The Valuation of Intangible Assets within the Pharmaceutical Industry

Rijksuniversiteit Groningen

Faculty of Business Administration

The Valuation of Intangible Assets within the Pharmaceutical Industry

David Rutges S1175971

Laren, January 2004

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Supervisor: Prof. Dr. J. van der Meer-Kooistra RA

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Supervisor: Drs. A. Smeenge RA

The Valuation of Intangible Assets within the

Pharmaceutical Industry

Preface

This report concludes the research performed by order of KPMG LLP New York and the Rijksuniversiteit Groningen. The subject has been chosen in association with KPMG LLP New York. Intangible assets are not a new type of assets in the business world, but they certainly gained more attention over the past decade. Investors as well as accountants are acknowledging that a company’s value does not consist of monetary and tangible assets only. For companies in the pharmaceutical industry, the intangible assets are their most important type of assets. The developments within the industry are very important for the fair market value of intangible assets. Performing the research certainly increased my insight in the world of intangible assets and the valuation of them, and I trust this report does the same for the reader.

My thanks are due to Aaron Foster and Thomas Tsiopoulos, my supervisors at KPMG LLP, and Prof. Dr. J. van der Meer-Kooistra RA and Drs. A. Smeenge RA, my supervisors at the Rijksuniversiteit Groningen. Furthermore, I would like to thank the people at KPMG LLP who made it possible for me to conduct my research at the New York office.

David Rutges

January 2004

Abstract

This research is conducted by order of KPMG LLP New York and the Rijksuniversiteit Groningen. The main research question is: How do the developments within the pharmaceutical industry of the United States affect the value of intangible assets within the same industry?

In order to answer this main question, the following research questions are set:

How to identify intangible assets from an economic, accounting and legal perspective?

What are the methods for valuing intangible assets?

What are the developments in the US pharmaceutical industry?

How do these developments within the US pharmaceutical industry affect the value of an intangible asset within a case study company?

The first three research questions are answered by using a variety of books and journals.

The fourth research question is answered by conducting a case study of a pharmaceutical company, referred to as company Y.

Intangible assets have become increasingly important for businesses in the past decade, caused by a further globalization and deregulation of key economic sectors. These intangibles can create a competitive advantage for businesses, where the possibilities to obtain such an advantage on basis of monetary and tangible assets are limited. In order to have economic value, an intangible asset should possess legal property rights and should generate a measurable amount of benefit to its owner. There are five characteristics of intangible assets important for their value. The value increasing characteristics are:

Nonrivalry Network effects

The value decreasing characteristics are:

Partial excludability Inherent risk

Non-tradability

There is a difference between the book value of intangible assets and the fair market value. However, there is progression made in closing this gap. Nevertheless, a valuation practitioner still cannot use the book value of assets as an indication of their fair market value. The legal property rights are there to protect the property owners or to stimulate the property developers. For pharmaceutical companies, the laws protecting their tradenames and the laws applicable to patents are most important.

There are three main approaches to value intangible assets: the income approach, the

market approach and the cost approach. The income approach is the most suitable. The

market approach tries to identify comparable transactions in the market and accepts the

price that was paid in that transaction as an indication of the value of the asset. Because

of the uniqueness of intangible assets and the high degree of comparability required, this

approach is very difficult to apply to value intangible assets. The cost approach uses the

cost to replace or reproduce the same asset. Cost does not equal value, and therefore the

physical depreciation, functional obsolescence and economic obsolescence of the asset

have to be determined. However, this determination is very difficult. Moreover, the cost

approach is not forward looking and investors are much more interested in future economic benefits related to owning the asset. The income approach recalculates future income streams into a present value. This approach consists of three important components: the economic remaining life of the intangible asset, the projections of future economic benefits related to the asset and the discount rate.

The most important developments in the pharmaceutical industry are:

• Breakthrough discoveries in human genomics

• Increased competition from biotech companies

• Many blockbuster drugs will lose their patent in the next few years, creating opportunities for other companies

• Increased direct-to-customer advertising by pharmaceutical companies make customers less loyal towards drugs

• Federal as well as private healthcare plans push to cut costs

• Increased threat of generics and “branded generics” for branded drugs

• Increased threat of other branded drugs

Company Y owns a tradename related to product X. The income approach uses projections of income streams related to the intangible asset to determine the net present value. Also a discount rate and the economic remaining life of the intangible asset have to be determined. The discount rate is usually determined by using the WACC or CAPM.

The projections can change under the influence of the above mentioned developments in the pharmaceutical industry. Different projections lead to substantial different values for the tradename.

The main conclusion that can be drawn is therefore that the developments in the industry

have a substantial influence on the value of the intangible assets in the same industry. A

more dynamic and therefore a riskier industry, as is the case with the pharmaceutical

industry, should lead to a higher discount rate, and vice versa. The income approach is

the most suitable to value intangible assets. When using the WACC or CAPM to

determine the discount rate for intangible assets, the valuation practitioner should be

aware that adjustments to the discount rate may be required. Also, the projections of the

income streams related to the intangible asset should be critically reviewed.

Contents

1 Introduction ...7

1.1 The Assignment...7

1.2 Research Questions ...8

1.3 Research Approach...9

1.4 Research Design ...10

2 Intangible Assets...12

2.1 The Growing Importance of Intangibles ...12

2.2 The Economics behind Intangible Assets ...13

2.3 Accounting Aspects of Intangible Assets ...16

2.4 Intangible Assets from a Legal Point of View...19

3 Methods for Valuing Intangibles ...21

3.1 The Market Approach ...21

3.2 The Cost Approach...24

3.3 The Income Approach...26

4 Analysis of the Pharmaceutical Industry...29

4.1 How the Industry Operates ...29

4.2 Industry Overview ...32

4.3 Industry Trends...37

4.4 Technology and innovation...40

4.5 Regulatory and Political Environment ...44

4.6 Barriers to Entry ...48

4.7 Market Trends...48

4.8 Market Structure ...51

4.9 Customers...55

4.10 Summary of the Major Changes in the Pharmaceutical Industry...55

5 Company Y ...57

5.1 Classification of Products ...57

5.2 Company Y Value Chain in the US ...58

5.3 Critical Success Factors ...59

5.4 Company Y Legacy Products ...62

5.5 Intangible Assets...64

6 The valuation of an intangible asset within Company Y ...67

6.1 Background ...67

6.2 Isolating the intangible cash flow...69

6.3 Determining the Discount Rate ...72

6.4 Valuing the intangible asset under different scenarios...74

7 Conclusions and recommendations ...79

Appendix A ...82

Appendix B...84

Appendix C...85

1 Introduction

This report concludes the research that has been conducted by order of KPMG LLP in New York and the Rijksuniversiteit Groningen.

The first section of this chapter elaborates on the assignment as given by KPMG LLP in New York. The second section discusses the research objectives. The third section deals with the research approach that is used to conduct this research. The fourth section covers the conceptual model and gives a further overview of the contents of this report.

1.1 The Assignment

The research is conducted by order of the Economic and Valuation Services (EVS) department of KPMG LLP in New York. Before the assignment is discussed, a short overview is given of the activities in which EVS is involved.

EVS offers a wide range of economic and business services to meet the needs of companies in an ever-changing global business environment.

EVS offers solutions to issues involving transfer pricing compliance and documentation, dispute resolution, alternative dispute resolution, planning, quantitative analysis, and financial services economics.

Transfer Pricing Compliance and Documentation

Increasingly, countries throughout the world are requiring companies to prepare transfer- pricing documentation to ensure compliance with local tax laws. EVS assists companies by providing:

• Analysis of global compliance requirements based on local-country transfer-pricing rules

• Multiple-country transfer pricing documentation and update studies

• Assistance with establishing and implementing groupwide transfer pricing policies Dispute Resolution

Just as transfer pricing compliance requirements have increased, so have tax-authority challenges. Transfer pricing audits can be costly and time-consuming; an unfavorable outcome can result in income adjustments, penalties, and interest. Often, such disputes require significant time commitments from senior professionals, taking these individuals away from core business activities. EVS delivers the following dispute resolution services:

• Assistance in developing the appropriate strategy to respond to the challenge

• Supporting analysis to respond to requests for information

• Expert economic testimony Alternative Dispute Resolution

There are several avenues other than litigation to resolve transfer-pricing disputes with taxing authorities. EVS assists companies in taking advantage of alternative approaches, providing the following solutions:

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www.kpmg.com

• Advance pricing agreements (APAs), from prefiling through negotiation

• Assessment of the risks of tax-authority challenges and identification of appropriate solutions outside of litigation

• Assistance in Competent Authority negotiations Planning

EVS practice teams with KPMG’s tax and assurance professionals and professionals from KPMG Consulting to offer:

• Intangible holding company analysis

• Cost-sharing analysis and development of arm’s-length buy-in payments

• Functional and business risk analysis to support operational planning decisions Quantitative Analysis

EVS’s quantitative analysis professionals use their problem solving skills to formulate:

• Strategy evaluation and competitive analysis

• Statistical, econometric, and financial analyses

• Operational performance evaluation Financial Services Economics

EVS’s financial economists serve international financial institutions by providing:

• Transfer pricing analyses under the final global dealing regulations

• Trading book and investment bank trading studies

• Asset-based management analysis and asset management studies

As a leader in economic consulting, EVS brings together a team of 150 professionals located in the major cities throughout the United States. Additionally, the team draws on KPMG’s broad resources- tax economists, industry professionals, international tax professionals, financial analysts, and valuation and management consultants.

This research focuses on the valuation of intangible assets. Valuation of intangible assets can serve many purposes, e.g. for tax purposes or assessing the value of a company for acquisition purposes. The value of intangibles is dependent on many aspects. For example, whether an intangible asset is legally protected and the length of the protection is very important for the value. KPMG indicated that the pharmaceutical industry has been and is considered to be going through major changes that externally affect the value of intangibles. Therefore, KPMG LLP in New York wants to have a better understanding of the developments within the pharmaceutical industry and their impact on the value of intangibles within the pharmaceutical industry.

1.2 Research Questions The main research question is:

How do the developments within the pharmaceutical industry of the United States affect the value of intangible assets within the same industry?

The following research questions are set:

How to identify intangible assets from an economic, accounting and legal perspective?

What are the methods for valuing intangible assets?

What are the developments in the US pharmaceutical industry?

How do these developments within the US pharmaceutical industry affect the value of an intangible asset within a case study company?

Restrictions to the research:

This research solely focuses on the valuation of intangible assets from a US perspective.

The theory in this research focuses on marketing-, technology- and customer-related intangibles, since these intangibles are the most important for pharmaceutical companies.

The case study is concerned with marketing-related intangible assets only.

There are confidentiality restrictions with respect to the company used in the case study. Therefore the name and any other confidential information used in this report are made anonymous.

Intangible assets are for the purposes of this study considered to refer to those assets that are protected by property rights only. This type of intangible assets is sometimes referred to as intellectual property, however in this study the terms intangible assets and intellectual property are used interchangeably.

1.3 Research Approach

This section discusses the research approach that is chosen to meet this research’s primary objective, which is to assess the impact of changes in the pharmaceutical industry on the value of intangible assets. The literature makes a distinction between the inductive approach and the deductive approach to a research.

The deductive approach develops a theory and hypothesis and the research is conducted in order to test the hypothesis. The inductive approach on the other hand, is about collecting data and developing theory as a result of the data analysis. This research uses the inductive approach, as the primary focus of this research is to develop new theory regarding the impact of changes in the pharmaceutical industry on the valuation of intangible assets.

Theory is applied to the case study in chapter 6, but is not being tested.

Saunders, Lewis and Thornhill

also make the distinction between explanatory, exploratory and descriptive research. Explanatory research is looking for causal relationships between variables. Descriptive studies’ objective is to describe an accurate profile of persons, events and situations. Exploratory research is looking for new insights, basically to explore certain phenomena. For this research the latter approach applies.

Based on the assignment as given by KPMG LLP, the effect that changes in the pharmaceutical industry have on the value of intangible assets is explored.

Chapters 2 and 3 use a wide variety of literatures to build the framework with which the valuation of intangible assets within a case study in chapter 5 and 6 can be conducted.

These literatures mainly consist of books and journals. Chapter 4, where the changes in

2 Saunders, Lewis, Thornhill (2000) Research Methods for Business Students (2^nd edn), Harlow, Prentice Hall

3 Ibid.

the pharmaceutical industry are identified, uses primarily journals. Chapter 5 and 6 consist of a case study of a pharmaceutical company. Robson

defines a case study as the development of detailed, intensive knowledge about a single case, or a small number of related cases. This research uses a single case, due to the limits of time and other resources. For the case study almost exclusively primary data is used. The methods to produce primary data are the interviewing of people both within KPMG LLP and people within the pharmaceutical company that is used for the case study and a documentary analysis. Secondary data is used as well and consists of reports made for other purposes, but nevertheless extremely suitable for this study.

1.4 Research Design

For this research, a number of theories are used to analyze the different aspects of this study. Figure 1 describes the research design.

Figure 1. Research design

4 Robson, C. (1993) Real World Research, Oxford, Blackwell

Legal Analysis of Intangibles

Analyzing the US Pharmaceutical Industry

Valuing Intangible Assets within a Case Study Company

Assess the impact that recent changes within the pharmaceutical industry have on the value of intangible assets

Identifying Intangible Assets within a Case Study Company Economic Analysis

of Intangibles

Accounting Analysis of Intangibles

Methods for Valuing Intangibles

Chapter 2 discusses intangible assets from an economic, legal and accounting perspective. These three angles are needed in order to be able to identify intangible assets. To discuss the economic perspective, the theory of Baruch Lev (Intangibles;

management, measurement and reporting) is mainly used. The legal aspects of

intangibles are discussed using mainly the theory provided by Reilly and Schweihs

(Valuing Intangible Assets). To describe the accounting rules with respect to intangible

assets and to describe the methods for valuing intangibles, the main source is Valuation

of Intellectual Property and Intangible Assets, by Smith and Parr. Chapter 4 deals with

the analysis of the pharmaceutical industry. Chapter 5 discusses the company and

products of the case study company, followed by Chapter 6, which values the intangible

asset related to one product that is identified in chapter 5. Chapter 7 concludes the

research and gives recommendations to KPMG LLP.

2 Intangible Assets

This chapter discusses intangible assets from different angles. First, the reasons behind the growing importance of intangibles are dealt with. Then intangible assets are analyzed from an economic, accounting and legal perspective.

2.1 The Growing Importance of Intangibles

The definition of intangible assets as given by Baruch Lev

is:

Intangible assets are nonphysical sources of value (claims to future benefits) generated by innovation (discovery), unique organizational designs, or human resources practices.

Intangibles often interact with tangible and financial assets to create corporate value and economic growth.

Nowadays, intangible assets are an important way for companies to create competitive advantages. The following results of a survey that was held by the manufacturing chemist

emphasizes the importance of intangible assets within the pharmaceutical industry. The survey, which was carried out anonymously among UK pharmaceutical companies with an annual turnover in excess of € 7.5m, reveals that directors in the sector have a high regard for their intangible assets: 79% of those surveyed believe that it is important to value their intangible assets, and the same number think their IP (Intellectual Property; intangible assets protected by property rights) rights are key business assets.

Although under current accounting standards there is normally only part of the value of intellectual property shown in a company's accounts, when acquiring another company 93% of directors in pharmaceutical companies believe that a company's IP portfolio is an important determinant in assessing its worth. Furthermore, 61% believe that there should be a method for showing the full value of their intellectual property on the balance sheet.

The companies have set up businesses to aggressively manage, market and sell their most valuable intangible assets, e.g. patents, trade secrets, and product formulations, process technology, and even standard business practices.

Ralf Dujardin, manager of new business development at Bayer AG, was quoted in Industry Week

saying: "We now realize that R&D has a product called intellectual property, and it has a value, and we can sell it profitably." At Bayer, profit margins on some sales of intellectual property average 78% after expenses, says Dujardin.

But why have intangible assets become so important for companies now and not 10 years ago. Baruch Lev identifies two fundamental changes driving intangibles. Globalization of trade and deregulation in key economic sectors has caused the intensification in business competition. Intensifying business competition means companies have to innovate more quickly in order to stay ahead of competition. Innovations are created primarily by

5 B. Lev (2001) Intangibles- Management, Measurement, and Reporting, Washington D.C., Brookings Institution Press; Pg. 5

6 Manufacturing Chemist March 2003, Vol. 74, No. 3; Pg. 6

7 Industry Week May 2002, Vol. 251, No. 4; Pg. 39(4);

investment in intangibles, e.g. R&D, acquired technology and employee training. When these innovations create commercially viable products, then the patents and tradenames are intangible assets.

Flexible companies became necessary to survive. The flexibility is needed to be able to adjust quickly to the dynamism surrounding businesses. The second fundamental change is the advent of information technology, which made this flexibility possible. Large vertically integrated companies became obsolete, because the economies of scale and scope could now also be achieved with the new flexible production equipment and network connections to suppliers and customers. For example, customer-related intangible assets (e.g. customer lists, customer contracts) were the result of this development.

The globalization has had its effects on human resources as well. The migration of employees between companies has increased as well as employees who leave companies in order to start their own company. So companies that are able to maintain a stable workforce and keep their employees with the knowledge and innovative ideas within the company, have human capital-related intangible assets (e.g. union contracts).

2.2 The Economics behind Intangible Assets

This section is primarily based on Valuing Intangible Assets by Reilly and Schweihs.

From an economic perspective, and for the purposes of this study, an intangible asset should possess a number of attributes to qualify for being an intangible asset.

An intangible asset should be property, and should therefore be subject to property rights.

Therefore there should be a precise description that will identify the intangible as a unique asset and it should possess the legal rights of property. This distinction from assets that do not qualify as intangible or tangible property is very important, because when an asset does not possess the legal property rights, it cannot be transferred. And that potential transferability is another prerequisite to be of economic value. This point is also one of the value detractors (non-tradability) as identified by Lev later in this section. The prerequisite of transferability does not mean that all intangibles should be able to be transferred separately or independently from other assets. However, regardless of the structure the legal ownership must be transferable. Also, an intangible asset must have a tangible proof of existence. E.g. a patent will have written registration documents. The final characteristic attributable to intangible assets, is that intangibles must have a point in time were the intangible came into existence, and a point in time where the existence of the intangible can be terminated. This termination may be caused by several factors, e.g.

the expiration of a contract, an expiring patent, or the cessation of business operations.

For an intangible asset to have value, it again should possess certain characteristics. First of all, an intangible should generate a measurable amount of benefit to its owner. This can be an income increment or a cost decrement. The actual valuation of this benefit is something that will be dealt with later in this report. Second, it should add value to other assets with which the intangible asset is linked. These other assets can be tangible or intangible. For example, a tradename adds value to the tangible product. For intangible assets to fully exploit the value they contain, very often tangible assets are required. E.g.

8 R.F. Reilly, R.P. Schweihs (1999) Valuing Intangible Assets, New York, McGraw-Hill

to exploit the worth of a patent, a company must have manufacturing equipment.

However, it is not necessary for a company to actually possess tangible assets in combination with intangible assets. A company can license the intangible to a manufacturing company against the payment of royalty.

Reilly and Schweihs

divide intangible assets in the following 9 categories:

1. Marketing- related intangible assets (e.g. trademarks, trade names, brand names, and logos).

2. Technology-related intangible assets (e.g. process patents, patent applications, technical documentation, such as laboratory notebooks, technical know-how).

3. Artistic-related intangible assets (e.g. literary works and copyrights, musical compositions, copyrights, maps, engravings).

4. Data processing-related intangible assets (e.g. proprietary computer software, software copyrights, automated databases, integrated circuit masks and masters).

5. Engineering-related intangible assets (e.g. industrial design, product patents, trade secrets, engineering drawings and schematics, blueprints, proprietary documentation).

6. Customer-related intangible assets (e.g. customer lists, customer contracts, open purchase orders).

7. Contract-related intangible assets (e.g. favorable supplier contracts, license agreements, franchise agreements, non-compete agreements).

8. Human capital-related intangible assets (e.g. employment agreements, union contracts).

9. Location-related intangible assets (e.g. leasehold interests, mineral exploitation rights, easements, air rights, water rights).

This report mainly focuses on the marketing- and technology-related intangible assets within the pharmaceutical industry. For a pharmaceutical company, the most important intangible assets are patents and tradenames. The case study in chapter 6 values a tradename.

The fundamental changes described in section 2.1 have made the corporate world change in a way that extremely suits the economics behind intangibles. Lev

believes that the benefits from intangible assets come at a certain price. He indicates two benefits and three major cost drivers. As benefits he distinguishes:

Nonrivalry (nonscarcity) Network effects

Major cost drivers for intangible assets are:

Partial excludability Inherent risk

Non-tradability

Nonrivalry. With respect to intangibles, a company does not have to worry about the opportunity costs, namely the costs of not deploying the asset in the next best alternative.

An example would be FedEx, a parcel delivery service. When a parcel has to be

9 Ibid; Pg. 19-20

10 B. Lev (2001) Intangibles- Management, Measurement, and Reporting, Washington D.C., Brookings Institution Press; Pg. 21

delivered, then the car, the employee and the capital deployed for this delivery, cannot be used at another delivery. As opposed to that, an intangible asset, like the technology behind the system that assigns cars and employees to the different tasks, can serve the whole company. So the opportunity costs are zero. To develop these intangible assets a company is required to invest heavily in this development. Intangible assets are therefore characterized by high fixed costs. But once the intangible assets are developed, then the exploitation of this intangible asset usually requires very little additional costs, or marginal costs. For instance the investment in a new drug, possibly resulting in a patent for the drug, often requires heavy investment in R&D, while the cost of producing the new drug is negligible. The exploitation of these intangible assets is often only limited to the size of the market served by the company that owns the intangible asset. As opposed to economies of scale and scope, which apply to the tangible production factors, there is no point in which further exploitation of the intangible asset would diminish. Due to the fact that businesses are expanding throughout the world and are able to expand the markets they serve, it is possible for these businesses to exploit the intangible assets even further. Moreover, as a company has to depreciate on its machines, knowledge is often cumulative, with the next idea building on the last.

Network effects. The second value driver for an intangible asset that is identified by Lev is network effects. With respect to these networks it is very important to set the standard, or being part of a network that is the standard in an industry. Because for the economics of networks counts the larger the network the more valuable the network. There are network effects in the pharmaceutical industry. In this industry it is important that the more people prescribe the drug (doctors, physicians) and use it (consumers), the better the perceptions about the drug’s efficiency, safety and acceptability (customer-related intangible assets). Drugs can become the standard for certain diseases and exploit the network effects. In another industry, the VHS video-recorder system is a famous example of an investment in a system that ballooned into a technology with enormous worth, just because the system became the industry standard. To set the industry standard, businesses have to invest heavily in R&D and at the early stages of market competition. At the core of an important network lies an innovation that was developed into a product or service, and for which property rights are secured by patents or trademarks, thus at the core of a network lies an intangible asset.

Partial Excludability. There are reasons, however, why not all companies are substituting their physical assets for intangible property. A problem is the spillover dangers embedded in intangible assets. For example patents protect a drug from being copied by competitors. To acquire the patent, a company must give away information about the project. Competitors can use that information to imitate the drug and avoid patent-protection, known in the pharmaceutical industry as me-too products. And patents expire, so after the expiration, other companies can start to produce the drug in a generic or branded form. The large number of patent infringement lawsuits shows the difficulties with respect to the patents. And patents are necessary for businesses to recoup the high development costs. The following article in the London Financial Times

discusses the difficulties with respect to patents:

11 June 21, 2001

Patents are making headlines with unprecedented regularity. In the US, Amazon's drive to protect its one-click business method patent was temporarily halted when the court overturned a preliminary injunction preventing Barnes & Noble from using its version of one-click shopping. In South Africa, 39 pharmaceutical companies attempted, unsuccessfully, to block the Pretoria government from importing or manufacturing generic copies of their patented Aids drugs. And in the UK, while biotech firms scrambled to patent natural processes in the human body, Pfizer was recently prevented from patenting the biological process mediated by its branded Viagra drug.

As governments and judiciaries grapple with the issues raised by product ownership, companies are being forced to manage in a climate of uncertainty. For both the corporate and financial sectors, patenting poses some strategically challenging questions, not least being the very different mindset between the US and European markets.

Inherent risk. The second value detractor of intangibles discussed by Lev is the risk associated with intangibles. Intangibles such as R&D, human capital and organizational assets are the major inputs into firms’ innovation process. Innovation is a high-risk part of business operations, since the success of the innovation cannot be measured on forehand. So large investments can lead to commercially non-attractive products or can smother in the middle of the innovation to market implementation continuum. The investment in intangibles is the highest in the initial stage of invention. Investments have to be made in R&D, employee training, acquired technologies, and research alliances, and these investments decrease as the invention develops into prototypes and finally the product that will be brought to market. It’s the other way around for physical assets. Once the product is developed, a company has to make big investments in manufacturing equipment and distribution channels. These investments are lesser in initial stage of invention. To hedge against these risks companies are increasingly cooperating in R&D projects and have diversified portfolios of innovative projects.

Non-tradability. For intangible assets there is not a clear market. Market prices provide information about values of goods and services that is vital to optimal resource allocation.

The absence of organized markets for intangible assets has consequences for the valuation of intangibles. This valuation is restricted by the scarcity of comparables.

Intangibles do not have clear property rights, a prerequisite for markets to work. E.g.

investments of company A in R&D project X have yielded ideas for a new product.

However, at this point this asset for company A cannot be transferred to company B, because it would be impossible to establish property rights at this point of the R&D.

Moreover, it would be very difficult to value the asset. So at this point the investment in R&D for company A would be booked as costs, and not as an asset. However, the fact that there is no clear market for intangible assets does not mean that there is no transfer of intellectual property between companies.

2.3 Accounting Aspects of Intangible Assets

The intangible assets of companies do not completely appear in a company’s financial

statement. This section is important because in order to use data for the valuing of

intangible assets one must understand the data and the way it is accounted for.

There is a world of difference between what the market considers to be the worth of a company and what the book value of a company is. To illustrate this point, the market-to- book-value, which is the ratio of the capital market value of companies to their net asset value as stated on their balance sheets, can be used. For Pfizer the market value as of 2002 is $245,515,800,000 and the net asset value is only $46,356,000,000, which gives a ratio of ~5,29

. For Merck the ratio is $123,304,000,000: $47.561.200.000= ~2,59.

This gap between the market value and book value could be partly explained by the fact that intangible assets are not fully accounted for in financial statements. This section discusses the US accounting rules regarding intangible assets.

As explained in section 2.1 intangible assets are becoming more important for companies over the past years. The financial statements of a company are there to inform stakeholders of the current situation and recent results of a company. However, accountants are still struggling with the best way to capture intangible assets in these financial statements. A part of the intangibles of a company is referred to as goodwill and another part is simply referred to as intangible assets. According to GAAP (Generally Accepted Accounting Principles, applicable in the US), for an intangible asset to qualify as an intangible asset in accounting terms the asset must have a number of characteristics:

Identifiability; Patents, copyrights, franchises, trademarks, and other similar intangible assets can be specifically identified with reasonably descriptive names.

Other types of intangible assets lack specific identification, which are then usually brought together under the header goodwill.

Manner of acquisition; Intangible assets may be purchased or developed internally and may be acquired singly, or in groups, or in business combinations.

Determinate or indeterminate life; The identifiable intangible assets have determinate lives, established by law or by contract. Organizational costs, secret processes and goodwill lack the characteristic of a determinate life. Their term of existence and period of benefit are indeterminate at the point of acquisition.

Transferability; The rights to a patent, copyright, franchise can be identified separately and thus bought and sold. Organizational costs are not easy to identify, let alone transferred to another company. Similarly, goodwill is inseparable from a business and is transferable only as an inseparable intangible asset of an enterprise.

These characteristics are very narrowly determined and therefore few intangible assets are ever reflected on a balance sheet. Goodwill came to be regarded as everything that might contribute to the advantage that an established business possessed over a business to be started anew

. Twenty-five years ago it was argued that valuation techniques would develop to a point where the rather vague term goodwill need no longer appear in financial statements and that all corporate assets can be valued separately. However, at

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www.pfizer.com

13

www.merck.com

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www.assurancesource.kworld.kpmg.com

15 G.V. Smith & R.L. Parr (2000) Valuation of Intellectual Property and Intangible Assets (3^rd edn), Canada, John Wiley & Sons

present it is clear that this is still not the case. This shows that the valuing of intangible assets is still very difficult. As is shown by the example of the market-to-book value of a company, investors value intangible assets higher than accountants do. Investors are mainly interested in future earning power, and less, like accountants, in the accounting results of historical operations. And since intangible assets are considered to be able to generate high future earnings, investors value them higher.

Smith and Parr

point to a number of reasons why accountants are cautious with accounting for intangible assets:

Financially describing intangible assets or intellectual property requires forecasts, which are obviously not precise

Definitions of intangibles are unclear

Methods for valuing intangibles are thought to be imprecise The economic useful life of intangible assets can be unclear

There are a number of solutions proposed, mainly on an international level, to cope with the tension between accounting and investor’s perspectives. In a discussion sponsored by the OECD several years ago, a number of suggested courses of action emerged. It was acknowledged that the most important investments made by companies are indeed no longer tangible and that more information regarding their investments in intangible assets should be disclosed to a wide range of interested parties. The companies should also include the intangible expenditures the companies made in their annual reports, irrespective of whether such expenditures are recognized as assets on the balance sheet.

Furthermore, a disaggregation scheme was proposed in which intangible assets are divided in technology investments/ expenditures (research and development hardware and software, patents and licenses, and design engineering) and enabling investments/

expenditures (employee training, information systems, organizational restructuring, marketing, and trademarks/ brands). This resulted in IAS 38, a new standard on intangible assets published by the International Accounting Standards Committee on October 1, 1998. The key points of this standard are:

Intangible assets are to be recognized initially in financial statements at their cost only if (1) they are identifiable assets that are controlled and clearly distinguishable from the goodwill of an enterprise; (2) if it is probable that their future economic benefits will flow to the enterprise; and (3) their cost can be measured reliably.

Expenditures for intangibles that do not meet the above criteria must be recognized as an expense when incurred.

More specifically, expenditures for research and development are to be recognized as expenses, and assets, such as internally generated goodwill, brands, mastheads, publishing titles, customer lists, and similar items, may not be recognized as intangible assets on financial statements.

In an acquisition of a business by another, assets that do not meet the above criteria should be reflected as goodwill. This also applies to so-called R&D in process, which may not be recognized as an expense immediately at the date of acquisition.

After their initial recognition, intangible assets are measured by their cost less amortization and impairment loss, or at fair value less amortization or impairment

16 Ibid; Pg. 116

17 www.assurancesource.kworld.kpmg.com

loss. However, revaluations are permitted only if fair value can be determined by reference to an active market, which is a situation considered to be rare for intangible assets.

Intangible assets are to be amortized over the best estimate of their useful life.

However, this will usually not exceed 20 years.

Intangible assets should be tested for impairment at least annually, in accordance with IAS 36.

IAS 38 is effective for accounting periods beginning on or after July 1, 1999.

A valuation practitioner needs to have the fair market value of the monetary, tangible and intangible assets, as opposed to the book value, to make proper judgments about the asset under valuation. That is why it is important that the book value and market value are beginning to be more similar under these new regulations.

2.4 Intangible Assets from a Legal Point of View

As discussed in section 2.1 assets have to be property. This section focuses on the legal rights concerning intellectual property.

Intellectual property is created by specific and conscious human intellectual activity.

Because of the unique creation process, intellectual properties are generally registered under and protected by specific federal and state laws. Intellectual property can be divided, from a legal point of view, into two categories that are descriptive of the intellectual property development process:

Creative (e.g. trademarks, copyrights, computer software) Innovative (e.g. patents, industrial designs, trade secrets)

The laws governing creative intellectual property are there to protect the property owners.

The laws governing innovative intellectual property are there to motivate the property developers. The laws must create an environment where the innovative intellectual property can be commercialized successfully. However, there is a severe tension between business and society interests when it comes to the protection of innovative intellectual property. The duration of patents can’t be too short; otherwise the owners of the intellectual property will not be able to re-earn their investment in the intellectual property. Society, as opposed to that, is served by not a too long duration of patents, because it will give businesses a monopoly for that product protected by the patent, and will slow down R&D investments in a general sense, and will prohibit society to gain from new inventions. So this is a difficult issue for the legislators, but as well for property owners, as the described tension resulted in laws very different per country.

This report focuses on the marketing- and technology-related intangibles. Therefore the laws governing these types of intangible assets are discussed.

Marketing-related Intellectual Properties. Trademarks, trade names, service marks, and logos are protected by the federal Lanham Act and by corresponding state statutes.

18 R.F. Reilly, R.P. Schweihs (1999) Valuing Intangible Assets, New York, McGraw-Hill; Pg. 21

The New Role of Intellectual Property in Commercial Transactions

describes the legal aspects of trademarks as follows:

A trademark is any word, name, symbol, or device, or any combination thereof- (1) used by a person or (2) which a person has a bona fide intention to use in commerce and applies to register on the principal register established by this, to identify and distinguish his or her goods, including a unique product, from those manufactured or sold by others and to indicate the source of the goods, even if that source is unknown. The purpose of trademark protection is twofold: One is to protect the public so it may be confident that, in purchasing a product bearing a particular trademark which it favorably knows, it will get the product which it asks for and wants to get. Secondly, where the owner of a trademark has spent energy, time, and money in presenting to the public the product, he is protected in his investment from its misappropriation by pirates and cheats. The owner of a mark therefore has the right to exclude another from using a symbol so related to his or her own that the ordinary consumer would likely be confused as to the source or sponsorship of the goods or services. Trademarks do not necessarily have to be registered in order to enjoy protection, however trademarks that are used for commercial purposes usually are registered.

Technology-related Intellectual Properties. Product and process patents are granted by the US Patent and Trademark office under the authority of section 101 of the US Code.

Patents are described as follows:

Patents may be obtained for any new and useful process, new machine, manufacture or composition of matter, or any new or useful improvement thereof. The claimed invention must also be new, useful and nonobvious, in relation to the prior art. Patents fall into one of several categories, including utility, process, and design patents. Utility and process patents are valid for a period of 17 years; design patents are valid for 14 years. A patent cannot be obtained for a system of doing business, an arrangement of printed matter, a mental process, or a naturally occurring article, but may cover machines, manufacturing processes, computer applications, and product configurations.

Contrary to trademarks, to enjoy protection a patent has to be granted.

For pharmaceutical companies, the most important intangible assets are trademarks, which can be very valuable when they create customer loyalty, and patents on the formula of drugs.

19 M. Simensky & L. Bryer (1994) The New Role of Intellectual Property in Commercial Transactions, New York, John Wiley & Sons; Pg. 290

20 Ibid; Pg. 291

3 Methods for Valuing Intangibles

This chapter discusses the techniques that are available to appraise intangible assets. The words appraise and value are used interchangeably throughout the chapter. This chapter is based on Valuation of Intellectual Property and Intangible Assets, by Smith and Parr.

Value; Value is the representation of all future benefits of ownership, compressed into a single payment. Therefore, value is continually changing as those future benefits increase or decrease. If a patent for a strategically important drug for a pharmaceutical company expires earlier because of changed regulation, than that affects the value of the patent tremendously.

Property; For the appraisal of assets, it is not only important to determine the asset under valuation, but even so important is to know the rights that accompany the asset. There is obviously a great difference between the rights to use a trademark for three years or to own the trademark until the end of its useful life.

Fair market value; The US tax authority defines the fair market value as “the price at which the property (or asset) would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

There are three fundamental groups of methods to value intangible assets. These three approaches share the objective to value intangible assets in the best way possible. But there are technical differences between the methods in the three groups.

3.1 The Market Approach

The market approach provides an indication of value by comparing the price at which similar property has been exchanged between willing buyers and sellers. When the market approach is used, an indication of the value of a specific item of intellectual property can be gained by looking at the prices for comparable property. Requirements for successful use of this approach include:

The existence of an active market involving comparable property Past transactions of comparable property

Access to price information at which comparable property exchanged Arm’s-length transactions between independent parties

The difficulty with this approach when it comes to the valuing of intangibles, is the lack of comparable transactions. Transactions of specific intellectual property are rare events, and even when they do take place, the terms of the exchange are often not disclosed.

When seeking intellectual property comparability, a number of factors should be considered:

21 G.V. Smith & R.L. Parr (2000) Valuation of Intellectual Property and Intangible Assets (3^rd edn), Canada, John Wiley & Sons; Ch. 7-8

22Internal Revenue Service Ruling 59-60

To apply this approach, the optimal comparable transaction is one that took place in the same industry. Industry cycles and economics can influence the value of businesses and their intangible assets.

The comparable intangible asset that was transferred should have the same profitability level as the intangible asset under valuation. For example, a group of companies within the same industry produce qualitatively similar products, however one company is making more profits than its competitors. That extra profit can be attributable to the trademark. In that instance, that trademark is valued higher than the trademarks of the companies’ competitors. So in order to find a comparable transaction, it is important to look at the intellectual property’s profit making ability and make sure that that is comparable to the intellectual property under valuation.

Market share is important as well, since companies that have a large market share in a big market benefit from economies of scale and the non-scarcity effect of intangible assets. Intellectual property transactions may not be comparable if the market share comparisons are not similar.

Competition from emerging new technologies can significantly decrease the value of an intangible asset, as it affects the economic remaining life. When looking for comparable transactions, then the possible threat from potential replacing technologies should be comparable to the threat to the intangible asset that is being valued. In the highly dynamic and fast-moving pharmaceutical industry, existing medicines are threatened by new and better medicines on an on-going basis, hence the economic remaining life is usually not very much longer than the patent that protects the drug. In some instances new ones replace existing medicines even before the patent expires.

Barriers to entry can extend the economic useful life of intangible assets, by keeping potentially threatening products from the market. Also, by keeping other products off the market, the intangible asset can generate more profits. Barriers include distribution networks and substantial capital investments. Also, in the pharmaceutical industry, approval from governing bodies like the FDA in the United States is a barrier to entry. Competitive products usually experience substantial time delays, as the companies have to wait for approval to sell the products on the market.

Intellectual property within a market with high barriers to entry is valued higher than intellectual property in an easily accessible market. The following article in the New Jersey Business journal

discusses the costs associated with a new drug application (NDA) and shows that the time from NDA to approval has varied over the past years.

“This past January, the Food & Drug Administration (FDA) enacted a new provision to the Prescription Drug User Fee Act (PDUFA), allowing the continued monitoring of a pharmaceutical into its post-marketing phase to further study its safety once on the market. According to Susan Cruzon, FDA spokesperson, "Sometimes, things are not picked up in clinical trials, so FDA post-marketing monitoring is supposed to pick up signals of problems or adverse effects of a pharmaceutical." PDUFA, first passed in 1992, calls for a pharmaceutical company to pay an application fee ($313,320 last year) each time it submits a New Drug Application (NDA). The FDA uses this money to hire more reviewers and support staff and upgrade its information technology to

23 June 1, 2003

speed up the drug review process without compromising quality. Besides an application fee, PDUFA also charges an annual Establishment Fee of $140,109 for each establishment that manufactures a drug, plus an annual product fee of $21,630 assessed on certain prescription drugs and biological products. The act is working.

Since its implementation, the time it takes for the FDA to approve a drug has decreased from 23 months in 1992 to 14 months in 2001. The 2001 figure represents an increase from 1999's low-point median of 11.6 months, but it is a decrease from 2000's time frame of 15.6 months. According to Cruzon, the approval time increased again last year to 15.3 months, but this is for 67 NDAs, compared with 56 NDAs in 2001. Looking back to the pre-PDUFA days of 1988, the median time it took to approve a drug was more than 30 months.

The main concern for pharmaceutical companies in regard to faster drug approval times is the time left to sell their drugs on the market. A patent (in the US) for a pharmaceutical drug lasts 17 years (up to 20 years with extensions). The patent time clock starts ticking when an entity is first discovered. The research and approval process can take up from eight to 12 years, giving the pharmaceutical company between 8 to 12 years to sell its product, recoup its research and development costs and make a profit.”

This article shows that with respect to new drug approval the barriers to entry in the pharmaceutical industry are the considerable costs associated with an NDA and the fact that it takes a considerable amount of time to get the approval. In chapter 4 where the pharmaceutical industry is analyzed the barriers of entry are more fully discussed.

Comparable market transactions are useless as value indicator if the properties being compared have different growth prospects. An intangible asset is worth more as the income generated in the future inclines compared to an intangible asset which future income is flat or even declining, assuming that the investment risks are the same.

Of course, as discussed before, the intangible asset needs to be protected by property rights to be of any value. The length of the protection and the danger of other companies designing around the protection are of influence to the value of the intangible asset. When looking for comparable transactions of an intangible asset, the legal protection should be taken into account as well.

The final characteristic of an intangible asset that should be comparable for the market approach to be successful is the economic remaining life of the intangible.

Even if all former characteristics are comparable, if the economic remaining life is different, than no comparison is possible under the market approach.

When a comparable transaction cannot be found, it is possible to use the market approach to value the total business enterprise to come to the value of an intangible asset. When a business enterprise is valued and the value is allocated to all assets other than intangible ones, then the residual value can be ascribed to the intellectual property. The value of a business enterprise consists of:

• Net working Capital (=current assets- current liabilities)

• Tangible Assets (=land + building + machinery + trucks + office equipment)

• Intangible Assets (=patents + trademarks + copyrights + process secrets)

As described, the book value in the financial statements differs from the fair market value and cannot be directly used to determine business value. The equity of a company can be valued by using the price at which the shares of the business are traded at the stock market, that is if the company is publicly traded. To determine the business value, the value of the long-term debt should be added. The book value of the long-term debt should be adjusted to interest rate changes, inflation, credit risk, and other variables. If a company is not publicly traded, a number of market multiples can be used. A possibility is to look at the price-to-earnings ratio of a comparable company that has been acquired.

The same ratio needs to be applied to the business enterprise to get to the value of the latter. For example, if a comparable pharmaceutical division of a company has been sold, and that division had a price-to-earnings ratio of 4, then by looking at the earnings of the division under valuation, the price/ value of that division can be determined.

For the market approach to work, the market is considered to be perfect. The comparable division of a company that was sold is supposed to have been sold where the buyer and seller were having reasonable knowledge of relevant facts. However, to be sure that a company or division was sold according to the value determined by a perfect market, a comparable company should possess the following characteristics:

• Significant holdings of the stock by institutional investors

• The availability of several research reports about the company from prominent security firms

• Active trading volume in the stock

3.2 The Cost Approach

The cost approach considers the value of an asset to be the same as the cost to replace or reproduce the asset. Therefore, this approach ignores the future economic benefits that can be derived from the asset and the economic remaining life of the asset. The shortcomings of this approach are discussed in more detail later in this section. Typically, the cost approach is used to value fixed assets for a company that has a going concern issue. However, the approach can be used to value intangible assets as well.

To obtain the value of an intangible asset using the cost approach, the first step is to assess the costs that have to be incurred in order to obtain a new replica of the intangible asset. There are two methods to do that.

Historical Cost Trending

Companies sometimes keep detailed records of the money that was spend on the development of the intangible asset. When these costs incurred are restated in current dollars, than an indication is given of the amount of money that would have to be spend to reproduce the intangible asset. When valuing for example a trademark, there are a number of expenses that are important to identify:

• Concept development.

• Consulting expenses.

• Preliminary consumer testing.

• Package designs.

• Advertising campaign development.

• Commercial planning, scripting, and recording.

• Television, radio, newspaper, and magazine spot costs.

The difficulty is to determine the starting and the end date of the development of the intangible asset. Also, when an intangible asset was developed a considerable time ago, physical, functional, and/ or economic obsolescence should be taken into account.

Re-creation costs

The second method looks at the costs that would have to be incurred by a company to create a similar asset. If a company failed to keep accurate records of costs involved with the development of the intangible asset, than this approach serves as a good alternative.

The tricky part lies in the fact that this approach provides an indication of the costs necessary to produce a brand new intangible asset. Once these costs are calculated, the next step is to calculate the physical depreciation, since the intangible asset under valuation is presumably not brand new. Also, functional obsolescence must be dealt with, since the intangible asset might no longer be state-of-the-art in the marketplace compared to other intangible assets. The last element is economic obsolescence. The economic obsolescence deals with the industry factors that can increase or decrease the fair market value of the asset. For example, a brand new state-of-the-art production line for a video- recorder has a low fair market value, because nowadays video-recorders are replaced by dvd-recorders. Hence, the future earning power of the asset determines part of the value of the asset. Also, the usefulness of the asset within other companies is important.

Intangible assets are often unique and therefore, because of the lack of tradability, valued below the costs to replace the intangible asset, minus the physical depreciation and functional obsolescence. The following formula sums up the cost approach:

FMV= CRN- PD- FO- EO Where,

FMV= Fair Market Value

CRN= Cost of Replacement (New) PD= Physical Depreciation

FO= Functional Obsolescence EO= Economic Obsolescence

Important to note when it comes to the cost approach is that costs do not equal value.

There are a number of adjustments that have to be made, as is shown by the formula

above. Moreover, regarding the valuation of intangible assets when using the cost

approach there are a number of shortcomings. The cost approach does not incorporate

any information about the economic benefits that are associated with the intangible asset,

and thus does not look at any trends in economic benefits and duration of economic

benefits. Both factors are very important when determining the value of an intangible asset. Also, risk associated with the future economic benefits is not taken into account. A high risk would be detrimental upon the value. The final shortcoming is that the affects of obsolescence are very difficult to quantify. As was mentioned at the beginning of this section, the cost approach is mainly used when it comes to valuing assets of a firm with a going concern problem. The cost approach, however, can be used in support of the market and income approach.

3.3 The Income Approach

The income approach consists of three parts. This section discusses the procedure to determine the income amount, or the economic benefit, that can be attributed to an intangible asset and the economic remaining life. The other part of the income approach is the discount rate (the risk factor). The discount rate is discussed in appendix A and section 6.3.

Smith and Parr define fair market value as “the present value of the future economic benefits of ownership.” That is exactly what the income approach does. Therefore, although it is considered to be the most difficult approach, it is also the most accurate when applied correctly. Income attributable to an intangible asset has to be identified, as well as quantified.

There is a possibility that the economic benefit can be attributed directly to the intangible asset. When in a mature market a company is able to make above average profits on a consistent basis, the difference between the above average and the average profit can be assigned to an intangible asset. And because of the legal protection of the intangible asset, it cannot be copied easily by competitors. In the pharmaceutical industry a branded drug is sold at a price above that of a generic drug, while the production costs are the same. The difference in price between the branded drug and generic drug can be attributed to the brand name. Business Week

reports that the patent for Tagamet was about to expire and that the company was planning to prepare a generic clone of Tagamet for half the price. In this instance, the patent gave the company a 50% profit differential, assuming that production and advertising costs remained constant. Another example is a patented process that cuts the production costs for a company, making the company earn above average profits.

In other instances it is not possible to attribute a part of the earnings directly to the intangible asset. In those instances indirect techniques are needed.

Relief from royalty method

A common indirect methodology is the relief from royalty method. This method is built on the premise that when a company owns for example a trademark, the company does not have to pay royalties in order to obtain one. By looking at the royalty rates that are common in the market, an average royalty rate can be acquired. This average royalty rate can be seen as income for the company that owns the trademark. As is the case with the market approach, it is vital to be sensitive to the terms of the comparable transaction and the intangible asset involved. The relief from royalty rate method can be applied to more

24 Business Week, January 10, 1994, p.85