10 In other words, headded the royalty rate on top of theprofit margin, thereby assuming thatthe licensee considers the profitabil-ity of the licensed business before pay-ing royalt ies for the IP and thenapplies the profit-split on this (high-er) margin. Lu now finds an average13% profit-split based on gross prof-it, 26% on EBITDA and 32% on EBIT.Based on these results, Lu concludes“The 25% rule still rules” and sug-gests starting royalty negotiations with25% of EBITDA margin or 33% ofEBIT margin. What he does not say


EXHIBIT 1Profit-Split by Industry

Source: Goldscheider, Jarosz, Mulhern 2002

automotive

chemicals

computers

consumer goods

electronics energy food

internet

machine, tools

pharma, biotech semiconductors

software

telecom

0%

5%

10%

15%

20%

25%

30%

35%

2% 3% 4% 5% 6% 7% 8%

avg

oper

atin

g p

rofit

mar

gin

mean royalty rate

IP Profit Split by Industries - Goldscheider Study 2002

50% split line

25% split line

15% split line

healthcare

however is that on this pre-royaltyassumption Goldscheider’s classic rulewould transform from 25% down to20%.11 Moreover, he does not addressthe large bandwidth of the individualor industry value around the overallaverage.

Evidence Not Provided. None of theempirical tests could provide evidencefor the validity of the 25% rule.12 Thedifficulty with these studies is that itwas not possible to analyze the royal-ty rate and the profitabi l it y of alicensed business from the same setof data. Typically, researchers ana-

lyzed a set of royalty rates, and a sep-arate set of profit rates of other busi-nesses in the same industry. There issome evidence that the overall averageprofit-split might well be in the areaof 25%, depending on the profit baseused. However, the variance from thataverage can be very large at the levelof individual cases, thus the averagebeing eventually meaningless in a spe-cific case. The rule might still be usedas some sort of a rule if the frequen-cy distribution of the individual val-ues around the mean va lue wasknown. This not being the case, therule is not a rule but an average val-ue with little relevance for a subjectcase. Insofar, the Court of Appealswas correct to require the considera-tion of relevant facts and circum-stances of the case at issue.

Does Profit Explain IP Value At All?Very broadly speaking, valuation isstrongly oriented towards marketprices or other concepts that comeclose to it. If market prices do not exist

for an asset—which is typical for anyIP asset—the next best principles arefair value or arm’s-length. Both prin-ciples try to reconstruct a hypotheti-cal but realistic transaction betweenunrelated parties.

Now, how does profit-split fit intothese principles? According to profit-split, the price of an IP asset dependson the profitability of the businessthat uses this IP. If the profitability ofthe business is low, a hypotheticalindependent buyer would pay a lowprice for it, and vice versa. However inreality, the value of the IP for the buy-er might depend less on the prof-itability of the sel ler than on thebenefit of the IP for the buyer. Thisraises the question if the value of IPdepends on business profitability, andif this is a discrepancy between prof-it-split and other valuation methodswhich are based on market transac-tions? Interestingly, the valuation pro-fession never discussed the questionif there is a s ignif icant causal it ybetween business profitability and IPvalue. A clear yes to this question ishowever a prerequisite for the futureappl icat ion of the prof i t -spl i tmethod—at whatever percentageratio. To have a closer look at thisquestion, we have to change perspec-tive. The question to ask is not if prof-itability explains the value of IP, butrather, if IP contributes to profitabil-ity, and if, so how much?

Tangible Assets. If we looked for amoment at tangible assets only—PP&E, inventory, receivables—they arenot profitable as such. The businessmust generate enough profit to pay fortheir depreciation. If the business want-ed to sell them, it would typically earntheir book value, without making aprofit or a loss. If it is able to makeprofit on tangible assets, it is eitherbecause of speculation or these assetsare currently in short supply. Thus, alltangibles sitting on the balance sheetgenerate the profit they have to: theirdepreciat ion and/or their cost offinance. Let us call this the base prof-it on book value.


5 Or more, depending on the required return rateson tangibles and intangibles.

6 Goldscheider, Jarosz, and Mulhern, “Use Of The25 Per Cent Rule in Valuing IP,” 37 Les Nouvelles123 (December 2002).

7 Using data from successful licensees only. 8 This range does not include the media and enter-

tainment and the internet industry. Here, long-term industry profitability is far below medianroyalty rates, resulting in flawed ratios.

9 Kemmerer and Lu, “Profitability and RoyaltyRates Across Industries: Some PreliminaryEvidence,” 8 J. of the Academy of Business andEconomics (March 2008).

10 Lu, “The 25% Rule Still Rules—New Evidencefrom Pro Forma Analysis in Royalty Rates,” 46Les Nouvelles (March 2011).

Valuators are expected toprovide comparable data whichalmost always does not exist.

Unaccounted Intangibles. Any addi-tional profit on top of such base prof-it would be for assets that are not yeton the balance sheet—(unaccounted)intangibles. The value of these intan-gible assets would be the higher themore profitable the business. This is avery simple logic. The only difficulty isthat we can’t see the value of theseintangibles in the books. They are notaccounted for—unless the business isacquired.

A next question is—what wouldhappen if the profitability and thevalue of the business increased? Fromwhich “improved” assets would theincreased profitability come from? Tounderstand these connections better,we have a closer look at the consec-utive purchase accounting of twocompanies that were acquired twotimes within a few years, and analyzehow different assets developed (seeExhibit 2).13

Both cases are quite different intheir valuation multiples. EPAX has ahigh valuation in a high-margin andgrowth business; Cellu is a commod-ity business with low margins andlarge machinery. In both cases, thefirst acquirer created significant val-ue before he resold the company. Vis-ibly, both invested mass ively intangible assets, thereby restructuringthe business and increasing capacity,revenues and margins. But enterprisevalue grew by much more than onlyby these v is ible and accountableinvestments in tangibles. Intangible

assets increased as well. Higher qual-ity, more efficient processes, andincreased expenses for R&D and mar-keting might all have contributed tothe increase in intangibles. Whateverit was, the two examples show thathigher profitability typically resultsin higher valued intangibles.

Data Availability. Data availability islimited for such time-series analysis.Only a few such cases are known andreported in sufficient details. Howev-er, single values can be analyzed inlarge data samples from purchaseaccounting databases, like MARK-ABLES.14 Linear regression analysisillustrates how the asset structure ofbusinesses changes with increasingprofitability. The share of tangiblesassets within enterprise value decreas-es with increasing profitability, whilethe share of goodwill increases. Iden-tifiable and separable intangible assetsbehave steadily, as illustrated in Exhib-it 3.15

The flat line for intangibles showsthat the value of intangibles behavesproportionately with profitability. Inother words—if profitability doubles,

the value of intangibles will—on aver-age—also double. Of course—this rela-tion might be different for a particularbusiness. But as an overall relation-ship, there is causality between prof-itability and the value of intangibles.This may sound simple and clear-cut,but it is an important if not vital find-ing for the future of the profit-splitmethod. If this causality did not exist,profit-split would be doomed to die,not only as a 25% flat rule, but alto-gether.

Applying Profit-Split Based onPurchase Accounting DataAs stated earlier, one major problemof the classic profit-split method isdata availability. Except for the fewPhilco licensees cited by Robert Gold-scheider, profit-split could never betested from a concise set of data. Itwas simply not possible to observethe value of the IP (its royalty rate)and the profit for the same IP, becauseeither one of the two was unknown.A license agreement shows a royaltyrate, but not the profitability of the


11 25/100 versus 25/(100+25). 12 A detailed discussion of the empirical tests was

published by Kidder and O’Brien, “Simply Wrong:The 25% Rule Examined,” 46 Les Nouvelles 263(December 2011).

13 Norwegian EPAX AS, a supplier of Omega-3 fishoils, was acquired in 2007 by Austevoll SeafoodASA, and then in 2013 by FMC Corporation. CelluTissu is a manufacturer of specialty tissue paperfor use in personal hygiene products. Cellu Tissuwas acquired in 2006 by Weston Presidio (aninvestment firm), and in 2010 by ClearwaterPaper.

14 MARKABLES is a database containing data fromover 6,500 PPAs, with a particular focus on trade-mark and brand assets. www.markables.net

15 The three lines add up to more than 100% dueto non-interest-bearing liabilities. Such liabilitiesdecrease with increasing profitability.

Meaningful profit-splitdata is available frompurchase accounting.

licensed business, even not its expect-ed profitability. Even more, a licenseewould be il l-advised to reveal hisprofit expectations to the licensorduring license negotiations. And yearslater, the profit and loss statement ofa licensed business no longer tellswhat royalty rate the licensee wouldhave accepted, had he known its lat-er profitability.

Data from Purchase Accounting.

However, meaningful profit-split datais available in substantial numbersand detail from purchase account-ing. Possibly, our view was cloudeddue to the approach of splitting prof-it between two separate parties webecame so much used to. Purchaseaccounting, which is also frequentlyreferred to as acquisition account-ing, is the process of classifying, valu-ing, and accounting for all of theassets and liabilities that are includ-ed in the acquisition of a business.This process is rather standard forthe tangibles assets and the liabili-ties that are already in the books ofthe acquired business. The differencebetween the book va lue of the

acquired assets and liabilities and thepurchase consideration is then allo-cated to the various intangible assets,and to goodwill.

Technically, the purchase consider-ation paid for the acquired business(or the enterprise value including debt)is the present value of all returns it isexpected to generate in the future. Thevaluation of the intangible assets is anallocation of these expected futurereturns to particular assets. And thepresent value of any intangible assetat the date of the acquisition relates toits share of total future returns that are

expected from that business. This readslike the nearly perfect profit-split forintangibles, and in fact it comes closeto it . The results f rom purchaseaccounting— purchase price alloca-tions on business combinations—arereported manifold in the financialstatements of public companies. Exhib-it 4 illustrates how to compute profit-split data from the results of a purchaseprice allocation. In this particular busi-ness, 38% of future profits are expect-ed to come from (existing) customerrelations, 17% from product technol-ogy and 4% from trade names.


EXHIBIT 2Asset Development over Time

Source: MARKABLES.net

Development of Assets Over Time – Purchase Accounting

EPAX AS Cellu Tissu Holdings, Inc.

US$ million 2007 2013 2006 2010

revenues 40 75 1.9x 329 511 1.6x

enterprise value 98 340 3.5x 208 534 2.0x

sales multiple 2.5x 4.5x 1.9x 0.6x 1.0x 1.7x

tangible assets 40 212 5.2x 143 406 2.8x

intangible assets 91 215 2.4x 70 286 4.1x

debt 42 0 - 163 287 1.8x

EXHIBIT 3Value of Identifiable Intangible Assets

4,550 share deals between 2004 and 2014 Source: markables.net

profitability enterprise value / revenues

0%

20%

40%

60%

80%

100%

0x 1x 2x 3x 4x 5x 6x 7x 8x 9x 10x

per

cent

of e

nter

pris

e va

lue

tangibles intangibles goodwill

y = -0,0532x + 0,972

y = 0,0133x + 0,4608

y = -0,0025x + 0,3816

Profitability and Asset Value

Linear Regressions

These data applied to the more clas-sic profit-split methods mean that LifeTechnologies would be willing to pay21.6% of his profits as a royalty tolicense-in product technology, trade-marks and in-process research.16

Moreover, Life Technologies wouldlikely not pay a royalty for customerrelations because these are typicallyowned and cannot be licensed-in.

The use of such data is compellinglyconvincing. Still, the following limita-tions should be noted: 1. Useful life. Intangibles assets have

different useful lives. For an intan-gible asset with a short useful life, itsprofits are expected to be generat-ed faster, and vice versa for an intan-g ible asset w ith ver y long orindefinite life. A 10% profit-split

with a useful life of ten years meansa higher profit margin (for the nextten years) than a 10% profit-splitover 20 years.

2. Fair value. The value of an intangi-ble asset as stated in the purchaseprice allocation (PPA) is its fair val-ue, not its market value or marketprice.17 It is thus the result of a fairvalue calculation. Still, it comesclose to the w il l ingness of theacquirer to pay for this particularasset, based on a real transaction ofownership of the subject business intotal. Based on this real transaction,the fair values for particular intan-gibles can serve as a meaningfulapproximation for “market” pricespaid for such intangibles.

3. Different use. The data representsthe view of the acquirer, not the pre-vious owner. If the acquirer intendsto restructure the business, or if hehas only little use for a particular


EXHIBIT 5Profit-Split Analysis

0

50

100

150

200

250

300

350

2.5%

7.5%

12.5

%

17.5

%

22.5

%

27.5

%

32.5

%

37.5

%

42.5

%

47.5

%

52.5

%

57.5

%

62.5

%

67.5

%

72.5

%

77.5

%

82.5

%

87.5

%

92.5

%

97.5

%

occu

renc

e

% of enterprise value

Profit Split of Licensable Intangibles in % of enterprise value

25% quartile 9.0% median 18.2% 75% quartile 32.1% mean 24.4%

4,550 share deals between 2004 and 2014; identifiable intangible assets not including customer relations

Source: markables.net

75 quartile 25 quartile

median

EXHIBIT 4Computation of Profit-Split Data

Useful life (years)

LifeTechnologies(In millions)

Purchase Price

Net Assets Acquired

Cash paid $ 13,487.32,279.5

7,167.0

$ 15,303.8

2,626.95,883.0 16

748.1

619.1

246.7

58.4

$ 15,303.8

$ 1,755.5

(463.0)

(3,800.9)

Current assetsProperty, plant and equipmentDefinite-lived intangible assets:

Indefinite-lived intangible assets:

GoodwillOther assetsLiabilities assumed

Customer relationshipsProduct technologyTrade names and other

In-process research and development

Debt assumedCash acquired

11 9

Profit split

100.0%

38.4% 17.2% 4.0%

0.4% 46.8%

Acquisition of Life Technologies Corp. by Thermo Fisher Scientific Inc. Purchase Price Allocation as of February 3, 2014

Source: Thermo Fisher Scientific Inc., Form 10-K for the Period Ending 12/31/2014; profit split calculation by authors

intangible, he might allocate onlylittle value to it, while this particu-lar asset had a higher value to theprevious owner, and vice versa.

4. Liabilities involved. In the PPA illus-trated in Exhibit 4, the acquisitionwas a share deal involving non-interest-bearing liabilities of $3.8billion. These interest-free liabili-ties reduce the 100% base. Or, thereare assets in the same amount thatdo not need to generate returns.Often, this is covered by netting ofshort-term working capital. If theacquisition is however performedas an asset deal, these liabilities areoften not part of it, and the 100%base is higher. In such cases, prof-

it-split data taken from asset dealsmust be adjusted by liabilities thatare typical for the subject industry.

5. Tax. The value of intangibles andgoodwil l can var y for its taxdeductibility. Tax deductibilityresults in a higher value and in aninterest-free tax liability of the sameamount, and thus in a higher prof-it-split percentage. Typically, thisinformation can be found with thePPA. In the case illustrated in Exhib-it 4, neither intangibles nor goodwillare deductible for tax purposes. Benefits. On the other hand, the ben-

efits of profit-split based on purchaseaccounting data are quite obvious: 1. Data availability. Numerous data are

available in the public domain andfully open to scrutiny.

2. Data quality. Data are calculatedaccording to national and interna-tional accounting standards. More-over, results of va luat ions are

cross-checked relative to each oth-er and against the 100% thresholdof purchase consideration effectivelypaid. Finally, data are audited byCPAs.

3. Transaction-based. Data result fromreal market transactions on M&Amarkets, where market conditionsare more “perfect” than on licensingmarkets. Prices paid are based oncommonly accepted valuation mul-tiples and on thorough due dili-gence.

4. Established businesses. Businessescovered are fully established andreliably assessable. This comparesto licensed businesses which arenew and risky at the effective dateof the license agreement, and oftenfail to succeed.

5. Profits from long-term ownership.Profitability is based on expectedlong-term, fully loaded profits toacquire and own the intangible. Thisis a more realistic concept thanprofit under a rather short-termlicense agreement.

6. Integrated data. Last but not least,the method is based on integrateddata. Both price (value) of intangi-bles and profit-split relate to oneand the same business.

A Reconciliation of the Classic Profit-Split MethodUsing data from purchase accountingas comparables for profit-split valua-tion is a new approach. Now, it wouldbe interesting to see how such datacompare to the earlier attempts to ver-ify the validity of the classic profit-split method. The following analysisis based on data taken f rom theMARKABLES database.18 The profit-split for the sum of licensable intangi-bles was analyzed as percent ofenterprise value. Licensable intangi-bles were defined as identifiable intan-gibles not including such intangiblesthat are typically not licensable (e.g.,customer relations, customer contracts,or backlog). The findings are illus-trated in Exhibit 5.


16 17.2% + 4.0% + 0.4%. 17 For a comprehensive and detailed overview of

fair value accounting, see Zyla, note 2, supra. 18 The MARKABLES database contains data from

over 6,500 PPAs, with a particular focus on trade-mark and brand assets (www.markables.net).

Business reality is far toodiverse to be mapped with

averages or narrow ranges.

Support for Goldscheider. Interest-ingly, the findings provide strong evi-dence for Robert Goldscheider’s earlyobservations. The mean profit-split oflicensable intangibles is 24.4%, thusvery close to Goldscheider’s 25%observation. This finding is good forboth Goldscheider, whose classic rulereceives some sort of reconciliation,and for the purchase accounting-basedmethod which shows mean values verysimilar to those found in the earlierresearch performed by Goldscheideret al. It must be noted that these find-ings relate to the sum of all (hypo-thetically) licensable intangibles acompany owns or uses.

But beyond that 25% mean value,the findings also show the large band-width of individual data. 50% of allcases are situated somewhere betweena 9% and a 32% profit-split. The oth-er 50% of the cases have profit ratioseven below or above these percentages.Obviously, there exist many business-es that need very little if any licens-able intangibles to operate, and thereare others whose value structure is dri-ven to a very large extent by suchintangibles. This is exactly what theCourt of Appeals found and ruled inthe Uniloc decision. Business reality isfar too diverse to be mapped with aver-ages or narrow ranges.

Trademark Profit-Splitprofit-split in the original Philco analy-sis—and in many cases thereafter—was based on a bundle of different IPrights, including patents, know-how;trade names, and copyrights. Thisbundling seems to be usual practicein IP licensing. Out of 13,078 licenseagreements with unredacted runningroyalty rates listed in the RoyaltySourcedatabase, 83% comprise bundles ofvarious IP rights, and no more than13% are pure play license agreementscovering one specific IP only.19 How-ever, IP valuation and litigation is oftenabout one particular IP; the bundle ismore typical in transfer pricing forsubsidiaries. The following discussiontakes a closer look at the valuation ofone particular intangible asset, name-ly trademarks (or brands).

Exhibit 6 illustrates the frequencydistribution of trademark profit-splitwhich—being a part of the total licens-able asset bundle—must necessarilybe lower (further left) than the distri-bution for all intangibles in Exhibit 5.The analysis shows that trademarks(or brands) account for an average of13.1% of enterprise value or futureprofits. The median of the distributionis 6.6%. With regard to the classic prof-it-split rule of 25%, this would be fartoo high to be applied as a rule ofthumb on a pure play trademark alone.Again, the bandwidth over all differenttrademarks in the sample is very high,ranging from close to zero up to over100%.20

It is immediately clear that a brandof Swiss luxury watches must make amuch higher contribution to profitthan the trade name of an oil welldrilling business in Idaho. Or in thecase of a natural cat litter business, thevalue of the brand accounts for near-ly 100% of enterprise value; the busi-ness sources the packaged productsfrom a quarry mill nearby; it has noown production or technology, and norelations to end customers. Almost allof its enterprise value is driven by thebrand. As the Court of Appeals con-cluded in Uniloc, “evidence … must be


EXHIBIT 7Trademark Profit-Split Analysis of Watch Businesses

0% 5% 10% 15% 20% 25%

- trademark profit split and royalty rates -

0%

20%

40%

60%

80%

100%

120%

1 2 3 4 5 6 7 8 9 10 11

Watch businesses Watch businesses - trademark profit split (% of enterprise value) -

luxury watches

commercial watches

distressed businesses


R = 0.85112

75 %ile 25 %ile median

EXHIBIT 6Frequency Distribution of Trademark Profit-Split

0

50

100

150

200

250

300

350

400

450

1%

3%

5%

7%

9%

11%

13%

15%

17%

19%

21%

23%

25%

27%

29%

31%

33%

35%

37%

39%

Trademark Profit Split in % of enterprise value

0

50

100

150

200

250

300

350

400

450

1%

3%

5%

7%

9%

11%

13%

15%

17%

19%

21%

23%

25%

27%

29%

31%

33%

35%

37%

39%

occu

renc

e

% of enterprise value

25% quartile median 75% quartile mean

4,550 share deals between 2004 and 2014


75 quartile 25 quartile

median

2.5% 6.6%

16.5% 13.1%

tied to the relevant facts and circum-stances of the particular case at issue.”

To further illustrate this, a peergroup analysis of trademark profit-split in the watch-making businessbased on purchase accounting data wasperformed (see Exhibit 7). Watches aregenerally known to be highly branddriven and to generate attractive prof-it margins. The peer group includeseleven different watch brands of whichsix are based in Switzerland, four inthe U.S., and one in Germany.

Obviously, the profit-split ratios forthe eleven watch businesses show awide range from 18% to 102% (Exhib-it 7, left part). The 25-75 quartilesrange from 22% to 60%, the median is25%. Towards the high end of the dis-tribution, the curve shows a steepincrease. This particular peer group—as any other peer group—illustratesthat industry or category specific prof-it-split ratios do not exist. Too differ-ent are the va lue dr iver andprofitability structures at a companylevel, even within the same industry.

Further analysis reveals however alinear relation between trademarkprofit-split and royalty rates (Exhib-it 7, right part). The higher the prof-it-split ratio, the higher the royaltyrate which the trademark generateson revenues. When looking closer atthe eleven watch businesses, a clearsegmentation appears. Luxury watch-es during normal course of businessshow both high profit-split ratios andhigh royalty rates. Commercial orfashion watches show medium roy-alty rates and profit-split ratios. Thethird segment comprises watch busi-nesses in a turnaround situation.Considering the retail prices of thewatches in that segment, they belongto the premium/luxury segment; con-sidering their weak profitability how-ever, their accounts leave no room forhigh trademark values. Thus, trade-mark profit-split becomes a majordeterminant of trademark value inconnection with other determinantslike royalty rate and overall profitmargins. Similar trademark analysescan be performed for most categoriesor industries.

Transfer Pricing Application. Theapplication of such profit-split analy-ses is not limited to the valuation ofintangible assets; it is also helpful in

transfer pricing issues between sub-sidiary companies of a large corpo-rat ion. prof i t -spl i t shows theconsolidated profit of the group whichis attributable to a particular intangi-ble asset (l ike trademark). Basedthereupon, a functional analysis oftrademark-related functions per-formed by the IP holding entity andthe subsidiaries provides a furtherallocation of overall trademark prof-it onto different group entities.

ConclusionPurchase accounting data is helpfulfor gaining a deep understanding ofthe transaction values of intangibleassets, and their expected contribu-tion to future profits of acquired busi-nesses. Such data helps to reconcileand redirect the profit-split method,which has long been an importantmethod for valuing intangible assets.With ample purchase accounting dataavailable as comparables in the publicdomain, in-depth case-specific peergroup analyses become possible. Thiswill not only improve the quality ofthe profit-split method itself, but alsomake an important contribution tothe overall accuracy of the valuation ofintangibles in general. �


19 Silva, “Letter in Reply to OECD on TransferPricing Comparability Data and DevelopingCountries,” 4/11/2014. Accessed at http://www.oecd.org/ctp/transfer-pricing/royaltystatllc-conparability-and-developing-countries.pdf.

20 The graph is cut at 40%.

intavnaluatiogn of ibles - markables · the profit-split method remains an essential tool for...

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