The Handbook of Business Valuation and Intellectual Property Analysis pot

Treasury Bond Returns 1.2 Disaggregated Ibbotson Associates ReturnPremium Data Estimates Decile Portfolios of the NYSE/AMEX/ Nasdaq1926–2002 with Annual Beta Historical Data 1926–20021.6

The Handbook of Business Valuation and Intellectual Property Analysis

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1 Business enterprises—Valuation 2 Intellectual property—

Valuation I Reilly, Robert F II Schweihs, Robert P.

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ROGERJ GRABOWSKIand DAVIDW KING

Introduction Realized Return or Ex Post Approach The Selection of the

Observation Period Which Average: Arithmetic or Geometric? Expected

ERP versus Realized Equity Return Premiums Noncontrolling Ownership

or Controlling Ownership Interest Returns? Forward-Looking Methods

Bottom-Up Methods Projected Real Equity Returns Surveys Other Sources.

Realized Returns and the Size Effect Criticisms of the Small Stock Effect

The January Effect Bid/Ask Bounce Bias Geometric versus Arithmetic Averages Infrequent Trading and Small Stock Betas Delisting Bias Transaction Costs.

No Small Stock Premium Since 1982 Summary and Conclusion.

2 The Discount for Lack of Control and the Ownership

M MARKLEE

Introduction Determinants of the Discount for Lack of Control Suboptimal

Management of the Firm Treatment of Passive Equity Holders Valuing

Ownership Control and Passive Ownership Interests in Operating

Companies Ownership Control Premium Procedures Direct Procedures

Discount for Lack of Control in Investment Companies Valuing Passive

Ownership Interests in Family Investment Companies Public Closed-End

Fund Data The Partnership Spectrum Data Conclusion

JACOBP ROOSMAIntroduction Base Case Discussion of Methodology Financial Model of the

Investment Alternatives Sensitivity Analyses Spread between the Investment

Rate of Return and the Debt Interest Rate Investment Rate of Return Corporate Income Tax Rate Individual Income Tax Rate Inside Tax Basis Preliminary Conclusions of Sensitivity Analyses Some Real-World Assumptions

Assumptions Regarding Expected Rates of Return Using Put Options toAddress the Contingencies of Direct Asset Purchase Reasonableness CheckUsing the Price of the Put Option Investment Holding Period Adjustment

v

Dividends Potential Value of the S Status Election Financial Model of the

S Corporation Election Strategy Sensitivity Analyses—S Corporation

Election Analysis Debt Interest Rate Spread between Investment Rate of

Return and Debt Interest Rate Corporate Income Tax Rate Individual Income Tax Rate Inside Tax Basis Conclusion of Sensitivity Analyses

Amortizable/Depreciable Appreciating Assets Short-Cuts Taken and OtherPotential Criticisms Summary and Conclusion Other Implications forBusiness Valuations Involving the BIG Tax

DANIELR VANVLEET

Introduction Basic Premises Business Valuation Approaches Income-Based

Approaches Asset-Based Approach Conceptual Mismatch between S

Corporations and C Corporations The S Corporation Economic Adjustment

S Corporation Equity Adjustment Multiple Application of the SEAM Primary

Assumptions and Potential Adjustments S Corporation Perpetuity Assumption.

Cash Investment Returns and Unrealized Capital Gains Recognition of Capital Gains Taxes Tax Status of Buyers and Sellers Current Income Tax Law Profitability Assumption Summary and Conclusion.

5 Applying the Income Approach to S Corporation and Other

ROGERJ GRABOWSKIand WILLIAMP MCFADDENIntroduction Pass-Through Entities General Advantages of Pass-ThroughEntities Restrictions and Benefits of an S Corporation Economic Basis forConsidering Income Taxes Considerations in the Valuation of Pass-ThroughEntities Fair Market Value and the Pool of Likely Buyers for S CorporationShares Controlling Ownership Interest Valuation Considerations

Noncontrolling Ownership Interest Valuation Considerations How Should SCorporations Be Valued Using the DCF Method? Three Suggested Methods

of S Corporation Valuation Applying the Three Methods to Value an S

Corporation Traditional Method The Gross Method Valuing a Controlling Ownership Interest The Modified Gross Method C Corporation Equivalent

Method The Pretax Discount Rate Method Valuing a Noncontrolling

Ownership Interest Summary of Before Lack of Marketability DiscountExample Summary of Example with 5 Percent Long-Term Growth RateAssumed Effect of Jobs and Growth Tax Relief Reconciliation Act of 2003 Proposals to Simplify Subchapter S Conclusion

DAVIDACKERMANand SUSANE GOULD

Introduction The Current Tax Laws Authorization of S Corporation ESOPs

Repeal of Unrelated Business Income Tax New Distribution Rules Exemption from Prohibited Transaction Rules Denial of Special ESOP Tax Incentives.

No Section 1042 Tax-Deferred Sales Limit on Contributions No Deduction for Dividends New Antiabuse Rules for S Corporation ESOPs Perceived Abuses Disqualified Persons Nonallocation Year Penalties for Violation of the Nonallocation Rules Regulations Effective Dates The S Corporation

Election Taxation of S Corporations and Their Shareholders Eligibility

to Make the S Election Advantages of the S Corporation Election

Avoidance of Double Tax Tax Savings on the Sale or Liquidation of a Business Pass-Through of Losses Other Benefits Disadvantages of the

S Corporation Election Shareholder Limitations One-Class-of-Stock

Limitation Limitation on Other Benefits Fiscal Year State Income Tax Considerations Advantages of an S Corporation ESOP Disadvantages of an

S Corporation ESOP Valuation Issues for S Corporation ESOPs Fair Market

Value S Corporation Valuations versus C Corporation Valuations—The Conventional Method Recent Judicial Precedent Range of Value 100 Percent S Corporation ESOPs Valuation Conclusion Planning Opportunities Should ESOP Companies Make the S Election? Tax-Deferred Sales to ESOPs Limits on Plan Contributions Corporate-Level Income Tax Should S

Corporations Adopt ESOPs? Unresolved Issues Use of S Corporation Distributions to Pay Off an ESOP Loan Distribution of S Corporation Earnings to Plan Participants Special Issues for S Corporation ESOPs Lack of Marketability Discount Repurchases from Plan Participants ESOP Income Tax Shield Sale of an S Corporation ESOP S Corporation ESOPs and Step Transactions S Corporation ESOPs in Distress Situations

S Corporation ESOPs and Acquisitions Managing Repurchase Obligation in

an S Corporation ESOP Conclusion.

ALEXW HOWARDand WILLIAMH FRAZIERIntroduction The Partnership Structure Rationale Behind FLPs InternalRevenue Code Chapter 14 Adequate Disclosure The IRS and Valuation

Discounts Valuation Parameters FLPs That Own Primarily Marketable

Securities FLPs That Own Primarily Real Estate Lack of Marketability Summary Understanding and Interpreting the Partnership Agreement Business Purpose Contributions Management Prerogatives Distributions to the Partners Control and Lack of Control Transferability of Family Limited Partnership Interests Section 754 Dissolution/Liquidation Recent Tax

Court Cases Strangi v Commissioner McCord v Commissioner Other Relevant Cases Estate of Thompson v Commissioner Estate of Morton B.

Harper v Commissioner Estate of Kimbell v United States Church v United States Knight v Commissioner Kerr v Commissioner.

GILBERTE MATTHEWSIntroduction Calculation and Miscalculation of Aggregate Market Value

Diluted Shares Long-Term and Short-Term Debt Preferred Stock and Minority Interests Cash Selection and Use of Guideline Companies and

Guideline Acquisitions Acquisition Price Premiums Overstating Averages

by Using the Arithmetic Mean Irrational Pricing Multiples Limitations of

the Application of the Discounted Cash Flow Method Unreliability of

Financial Projections Sensitivity to the Present Value Discount Rate Sensitivity to Terminal Value Depreciation and Capital Expenditures Asset

Value Proper Standards of Value Stock-for-Stock Consideration to OtherClass Members High-Vote versus Low-Vote Shares Structural Fairness Presentation of Fairness Opinions Updating Fairness Opinions Conclusion

9 Valuing a Canadian Business for a U.S Purchaser:

RICHARDM WISEand SHERI-ANNEDOYLEIntroduction Foreign Ownership Considerations Acquisition of a Canadian

Corporation—Income Tax Considerations Acquisition of a Small Business

Canadian Withholding Taxes Other Business Corporations Acts—

Shareholder Rights Dissent and Oppression Remedies Take-Over Bids and

Follow-Up Offers Canadian Publicly Traded Securities Formal Valuations— Ontario Securities Commission Environmental Laws Intellectual Property

Conclusion

ROGERJ GRABOWSKI, JACKHUBER, and ROBERTCANTONIntroduction The State of the Major Professional Sports Leagues Economics

of the Four Major Sports Leagues National Broadcasting Revenue Local

Broadcasting Revenue Ticket Revenue Stadium Leases Naming Rights Sponsorships Collective Bargaining Agreement Buyers of Professional

Sports Teams Sports Team Values National Football League Major League

Baseball National Basketball Association National Hockey League Income

Tax Consequences of Professional Sports Team Acquisitions Acquired

Assets Player Contracts Stadium Lease/Premium Seat Agreements Season Ticket Holders Broadcasting Agreements Sponsorship Agreements

Nonplayer Contracts and Noncontractual Employees Draft Picks Other Intangible Assets Venue Feasibility Analysis The Study Process for the

Franchise Owner Considering a New Market Income from Operations Venue Financing Alternatives Economic Impact on the State and/or LocalCommunity Conclusion

CHARLESA WILHOITE

Introduction Health Care Entity Valuation Methodology Valuation

Approaches Asset-Based Approach Income Approach Market Approach

Significant Valuation Issues Managing Expectations Identifying and

Rationalizing Value Trade-Offs Issues of Management/ Operational Control Complying with Regulatory Constraints Impact of Market Activity on Current

Practice Values Shift toward Gainsharing Summary and Conclusion

12 Three Peas in the Business Valuation Pod: The Resource-Based

WARREND MILLER

Introduction Michael Porter Edith Penrose People The Resource-Based

View of the Firm, Value Creation, and Strategy External Sources of

Investment-Specific Risk Macroenvironmental Analysis Industry Dynamics

Competitive Analysis Internal Sources of Investment-Specific Risk Ratio Analysis Tool #1: The Resource-Based View of the Firm Tool #2: The Value Chain Tool #3: The VRIO Framework Tool #4: Generic Competitive Strategy Tool #5: The Star Framework Summary and Conclusion

Afterword: Competitive Analysis

13 Differences between Economic Damages Analysis and

MICHAELK DUNBARand MICHAELJOSEPHWAGNERIntroduction Value the Whole or Just a Part? Use All Valuation

Approaches? Damages Before or After Taxes? The Income Tax–Affect

Procedure Complications to the Tax-Affect Procedure Typical Lost Profits Claim Value Only the Future? Know Only the Past? Background for the

Ex Ante and Ex Post Discussion Expectancy versus Outcome Damages

Advantages and Disadvantages of the Ex Ante Analysis Advantages and Disadvantages of the Ex Post Analysis Hybrid Analysis Projected or

Expected Cash Flow Differences in Reporting Requirements Use of Legal Precedent Conclusion

14 Intellectual Property Income Projections: Approaches and Methods 355

JACQUELYNDALSANTOObjective of Intellectual Property Income Projection Reliability of IncomeProjections Alternative “Scenario” Income Projections Extrapolation Methods

Linear Extrapolation Method Multicollinearity Curvilinear Extrapolation Method Multiple Regression-Based Extrapolation Method Tabula Rasa

Methods Life Cycle Analyses Product Life Cycle Stages Product Life

Cycles Vary in Length Sensitivity Analyses Simulation Analyses

Judgmental Methods Summary and Conclusion

15 Intellectual Property Discount Rates and Capitalization Rates 385

TIMOTHYJ MEINHARTIntroduction and Overview Discount Rate versus Capitalization Rate

Valuation of an Intellectual Property Using a Discount Rate Valuation of an Intellectual Property Using a Capitalization Rate Sensitivity Analysis Using Alternative Discount Rates and Growth Rates Using Discount Rates to

Quantify Economic Damages and Transfer Prices Economic Damages

Example Transfer Price Example Estimating Discount Rates and Capitalization

Rates for Intellectual Property Capital Asset Pricing Model The Build-Up

Model The Discounted Cash Flow Model Arbitrage Pricing Theory Model Weighted Average Cost of Capital Using the WACC to Estimate Discount Rates for Intellectual Properties Summary Suggested Reading.

16 Intellectual Property Life Estimation Approaches and Methods 421

PAMELAJ GARLAND

Introduction Importance of Life Estimation Performing a Life Estimation

Analysis Topics Covered in This Chapter Reasons to Perform a Life

Estimation Analysis Valuation Economic Damages Transfer

Price/Licensing Intellectual Property Life Measurements Statutory Life Contract Life Judicial Life Economic Life Technological Life Analytical Life Other Life Measurements Data Used in Intellectual Property Life

Estimation Registration Documents Contracts Judicial Decisions/Orders

Financial Statements Usage Data Operational Documents Technology Data Age/Life Data Summary Definitions and Analytical Methods Age Average Life Total Life Probable Life Average Remaining Useful Life Survivor Curve Probable Life Curve Survivor Curve and Probable Life

Curve Example Turnover or Retirement Rate Expected Decay or Depreciation Iowa-Type Curves Weibull Curves Technology Forecasting

Illustrative Examples Patent Infringement Example Trade Secret Valuation

Example Trademark Licensing Example Copyrighted Software Example

Summary and Conclusion Suggested Reading and Resources

ROBERTF REILLYIntroduction Importance of Residual Value Analyses Valuation Analysis

Intellectual Property Liquidation Value Alternative Types of Liquidation

Analyses Intellectual Properties within a Bankruptcy Context Summary and

Conclusion

PAMELAJ GARLANDIntroduction The Case Study Problem Purpose and Objective of the Analysis.Description of the Subject Intellectual Property Data and Data Sources

Analytical Approaches and Methods Cost Approach Income Approach

Market Approach Analytical Approaches and Methods Considered and Selected Analytical Variables Analyses and Results Cost per Person-Month COCOMO Analyses KnowledgePLAN Analyses Synthesis and Conclusion

Analysis Work Product Purpose and Objective Description of the Subject

Property and of the Subject Data Sources Valuation Methods and Procedures Valuation Synthesis and Conclusion Appendixes Illustrative Narrative Valuation Opinion Report Outline Schedules and Exhibits.

JAMESG RABE

Introduction The Case Problem Overview of the Licensee Overview of the

Licensor Importance of the Appropriate Royalty Rate Objective of the

Analysis Description of Subject Intellectual Property Data and Data Sources

Alternative Analytical Methods Considered Comparable Uncontrolled

Transaction Method Comparable Profits Method Profit Split Method Summary of Royalty Rate Estimation Methods Discounted Cash Flow

Method Base Case Analysis Discounted Cash Flow Method Alternative

Case Analysis Discounted Cash Flow Method Synthesis and Conclusion.

PART V Intellectual Property Transfer Price Analysis Issues 535

20 Transfer Pricing Considerations in Estimating Fair Market Value 537

KENNETHR BUTTONand JERRIEV MIRGAIntroduction: When Are Transfer Prices Likely to Be a Valuation Issue? The

Regulatory Framework Fair Market Value Financial Reporting and FASB

Statement No 57 Federal and State Tax Reporting OECD Guidelines How

Do Non-Arm’s-Length Transactions Distort an Entity’s FinancialStatements? The Identification of the Subject Company Related-PartyTransfer Prices Methods of Determining Arm’s-Length Transaction Prices

The Comparable Uncontrolled Price Method The Comparable Uncontrolled Transaction Method Resale Price Method Cost Plus Method The

Comparable Profits Method Profit Split Methods Use of “Comparable” Companies in Determining the Arm’s-Length Price Adjusting the Financial

Statements to Reflect Arm’s-Length Prices Sales of Product A and the

CUP Method Sales of Product B and the RPM Sales of Product C and the

CPM Administrative Overhead Charge and Cost Plus Method Intercompany Loan Use of Parent Manufacturing Technology with the CUT Method and the CPM Overall Impact on Financial Statements Conclusion

21 Intangible Asset Intercompany Transfer Pricing Analyses 563

THOMASJ MILLONJR

Introduction The Nature of Intercompany Transfer Pricing Income Tax

Consequences Key Features of Section 482 Regulations Reporting “Taxable

Income.” The Length Standard The Best Method Rule The Length Range Determining Comparable Circumstances Summary of the Section 482 Regulations Two Major Types of Intercompany Transfers

Arm’s-Intangible Asset Transfer Pricing Methods Comparable Uncontrolled

Transaction Method The Comparable Profits Method Other Methods

Transfer Pricing for Domestic Taxation Purposes Transfer Pricing–Related

Valuation Misstatement Penalties Valuation Misstatement Transfer Pricing

Penalty Safe Harbor Provisions The Role of Transfer Pricing Analysts Exposure Analysis and Defense Planning and Compliance

THOMASJ MILLONJR

Introduction Membership Leadership Division Publications Events

Endorsed Vendors IGTMA Services Endorsed Vendor Royalty Income

Purpose and Objective of the Analysis Premise of the Analysis Financial

Statement Analysis Consolidated Balance Sheets Consolidated Income

Statements Adjusted Financial Fundamentals Analytical Procedures

Description of the Intellectual Property Subject to Analysis Definition of Trademarks Attributes to Consider in the Economic Assessment of Trademarks Trademark Analysis Company-Specific Analyses Industry- Specific and Guideline Company–Specific Royalty Rate Analysis Market-

Derived Royalty Rate Analysis Economic Analysis Synthesis and Conclusion

23 Research Techniques for an Intellectual Property

VICTORIAA PLATT

Introduction Data Categories Owner/Operator Financial Statements

Comparative Companies, Transactions, and Empirical Market Data Industry Statistics and Economic Indicators Securities Analyst Research Reports Remaining Useful Life Data Prospectuses and Other SEC Documents Trade Association Publications and Materials Guideline/Subject Company Public Relations Information Information Requirements by Purpose

TERRYG WHITEHEADand DENNISM MANDELLIntroduction Background The Case Problem Purpose and Objective of theAnalysis Description of the Subject Intellectual Property Data and DataSources Alternative Analytical Methods Considered Analyses and Conclusions

Comparison of Operating Results “with” and “without” Infringement

Historical Lost Profits Method Discounted Cash Flow Method Reasonable Royalty Method Synthesis and Conclusion Analysis Work Product.

List of Exhibits

1.1 Historical Realized Return Premiums (StockMarket Returns vs Treasury Bond Returns) 1.2 Disaggregated Ibbotson Associates ReturnPremium Data

Estimates

Decile Portfolios of the NYSE/AMEX/ Nasdaq(1926–2002) with Annual Beta

(Historical Data 1926–2002)1.6 Actual Observed Rates of Return for the 25Portfolios Compared to Those Predicted by CAPM1.7 Alternative Stock Index Data: 1982–2002, ReturnPremiums over Treasury Bonds

2.1 Relationship of Stock Market and M&A Market

2.3 The Partnership Spectrum (2001 Discount fromNet Asset Value Studies)

3.1 Analysis of Comparative Returns, Value of

C Corporations with Built-in Gains, Base CaseScenario

3.2 Analysis of Comparative Returns, Value of

C Corporations with Built-in Gains, Base CaseScenario Adjusted for Debt Interest Rate3.3 Analysis of Comparative Returns, Value of

C Corporations with Built-in Gains, Base CaseScenario Adjusted for Investment Rate of Return3.4 Analysis of Comparative Returns, Value of

C Corporations with Built-in Gains, Base CaseScenario Adjusted for Corporate Income Tax Rate3.5 Analysis of Comparative Returns, Value of

C Corporations with Built-in Gains, Base CaseScenario Adjusted for Individual Income Tax Rates3.6 Analysis of Comparative Returns, Value of

C Corporations with Built-in Gains, Base CaseScenario Adjusted for Inside Tax Basis3.7 Analysis of Comparative Returns, Value of

C Corporations with Built-In Gains, Base CaseScenario Adjusted for “Normal” Spread3.8 Analysis of Comparative Returns, Value of

C Corporations with Built-in Gains, PutAnalysis—Base Case Scenario

3.9 Analysis of Comparative Returns, Value of

C Corporations with Built-in Gains, PutAnalysis—Stress Testing

3.10 Analysis of Comparative Returns, Value of

C Corporations with Built-in Gains, Calculation

of Maximum Price of Put—Direct Investor3.11 Analysis of Comparative Returns, Value of

C Corporations with Built-in Gains, Subchapter

S Election Adjusted for Rates3.12 Analysis of Comparative Returns, Value of

C Corporations with Built-in Gains, Subchapter

S Election Adjusted for Investment Return3.13 Analysis of Comparative Returns, Value of

C Corporations with Built-in Gains, Subchapter

S Election Adjusted for Corporate Tax Rate3.14 Analysis of Comparative Returns, Value of

C Corporations with Built-in Gains, Subchapter

S Election Adjusted for Individual Tax Rate3.15 Analysis of Comparative Returns, Value of

C Corporations with Built-in Gains, Subchapter

S Election Adjusted for Inside Basis4.1 Net Economic Benefit to Shareholders

4.3 S Corporation Equity Adjustment Multiples

4.6 Application of the SEAM: Asset-Based Approach5.1 Value of a Debt-Free S Corporation with NoExpected Growth: The Traditional Method (as if

C Corporation)5.2 Value of a Debt-Free S Corporation with No

Expected Growth: The Gross Method

5.3 Value of a Debt-Free S Corporation (ControllingOwnership Interest Basis) with No Expected

Growth: The Modified Gross Method

5.4 Value of a Debt-Free S Corporation (ControllingOwnership Interest Basis) with No ExpectedGrowth: The C Corporation Equivalent Method5.5 Value of a Debt-Free S Corporation (ControllingOwnership Interest Basis) with No ExpectedGrowth: The Pretax Discount Rate Method5.6 Value of a Debt-Free S Corporation(Noncontrolling Ownership Interest Basis) with

No Expected Growth: The Modified Gross Method

xiii

5.7 Value of a Debt-Free S Corporation

(Noncontrolling Ownership Interest Basis) with

No Expected Growth: The C CorporationEquivalent Method

5.8 Value of a Debt-Free S Corporation

(Noncontrolling Ownership Interest Basis) with

No Expected Growth: The Pretax Discount RateMethod

5.9 Value of a Debt-Free S Corporation with

5 Percent Expected Growth Rate: The TraditionalMethod (as if a C Corporation)

5.10 Value of a Debt-Free S Corporation with

5 Percent Expected Growth Rate: The Gross

Method5.11 Value of a Debt-Free S Corporation (Controlling

Ownership Interest Basis) with 5 PercentExpected Growth Rate: The

Modified Gross Method

5.12 Value of a Debt-Free S Corporation (Controlling

Ownership Interest Basis) with 5 PercentExpected Growth Rate: The C CorporationEquivalent Method

5.13 Value of a Debt-Free S Corporation (Controlling

Ownership Interest Basis) with 5 PercentExpected Growth Rate: The Pretax Discount RateMethod

5.14 Value of a Debt-Free S Corporation

(Noncontrolling Ownership Interest Basis) with

5 Percent Expected Growth Rate: The Modified

Gross Method

5.15 Value of a Debt-Free S Corporation

(Noncontrolling Ownership Interest Basis) with

5 Percent Expected Growth Rate: The

C Corporation Equivalent Method5.16 Value of a Debt-Free S Corporation

(Noncontrolling Ownership Basis) with 5 PercentGrowth Rate: The Pretax Discount Rate Method6.1 Tax on the Sale of Appreciated Property and

Liquidation, Assumes a $100,000 Taxable Gain

($ in 000s)

Owned ($ in 000s)

as of June 28, 2002, Ranked by PercentagePremium/(Discount)

of June 28, 2002, Ranked by PercentagePremium/(Discount)

7.3 Equity Real Estate Partnerships—Distributing as ofMay/June 2002, Ranked by Discount From NAV

Land Partnerships as of May/June 2002, Ranked

by Percentage Discount7.5 Summary of Partnership Resale Discounts 7.6 SEC Institutional Investor Study

7.7 The Silber Study Sample Characteristics 7.8 Columbia Financial Advisors, Inc., RestrictedStock Study

7.9 Summary of Restricted Stock Studies 7.10 Willamette Management Associates Studies,Summary of Discounts for Private TransactionP/E Multiples

8.1 Cable Acquisitions, October 1998–March 1999

Supermarket Chain Example

Hypothetical Company

Using Gordon Growth Model for HypotheticalCompany

8.5 Three Percent Growth, 10-Year Straight-LineDepreciation

8.6 Excess of Capital Expenditures over Depreciation8.7 Depreciation as Percent of Capital Expenditures 9.1 Cross-Border Transactions

10.1 State of the Major Sports Leagues ($ in 000s,Except Ticket Prices)

10.2 Major League Sports Largest Naming RightsContracts ($ in millions)

10.3 Recent NFL Team Sale Transactions ($ in millions)

10.4 Recent MLB Team Sale Transactions ($ in millions)

10.5 Recent NBA Team Sale Transactions ($ in millions)

10.6 Recent NHL Team Sale Transactions ($ in millions)

10.7 Typical Major League Sports Franchise PurchasePrice Allocation

Stadiums Since 1990 10.9 Sports Venue Development, Public versus PrivateFunding Sources

10.10 MLB Ballpark Development Costs, Source ofFunding

10.11 Typical Range of Sources of Private Funding 11.1 Multispecialty Discounted Cash Flow Analysis,Medical Clinic, Inc

11.2 Estimated Required Return on Equity 11.3 Weighted Average Cost of Capital 11.4 Multispecialty Guideline Merged and AcquiredCompany Analysis, Medical Clinic, Inc

12.1 Organizational Theory and Industrial Organization12.2 The Six Dimensions of the Macroenvironment12.3 Porter’s Five-Forces Framework

12.4 Examples of Financial Capital 12.5 Examples of Physical Capital

12.7 Examples of Organizational Capital

and Business Valuation Analysis 13.2 Excerpts from Case Law

Analysis13.4 General Case of Before-Tax vs After-TaxEconomic Damages Analysis

13.6 Present Value of Future Lost Profits 13.7 Alternative Definitions of Cash Flow and Cost ofCapital

13.8 Past and Future Economic Damages, Ex Ante and

Ex Post Damages13.9 Differences between Ex Ante and Ex PostAnalyses

13.10 Risk Parity, Expected Cash Flow, Expected Rate

of Return, and Time, Ex Post Economic Damages14.1 Creative Patent Company Income Statement($000s) Alternative Income Scenarios for VeryImportant Patent #501

14.2 Description of a Simple Linear Relationship—

Supply Curve for ABC Software

14.4 Alternative Values of Y for a Given Value of X When the Relationship Is Y + 10 + 2X + u and u Is

a Random Variable 14.5 Curvilinear Graphs14.6 Number of Units Sold and Product Price for 35Sales of Program F

14.7 Scatter Diagram, Number of Sales and ProductPrice for Soft ’n Bake Software

14.8 Multiple Regression Analysis, Primo Pet CareCompany, Patent Royalty Rate Example14.9 Product Life Cycle

14.10 Income Projections 14.11 Monte Carlo Analysis, Income Projection for aSoftware Valuation

14.12 Valuation Financial Model Based on “Best Case’’Scenario Valuation Variables from a Monte CarloAnalysis

15.1 Discounted Cash Flow Analysis, TrademarkValuation Example

15.2 Direct Capitalization Method, TrademarkValuation Example

15.3 Discounted Cash Flow Analysis, Increase inDiscount Rate, Trademark Valuation Example15.4 Discounted Cash Flow Analysis, Decrease inDiscount Rate, Trademark Valuation Example15.5 Direct Capitalization Method, Increase in theCapitalization Rate, Trademark Valuation Example15.6 Direct Capitalization Method, Decrease in theCapitalization Rate, Trademark ValuationExample

15.7 Discounted Cash Flow Analysis, Increase inExpected Long-Term Growth Rate, TrademarkValuation Example

15.8 Discounted Cash Flow Analysis, Decrease inExpected Long-Term Growth Rate, TrademarkValuation Example

15.9 Direct Capitalization Method, Increase inExpected Long-Term Growth Rate, TrademarkValuation Example

15.10 Direct Capitalization Method, Decrease inExpected Long-Term Growth Rate, TrademarkValuation Example

15.11 Discounted Cash Flow Analysis, Varying theDiscount Rate, Trade Secret Valuation Example 15.12 Discounted Cash Flow Analysis, Valuation ofWonder Club Patent, Economic DamagesAnalysis Example

15.13 Discounted Cash Flow Analysis, Valuation ofProprietary Computer Software, Transfer PricingAnalysis Example

15.14 Beta Measurement Characteristics of CommonFinancial Reporting Services

15.15 Fair Market Value of Trademark, Present ValueDiscount Rate Estimation, Extraction of DiscountRate from Guideline Sale/License Transactions 15.16 Differences between Intellectual Property andPublicly Traded Company Stock, Comparison ofDiscount Rate/Capitalization Rate

16.1 Illustrative Survivor Curve and Probable Life Curve

16.2 Turnover/Retirement Rate and RUL, Based on

Retirement Rate 16.3 Survivor Decay Rate, Based on Constant

Retirement Rate16.4 Weibull Analysis

Illustrative Survivor Curve Construction

Illustrative Survivor Curve and Best-Fitting Type Curve

Iowa-16.7 Goodfood Corporation Trade Secrets Valuation

Weighted Average Remaining Useful LifeCalculation

16.8 Goodfood Corporation Trade Secrets Valuation

Calculation of Composite Decay

Market Share Figures 16.10 Electronics Company Trademark License 3-DVD

Market Share Graph17.1 Expected Income During Discrete Projection Period

17.2 Residuum Income Flow, Negative Constant Rate

of Change 17.3 Zero vs Negative Growth Rate

17.4 Residuum Income Flow, Positive Constant Rate of

Change 17.5 Zero vs Positive Growth Rate

17.6 Illustrative Intellectual Property Maintenance

Expenditures 17.7 Economic Income Projection, Measured by

Expected License Royalty Income 17.8 Residual Value Maintenance Expenditures, Net

Present Value Analysis 17.9 Residual Value Maintenance Expenditures, Net

Present Value Analysis, Incremental EconomicIncome Basis, Incremental Operating ExpenseScenario

17.10 Residual Value Maintenance Expenditures, Net

Present Value Analysis, Incremental EconomicIncome Basis, Incremental Capital ExpenditureScenario

18.1 Illustrative Example of Overtaxation of Centrally

Assessed Taxpayers 18.2 On Track Railways, Cost per Person-Month, as of

January 1, 2003

by System Group, as of January 1, 2003

Mainframe Software, as of January 1, 2003

18.5 On Track Railways Valuation Analysis,COCOMO 4GL Software, as of January 1, 2003

Client/Server Software, as of January 1, 200318.7 On Track Railways Valuation Analysis,KnowledgePLAN Mainframe Software, as ofJanuary 1, 2003

18.8 On Track Railways Valuation Analysis,KnowledgePLAN 4GL Software, as of January 1,

2003 18.9 On Track Railways Valuation Analysis,KnowledgePLAN Client/Server Software, as ofJanuary 1, 2003

18.10 On Track Railways Internally Developed Software,Fair Market Value Synthesis, as of January 1, 200318.11 Sample Table of Contents for a Software-RelatedIntellectual Property Valuation Report

19.2 Jackpot, Inc., Comparable UncontrolledTransaction Method

19.3 Jackpot, Inc., Historical Balance Sheets19.4 Jackpot, Inc., Historical Common-Size BalanceSheets

19.5 Jackpot, Inc., Historical Income Statements19.6 Jackpot, Inc., Historical Common-Size IncomeStatements

19.7 Jackpot, Inc., Historical Ratio Analysis19.8 Jackpot, Inc., Comparable Profits Method 19.9 Jackpot, Inc., Base Case Analysis, ProjectedIncome Statements

19.10 Jackpot, Inc., Base Case Analysis, Common-SizeIncome Statements

19.11 Jackpot, Inc., Alternative Case Analysis, ProjectedIncome Statements

19.12 Jackpot, Inc., Alternative Case Analysis,Common-Size Income Statements19.13 Jackpot, Inc., Profit Split Method 19.14 Jackpot, Inc., Base Case Analysis, DiscountedCash Flow Method, Value Summary

19.15 Jackpot, Inc., Base Case Analysis, Discounted Cash Flow Method, Weighted Average Cost ofCapital

19.16 Jackpot, Inc., Alternative Case Analysis,Discounted Cash Flow Analysis, Value Summary19.17 Jackpot, Inc., Alternative Case Analysis,

Discounted Cash Flow Method, Weighted AverageCost of Capital

19.18 Jackpot, Inc., Impact on Equity Value of VariousAlternative Royalty Rates

20.1 Transactions among Related and Unrelated Parties20.2 Acquisition Cost of Products A and B for

Domestic Sales Subsidiary20.3 Acquisition Cost of Product C for ForeignSubsidiary

20.4 Administrative Services Charge Paid by DomesticSales Subsidiary

20.5 Loan from Parent to Domestic Sales Subsidiary20.6 Royalty Payment by Foreign Subsidiary for Use

of Parent’s Manufacturing Technology20.7 Sales Subsidiary before Adjusting Transfer Prices

to Arm’s Length ($ Values, Unless OtherwiseIndicated)

20.8 Sales Subsidiary after Adjusting Transfer Prices toArm’s Length ($ Values, Unless OtherwiseIndicated)

20.9 Foreign Subsidiary before Adjusting TransferPrices to Arm’s Length ($ Values, UnlessOtherwise Indicated)

20.10 Foreign Subsidiary after Adjusting Transfer Prices

to Arm’s Length ($ Values, Unless OtherwiseIndicated)

22.1A Independent Golf Tee Manufacturers Association,Royalty Rate Allocation Analysis, ConsolidatedHistorical Balance Sheets—Assets (in $) 22.1B Independent Golf Tee Manufacturers Association,Royalty Rate Allocation Analysis, ConsolidatedHistorical Balance Sheets—Liabilities &

Stockholders’ Equity (in $) 22.2 Independent Golf Tee Manufacturers Association,Royalty Rate Allocation Analysis, ConsolidatedHistorical Income Statements (in $)

22.3 Independent Golf Tee Manufacturers Association,Royalty Rate Allocation Analysis, AdjustedFinancial Fundamentals (in $)

22.4 Attributes That Affect the Economic Analysis ofTrademarks and Trade Names

22.5 Independent Golf Tee Manufacturers Association,Royalty Rate Allocation Analysis, Profit Split Method22.6 Independent Golf Tee Manufacturers Association,Royalty Rate Allocation Analysis, WeightedAverage Cost of Capital

22.7 Independent Golf Tee Manufacturers Association,Royalty Rate Allocation Analysis, ExcessEarnings Method—Asset Basis (in $)22.8A Independent Golf Tee Manufacturers Association,Royalty Rate Allocation Analysis, GuidelineCompany Analysis, Market Value of InvestedCapital

22.8B Independent Golf Tee Manufacturers Association,Royalty Rate Allocation Analysis, GuidelineCompany Analysis, Earnings before Interest andTaxes

22.8C Independent Golf Tee Manufacturers Association,Royalty Rate Allocation Analysis, GuidelineCompany Analysis, Earnings before Interest,Taxes, Depreciation, and Amortization 22.8D Independent Golf Tee Manufacturers Association,Royalty Rate Allocation Analysis, GuidelineCompany Analysis, Revenues

22.8E Independent Golf Tee Manufacturers Association,Royalty Rate Allocation Analysis, GuidelineCompany Analysis, Revenue Performance Ratios

22.8F Independent Golf Tee Manufacturers Association,Royalty Rate Allocation Analysis, GuidelineCompany Analysis, Definitions, Footnotes, andSources to Exhibits

22.9 Independent Golf Tee Manufacturers Association,Royalty Rate Allocation Analysis, Excess EarningsMethod—Industry-Specific and Guideline

Company–Specific (in $) 22.10 Independent Golf Tee Manufacturers Association,Royalty Rate Allocation Analysis, Third-PartyLicense Agreements

22.11 Independent Golf Tee Manufacturers Association,Royalty Rate Allocation Analysis, Summary 24.1 Dead Dried Meats, Inc., Product Sales Volumeand Pricing

24.2 Dead Dried Meats, Inc., Projected IncomeStatements

24.3 Dead Dried Meats, Inc., Historical Lost ProfitsMethod Summary

24.4 Dead Dried Meats, Inc., Business Enterprise ValueMethod, “without” Infringement Scenario

Summary24.5 Dead Dried Meats, Inc., Business Enterprise ValueMethod, “with” Continued Infringement ScenarioSummary

24.6 Dead Dried Meats, Inc., Reasonable Royalty RateAnalysis Summary

24.7 Dead Dried Meats, Inc., Reasonable Royalty RateAnalysis, Royalty Rate Transaction Data

24.8 Dead Dried Meats, Inc., Economic DamagesSummary

About the Editors

Robert F Reilly

Robert Reilly is a managing director of Willamette Management Associates andWillamette Capital He performs valuation consulting, economic analysis, and finan-cial advisory services including event analyses, merger and acquisition valuations,divestiture and spin-off valuations, solvency analyses, fairness opinions, ESOP fea-sibility and formation analyses, purchase price allocations, business and stockvaluations, restructuring and workout analyses, litigation support analyses, tangible/intangible asset transfer pricing studies, and lost profit/economic damages analyses.Robert has valued the following types of business entities and securities: closecorporations, public corporation restricted stock, public corporation subsidiaries/divisions, portfolios of nonmarketable securities, complex capital structures (vari-ous classes of common/preferred stock; options, warrants, grants, rights), generaland limited partnership interests, joint ventures proprietorships, professionalservice corporations, professional practices, LLPs, and LLCs He has performed eco-nomic damages, valuation, remaining useful life, and transfer price analyses ofnumerous intangible assets and intellectual properties

He has prepared financial advisory/economic analyses for merger and tion purposes including identification of merger and acquisition targets, valuation

acquisi-of synergistic/strategic benefits, identification and assessment acquisi-of divestiture andspin-off opportunities, analysis of alterative deal structures, transaction negotiationand consummation, fairness of proposed transactions, initial public offering (IPO)alternative pricing strategies, and design/valuation of alternative equity and debtinstruments in a multi-investor environment

Prior to Willamette, Robert was a partner and national director of the Deloitte

& Touche valuation practice Prior to Deloitte & Touche, he was vice president ofArthur D Little Valuation, Inc., a national appraisal firm Prior to that, he was asso-ciated with Huffy Corporation, a diversified manufacturing firm in various finan-cial management positions Prior to that, he was a senior consultant for Booz, Allen

& Hamilton, an international management consulting firm

Robert holds a master of business administration degree in finance fromColumbia University Graduate School of Business and a bachelor of arts degree ineconomics from Columbia University

Robert is a certified public accountant/accredited in business valuation, a tified management accountant, and an enrolled agent before the Internal RevenueService He is an accredited tax advisor, a chartered financial analyst, a certified busi-ness appraiser, and an accredited senior appraiser (certified in business valuation)

cer-He is also a certified real estate appraiser, a certified review appraiser, and a statecertified general appraiser in numerous states from New York to California He is

a state certified affiliate member of the Appraisal Institute

xix

Robert is the coauthor with Robert Schweihs of four other books and the thor with Robert Schweihs and Shannon Pratt of two other books He has con-tributed chapters to over a dozen anthology textbooks, and he has had over 300articles published in technical journals Robert currently serves on the editorial

coau-boards of several journals, including the American Bankruptcy Institute Journal, the Journal of Property Taxation, and Valuation Strategies.

He is an accredited senior appraiser (designated in business valuation) and a tified business appraiser He is a member of numerous professional organizations,including The ESOP Association, the Institute for Professionals in Taxation, theAssociation for Corporate Growth, the American Society of Appraisers, and theInstitute of Business Appraisers He recently served for two consecutive 3-yearterms as a trustee of The Appraisal Foundation

cer-He is the coauthor of Valuing a Business: The Analysis and Appraisal of Closely

held Companies, 4th edition (McGraw-Hill, 2000), Valuing Small Businesses and Professional Practices, 3rd edition (McGraw-Hill, 1998), Valuing Intangible Assets

Hill, 1999), The Handbook of Advanced Business Valuation Hill, 2000), and Valuing Accounting Practices (John Wiley & Sons, 1997) He has

(McGraw-also written numerous articles on valuation and economic analysis topics that havebeen published in various professional and technical journals

Bob is often called upon to speak at seminars and conferences of professionaland industry associations He has taught courses in business valuation and intangi-ble asset valuation both in the United States and abroad

Prior to joining Willamette, Bob was a partner and national director of Deloitte

& Touche valuation group Before that, he was a manager of Arthur D LittleValuation, Inc., a national appraisal firm

He holds a master of business administration degree in economics and financefrom the University of Chicago Graduate School of Business and a bachelor ofscience degree in mechanical engineering from the University of Notre Dame

Willamette Management Associates and Willamette Capital Willamette

Management Associates is a premier valuation consulting, economic analysis, andfinancial advisory firm Firm services include business valuation and security analy-sis, intangible asset valuation and remaining life analysis, intellectual property val-uation and royalty rate analysis, intercompany transfer price analysis, forensicaccounting, strategic investment analysis, merger and acquisition transaction fair-ness/solvency analysis, economic damages/lost profits analysis, economic eventstudies, and financial advisory and due diligence services

Willamette Management Associates provides these client services for purposes

of transaction pricing and structuring, taxation planning and compliance, ing securitization and collateralization, litigation support and dispute resolution,bankruptcy and reorganization analysis, and management information and plan-ning The firm’s board advisory services and corporate governance services includefairness opinions, solvency opinions, and special forensic investigations related tofraud and other allegations

financ-Willamette Capital is a private company investment banking firm affiliate ofWillamette Management Associates Willamette Capital specializes in middle-marketbusiness brokerage, capital formation (through the private placement of debt andequity securities), debt restructuring and capital structure reorganization, and lever-aged employee/management buyouts, both with and without an ESOP structure.The firm’s clients include publicly owned and closely held businesses, indus-trial and commercial corporations, professional service firms, financial institutionsand financial intermediaries, governmental and regulatory agencies, fiduciaries andfinancial advisors, the accounting profession, and the legal profession The firm’sclients include the largest multinational corporations and professional service firms—

as well as substantial family-owned businesses and professional practices

About the Contributors

David Ackerman is a shareholder in the Chicago office of Jenkens & Gilchrist, a

national law firm Mr Ackerman cochairs the Jenkens & Gilchrist ESOP Team,which is one of the largest ESOP practice groups in the country He is one of themost experienced ESOP attorneys in the country, and he is the immediate-past chair

of the Legislative & Regulatory Advisory Committee of The ESOP Association

Mr Ackerman is general counsel to numerous ESOP companies and also regularlyrepresents ESOP trustees and ESOP lenders He has written and lectured exten-sively on the subject of ESOPs Mr Ackerman is a graduate of Princeton Universityand of Harvard Law School

Kenneth R Button is senior vice president of Economic Consulting Services, LLC,

in Washington, DC He specializes in international corporate valuation assignments

He has testified as an expert witness before the U.S Tax Court, the Inter-AmericanCommercial Arbitration Commission, and the Indiana State Board of Tax Review

He also practices extensively on international trade matters before the U.S tional Trade Commission He received his MBA in finance from George WashingtonUniversity and his Ph.D in international economic development studies from theFletcher School at Tufts University

Interna-Robert V Canton serves as director of PricewaterhouseCoopers’ Sports, Convention,

and Tourism practice He has consulted on hundreds of economic and strategic ies related to professional and amateur sports teams and their venues, as well asother areas of the entertainment industry Mr Canton has served as a guest lecturer

stud-at the University of Tampa and is a frequent speaker stud-at industry events He serves onthe advisory board of the Management of Sports Industries program at the University

of New Haven and is on the editorial board of the Journal of Leisure Property.

Jacquelyn Dal Santo is a principal of Willamette Management Associates She

specializes in the appraisal of business entities and business interests, in the appraisal

of fractional business interests, and in the valuation, transfer price, and remaininglife analysis of intangible assets Ms Dal Santo holds a master of business admin-istration degree in finance from Loyola University and a bachelor of arts degree inmanagement from Purdue University She is an accredited senior appraiser of theAmerican Society of Appraisers, certified in business valuation

Sheri-Anne Doyle, graduate of McGill University, is a senior manager at Wise,

Blackman, Business Valuators, Montreal, where she has been involved in businessvaluation and the quantification of economic damages since joining the firm in

1998, prior to which she was a senior auditor at KPMG, Chartered Accountants

Ms Doyle has valued a wide array of Canadian and U.S businesses and has beeninvolved extensively in international transfer pricing She holds the chartered account-ant and chartered business valuator designations At McGill, she was recipient of theJames McGill Scholarship and the Schwartz Levitsky Feldman Scholarship

xxiii

Michael Dunbar is a vice president in the Silicon Valley office of Charles River

Associates He has extensive experience in the calculation of damages for ment of intellectual property rights, including valuing trade secrets, trademarks,copyrights, and patents He has also assessed damages for a wide variety of othercommercial disputes Mr Dunbar has published in the areas of valuation of emerg-ing technology and calculation of damages He holds bachelor’s and master’s degrees

infringe-in mechanical enginfringe-ineerinfringe-ing and an MBA from the Wharton School at the University

of Pennsylvania with a concentration in finance

William H Frazier, a principal in the firm of Howard Frazier Barker Elliott, Inc.,

has 28 years of experience in business valuation and corporate finance His articles

on the subject of business valuation have been published by the Philip E Heckerling

Institute of Estate Planning (1999), The Journal of Business Valuation (1999),

Valuation (1997), Shannon Pratt’s Business Valuation Update (1997), Estate ning (1996), and Business Valuation Review (1989) He also wrote and produced “The

Plan-Deal,” a multidisciplined valuation program presented at Valuation 2000 and the

2001 Advanced Business Valuation Conference An accredited senior appraisersince 1987, Mr Frazier is a member of the Business Valuation Committee of theAmerican Society of Appraisers

Pamela J Garland is a senior manager with Willamette Management Associates.

She specializes in the identification, valuation, and remaining useful life analysis ofintangible assets Ms Garland holds a master of business administration degree inaccounting and information systems from the J.L Kellogg Graduate School of Man-agement at Northwestern University, and a bachelor of arts degree in mathematicsfrom DePauw University She is a member of the Institute of Electrical and ElectronicsEngineers and the International Society of Parametric Analysts

Susan E Gould is a senior manager of Willamette Management Associates Ms.

Gould specializes in the valuation of business entities and equity security ests In particular, she has extensive experience in structuring transactions anddesigning special equity securities for ESOPs She holds a master of businessadministration degree in finance and economics from J.L Kellogg Graduate School

inter-of Management, Northwestern University, and a bachelor inter-of arts degree in ical science from Northwestern University Ms Gould is a chartered financialanalyst of the Association for Investment Management and Research and a can-didate member of the American Society of Appraisers in business valuation She

polit-is a member of The ESOP Association and the Finance Committee of The ESOPAssociation

Roger J Grabowski is a managing director in Standard & Poor’s Corporate Value

Consulting practice He is formerly a partner of PricewaterhouseCoopers LLPand one of its predecessor firms, Price Waterhouse (where he founded its U.S.Valuation Services practice and managed the real estate appraisal practice) He hasdirected valuations of businesses, intellectual property, real property, and otherassets Mr Grabowski has testified as an expert witness on numerous valuationissues His testimony in U.S District Court was quoted in the U.S Supreme Court

opinion in the landmark Newark Morning Ledger case He coauthors the annual S&P

Corporate Value Consulting Risk Premium Report, published at www.ibbotson.com.

He is an accredited senior appraiser and teaches Cost of Capital for the AmericanSociety of Appraiser’s Center for Advanced Valuation Studies, a course hecodeveloped

Alex W Howard is a founding principal in Howard Frazier Barker Elliott, Inc.

(HFBE ) Prior to founding HFBE, Mr Howard was employed in the corporate

finance departments of major regional investment banking firms in Houston Hehas over 30 years of experience in financial valuations Mr Howard holds B.S.and MBA degrees from New York University He is a chartered financial analyst ofthe Association for Investment Management and Research and is a member of theHouston Society of Financial Analysts He is an accredited senior appraiser of theAmerica Society of Appraisers Mr Howard has been a speaker at a variety ofseminars on business valuation issues and mergers and acquisitions He has also pub-lished articles on these subjects

Jack Huber is a senior associate at Casas, Benjamin & White, LLC Prior to joining

the firm, he was a manager at Standard & Poor’s Corporate Value Consulting Mr Huberhas managed valuation studies of businesses, interests in businesses, and intangibleassets He has valued businesses and assets in various industries including professionalsports, entertainment and media, publishing, mining, consumer products, leasing, rail-roads, information and communications, and financial services Mr Huber graduatedfrom Miami University where he majored in finance and accountancy He holds anMBA from the University of Notre Dame with a concentration in finance and is a CPA

Mr Huber’s sports clients have included the Atlanta Falcons, the Boston Celtics, theJacksonville Jaguars, and the Vancouver and the Memphis Grizzlies, among others

David W King is a director in the Standard & Poor’s Corporate Value Consulting

practice in their Chicago office He formerly worked in the valuation consultingpractice at PricewaterhouseCoopers LLP and one of its predecessors, Price Water-house LLP He has conducted extensive research into the theory and practical appli-cation of discount rates for domestic and international companies Mr King is a

chartered financial analyst He coauthors the annual Standard & Poor’s Corporate

Value Consulting Risk Premium Report, published at www.ibbotson.com.

M Mark Lee is senior managing director in charge of the New York office of Sutter

Securities Incorporated and has more than 30 years of experience in business uations, intangible asset valuations, corporate finance, and fairness opinions Formany years he was principal in charge of the Valuation Services Practice of KPMGLLP’s Northeastern Region and vice-chairman of Bear, Stearns & Co Inc.’s Valu-ation Committee Mr Lee has lectured and published extensively and testified incourt He also teaches business valuation at New York University’s School of Con-tinuing and Professional Studies Mr Lee is a chartered financial analyst and receivedhis BSE in economics from the Wharton School of Finance and Commerce of theUniversity of Pennsylvania and his MBA from New York University

val-Dennis M Mandell is a principal of Willamette Management Associates and the

director of the firm’s San Francisco office His practice includes forensic accounting,litigation support, fraud investigations, business valuations, and corporate financialadvisory services Mr Mandell holds a master of science degree in taxation fromGolden Gate University—Los Angeles and a bachelor of arts degree in accountingfrom California State University—Fullerton

Gilbert E Matthews is chairman of the board and senior managing director of

Sutter Securities Incorporated in San Francisco From 1960 through 1995, he waswith Bear, Stearns & Co Inc in New York where he had been senior managingdirector and a general partner of its predecessor partnership From 1970 through 1995,

he was chairman of Bear Stearns’ Valuation Committee, which was responsible forall opinions and valuations issued by the firm Mr Matthews received an A.B fromHarvard in 1951 and an MBA from Columbia in 1953 He is a member of the NewYork Society of Security Analysts and is a chartered financial analyst.

William P McFadden is a director in the Chicago office of Standard & Poor’s

Corporate Value Consulting practice He was formerly a director of houseCoopers LLP Mr McFadden has managed a wide range of valuation engage-ments including business equity, intangible assets, real estate, and machinery andequipment related matters He has testified as an expert witness in the state and fed-eral court systems His experience covers a broad spectrum of industries His pre-vious professional experience includes commercial lending and the administration

Pricewater-of closely held business interests held in estates and trusts Mr McFadden has anMBA degree and is a graduate industrial engineer

Timothy J Meinhart is a senior manager of Willamette Management Associates.

He specializes in the financial valuation of business enterprises, fractional business ests, and equity and debt securities Mr Meinhart holds a master of business admin-istration from Kellstadt Graduate School of Business, DePaul University, and a bachelor

inter-of science degree in finance from Northern Illinois University He is an accreditedsenior appraiser of the American Society of Appraisers, certified in business valuation

Warren D Miller, with his wife, Dorothy Beckert, founded Beckmill Research in

1991 Their home base is Lexington, Virginia The firm restricts its work to threedomains: strategic management, market research (B2B only), and valuation-related

activities Mr Miller’s research has appeared in Harvard Business Review, Academy

of Management Executive, American Fly Fisher, CPA Expert, CPA Consultant, and,

most recently, Business Valuation Review He is a former CFO and ex-strategy

aca-demic He is also a Level II candidate for the chartered financial analyst designation

He is a certified management accountant and a CPA/ABV Mr Miller has conductedin-house training for law, valuation, and CPA firms in 29 states and Puerto Rico He

is a frequent presenter at state and national valuation conferences

Thomas J Millon Jr is a principal of Willamette Management Associates and

director of the firm’s Washington, DC, office He has substantial experience in theappraisal of business entities and business interests, in the appraisal of fractional busi-ness interests, and in the valuation and remaining life analysis of intangible assets

Mr Millon holds a master of business administration degree in finance from LoyolaUniversity, a master of science degree in economics from the University of Illinois,and a bachelor of arts degree in economics from Ripon College He is an accreditedsenior appraiser of the American Society of Appraisers, certified in business valu-ation, and a chartered financial analyst of the Association for Investment Manage-ment and Research

Jerrie Varrone Mirga is a vice president of Economic Consulting Services, LLC, in

Washington, DC Her work focuses on the transfer pricing issues associated with company transactions involving tangible property, intangibles, and services Ms Mirgareceived her undergraduate degree from the College of William & Mary, and her MBA(with a concentration in international business) from George Washington University.She also completed post-MBA courses, specializing in international taxation

inter-Victoria A Platt is director of research of Willamette Management Associates For

the last 6 years, Mrs Platt has coordinated research services for six regional offices

and managed the library collection in the national headquarters office She is alsothe author of several articles and book chapters in various valuation-related publi-cations Mrs Platt is the current editor of the Special Libraries Association Business

& Finance Division Bulletin and has been a member of that association for 10 years

In addition to speaking at library conferences on Internet searching techniques, Mrs.Platt has spoken at local and national valuation conferences Prior to WillametteManagement Associates, Mrs Platt worked for the Chicago law firm Kirkland & Ellisand the Main Library at Michigan State University

James G Rabe is a principal of Willamette Management Associates and a

direc-tor of the firm’s Portland, Oregon, office His practice includes valuation ing, economic analysis, and financial advisory services Mr Rabe holds a master ofbusiness administration degree in finance from Washington University, GraduateSchool of Business, and a bachelor of science degree in business administrationand finance from the University of Missouri at Columbia He is a chartered finan-cial analyst of the Association for Investment Management and Research and anaccredited senior appraiser of the American Society of Appraisers, certified in busi-ness valuation

consult-Jacob P Roosma is a principal of Willamette Management Associates and

direc-tor of the firm’s New York office He has extensive experience in all aspects ofdomestic and international financial valuation involving taxation, dispute resolu-tion and expert witness testimony, allocation of purchase price, accounting andreporting, corporate finance, and mergers and acquisitions Mr Roosma holds abachelor of science degree in business administration and finance from the College

of Business Administration, University of Connecticut, and a bachelor of arts degree

in economics from the University of Connecticut

Daniel R Van Vleet is a principal of Willamette Management Associates and

direc-tor of the firm’s Chicago office Mr Van Vleet holds a master of business tration degree from the Graduate School of Business of the University of Chicago

adminis-He is an accredited senior appraiser (ASA) of the American Society of Appraisers,certified in business valuation, and a certified business appraiser (CBA) of theInstitute of Business Appraisers Mr Van Vleet currently serves on the InternationalBusiness Valuation Committee of the American Society of Appraisers He has served

as president of the board of directors of the Chicago Chapter of the American Society

of Appraisers and as an adjunct professor of finance at DePaul University in Chicago

Michael J Wagner is a senior advisor in the Silicon Valley office of Charles River

Associates Mr Wagner has testified more than 75 times in both federal court andstate court trials He is frequently called upon to provide expert testimony as tocommercial damages and business valuation During his 26-year career, Mr Wagner’sconsulting experience has covered most of the major industries in the United States

He has particular expertise in high technology and biotechnology A principle focushas been to determine the economic value of intellectual property including patents,copyrights, trademarks, and trade secrets

Terry G Whitehead is a founding member of American Financial Investments,

LLC, whose primary business is purchasing seller financed real estate mortgagenotes and trust deeds He was formerly a senior manager with WillametteManagement Associates where his practice included valuation consulting, economicanalysis, and financial advisory services Mr Whitehead holds a bachelor of science

degree in business administration from Warner Pacific College He is a certifiedpublic accountant and is a member of the American Institute of Certified PublicAccountants and the Oregon Society of Certified Public Accountants.

Charles A Wilhoite is a principal of Willamette Management Associates and a

direc-tor of the firm’s Portland, Oregon, office His practice includes valuation consulting,economic analysis, and financial advisory services Mr Wilhoite holds a bachelor ofscience degree in accounting and a bachelor of science degree in finance, both fromArizona State University He is a certified public accountant and is accredited in busi-ness valuation by the American Institute of Certified Public Accountants He is a cer-tified management accountant and certified in financial management, designated bythe Institute of Management Accountants He is also an accredited senior appraiser ofthe American Society of Appraisers, certified in business valuation Mr Wilhoiteserves on the board of directors of Oregon Health Sciences University, the PortlandBusiness Alliance, and the Urban League of Portland

Richard M Wise is partner of Wise, Blackman, Business Valuators, Montreal A

grad-uate of McGill University, he was president of the Canadian Institute of CharteredBusiness Valuators; fellow of the Institutes of Chartered Accountants of Quebec andOntario; and former international governor of the American Society of Appraisers

He holds the accredited senior appraiser and master certified business appraiserdesignations and is a fellow of the Canadian Institute of Chartered Business Valuators

Author of Financial Litigation—Quantifying Business Damages and Values (Canadian Institute of Chartered Accountants) and coauthor of Guide to Canadian Business

Valuations (Carswell), Mr Wise is a frequent speaker at professional conferences

across North America, and he has been valuation consultant to various Departments

of the Canadian Government

Intent of This Book

This book is intended to effectively serve as an updated companion to the Handbook

of Advanced Business Valuation (McGraw-Hill, 2000) Most chapters in that book

are still relevant and timely However, a few chapters have been updated And, it isimportant for several new chapters related to the topical issues in business and intan-gible asset valuation to be added

Instead of simply updating the Handbook of Advanced Business Valuation, this

text expands the scope of our previous work by focusing on intellectual property nomics In particular, this expanded scope includes the topics of intellectual prop-erty valuation, economic damages analysis, and intercompany transfer price analysis.Accordingly, the title of this text reflects its dual focus on (1) business valuation and(2) intellectual property analysis

eco-As business structures become more complicated, business valuations becomemore complicated As transparency in corporate financial reporting becomes moredesirable and less attainable, business valuations become more complicated And,

as securities market cycles become more exaggerated and less predictable, ness valuations become more complicated However, the complexities and contro-versies surrounding business valuation theory and practice pale in comparison to thesea of change related to the economy’s reliance on intellectual capital in this twenty-first century information age

busi-In the last 5 or so years, there has been a quantum level increase in the amount

of licenses, joint ventures, financings, litigation, and business formations related tointellectual property Personal and institutional fortunes were made—and lost—related to the formation, financing, and failure of Internet, dot-com, and other tech-nology companies The corporate strategies of most of these companies involved thedevelopment, exploitation, and commercialization of intellectual property

As with the intellectual properties themselves, intellectual property licenses,contracts, and agreements have become more complicated—and more common.Transfers of various intellectual property ownership rights often involve valuationand economic analysis issues In particular, the intercompany transfer (especiallycross-border) of intellectual properties involves both complex taxation issues andelegant economic analyses

More than any other effect, the proliferation of intellectual property developmentand commercialization has caused a proliferation in intellectual property litigation.This includes litigation claims related to infringement, breach of contract, fraud,lender liability, tortuous interference with business, expropriation, bankruptcy, andincome/transfer/property taxation And, litigation matters require the most rigor-ous valuation, lost profits, and economic damages analyses Nonetheless, litigationmatters attract the most imaginative and unsubstantial valuation, lost profits, and eco-nomic damages analyses

xxix

Accordingly, the intent of this book is to both (1) update and expand the fessional discussion on current business valuation conceptual theories and practi-cal applications and (2) recognize the commercial importance of intellectual propertywith a professional discourse on the topical issues in intellectual property valuation,economic damages, and transfer price analyses.

pro-Content of This Book

This book may be divided conceptually into six sections The first three sections relate

to various advanced business valuation topics The second three sections relate tointellectual property analysis issues Of course, the reader is encouraged to read all

of the chapters in this book However, it is possible that some readers may focus onone section only Some readers may even focus on a few individual chapters within

a section And, the detailed index in the back of the book will enable readers to zero

in on a specific topic of interest This book is written and edited to allow the reader

to do just that While there are many common themes and conclusions, each ter is intended to stand independently And, there are relatively few instances wherelatter chapters rely on material presented in earlier chapters

chap-However, the more general chapters are presented earlier in each section,and the more specific chapters are presented later in each section All topics andall chapters are presented at a fairly technical level, though This is intended

to be an advanced level book written for the use of an experienced practitioneraudience

Readers of this book are expected to be familiar with the concepts and principlespresented in intermediate college level finance, accounting, and economics texts Also,readers of this book are expected to be familiar with the concepts and principles pre-

sented in more introductory level valuation texts, such as Valuing a Business, 4th edition (McGraw-Hill, 2000) and Valuing Intangible Assets (McGraw-Hill, 2000).

Each chapter is written by one or more recognized experts in their respectivedisciplines, including law, finance, economics, and valuation All are experiencedpractitioners Many advanced concepts are researched and presented with academic

thoroughness But, the authors’ conclusions and insights are intended to be from practitioners to practitioners.

Therefore, the objective of the editing process was not to conform the chapterconclusions to a predetermined consensus In fact, just the opposite is true Theauthors were encouraged to (and many did) express original analytical approaches,methods, and procedures The objectives of the editing process were (1) to apply auniform vocabulary throughout the book and (2) to present a uniform narrative stylethroughout the book Accordingly, the authors’ experience and expertise shinethrough the stylistic editing

Throughout this book, all present value/future value calculations were madeusing the financial calculation feature of Microsoft Excel spreadsheet software Ifthe reader performs the same present value/future value calculations (1) using dif-ferent software or (2) using a handheld financial calculator, the reader may obtainslightly different present value/future value factors This slight difference is due tothe various rounding conventions used in the different software packages and finan-cial calculators Such slight differences will not materially affect the results of thecalculations And, such slight differences will not affect the intellectual rigor of theanalytical procedures presented in this book

Audience for the Book

As mentioned above, this book is written by practitioners for practitioners However,this book is intended to serve the needs of a wide variety of practitioners

First, this text is intended to expand the professional literature in the valuationcommunity This audience includes both business valuation analysts and intellec-tual property valuation analysts And, this audience includes analysts involved in bothtransactional valuations and notational valuations For this audience in particular,

this book will refresh and expand (but not replace) The Handbook of Advanced

Business Valuation.

Second, this text is intended to supplement the professional literature in the lectual property development and licensing communities This audience includes cre-ative and development personnel, licensors and licensees, licensing intermediaries,corporate executives responsible for commercializing intellectual property, and cor-porate executives and counsel responsible for protecting intellectual property.Third, this text is intended to serve the reference needs of the commercial liti-gation community, including litigants, lawyers, and judges Intellectual propertyattorneys are a particular audience for this book This includes attorneys responsible(1) for the safeguarding and corporate governance of owner/operator interests and(2) for the litigation of intellectual property claims As intellectual property represents

intel-an increasing percentage of total corporate value, intellectual property litigationrepresents a correspondingly increasing percentage of total commercial litigation.Fourth, transaction intermediaries are an intended audience of this book Thisaudience includes corporate, securities, and intellectual property intermediates.Both business brokers and private company investment bankers should benefit fromthe first half of this text Full-service investment bankers, venture capitalists, and secu-rity analysts should benefit from the entire book And, intellectual property brokers/intermediaries and joint venture/venture capital investors should benefit from thesecond half of this book

Fifth, taxation, financial planning, and estate planning professionals should findthis book a useful discussion of current valuation/investment analysis issues Thisaudience includes corporate taxation representatives specializing in income, prop-erty, or international taxation This audience includes tax administrators on the fed-eral, state, and local levels This audience includes tax advisors to closely heldbusiness owners And, this audience includes financial planners and estate plannersadvising business owners, high net worth individuals, and intellectual propertyowners/developers

This book strives to serve all of these audiences by including both (1) an demic discourse on relevant valuation, economic damages, and transfer pricing con-cepts and theories and (2) a practical explanation of the related analytical approaches,methods, and procedures

aca-Robert F Reilly and aca-Robert P Schweihs

Willamette Management Associates

8600 West Bryn Mawr Avenue, Suite 950Chicago, Illinois 60631

(773) 399-4300(773) 399-4310 (fax)rfreilly@willamette.com, rpschweihs@willamette.com

First, we would like to thank each of the chapter authors We were able to assemble

a remarkable group of nationally recognized valuation analysts, lawyers, economists,and intellectual property practitioners to contribute to this book All of the chapterauthors are recognized for their experience and expertise in their respective areas

of scholarship And, all of the chapter authors enjoy individual prominence andeminence in their respective professional community

These authors did not expend their valuable time and considerable effort forpersonal financial gain Rather, each author wanted to make a significant contribu-tion to the professional literature related to valuation, economic damages, and trans-fer price analyses The editors are extremely appreciative of each author’s significantcontribution

As is often the case with leading authorities in any profession, the positionsespoused by the chapter authors are not necessarily universally adopted by profes-sional societies and organizations In fact, sometimes, the chapter authors do not agreewith one another (or with opinions expressed elsewhere by the editors) As withleading-edge anthologies in most professions, the chapter authors have presentedadvanced discussions of the current thinking in their respective disciplines

In particular, we would like to thank Charlene M Blalock, a research ate in our Portland, Oregon, office Charlene served as the project manager for thisundertaking Charlene coordinated all aspects of the writing, editing, and publica-tion of this book She was responsible for obtaining permission to use materialreprinted in this book from other sources Charlene also prepared the index andedited and proofread the entire manuscript

associ-Jeffrey Tarbell, a principal of Willamette Management Associates, also editedand proofread the entire manuscript Ashley Reilly, an intern of the firm, checkedall of the mathematical expressions and calculations in the manuscript

Mary McCallister, our administrative assistant, typed and formatted much of themanuscript

We also wish to thank Kelli Christiansen, our editor at McGraw-Hill, for ance and assistance during the preparation of this book

guid-For permission to use material, we especially wish to thank:

Association for Investment John Wiley & SonsManagement and Research Kagan World MediaBusiness Valuation Resources Partnership Profiles, Inc

Ibbotson Associates

Robert F Reilly and Robert P Schweihs

Chicago, Illinois

xxxiii

As the title implies, this book focuses on the economics of both business valuation andintellectual property analysis In particular, this book focuses on valuation, eco-nomic damages, and transfer price analysis with regard to business entities andintellectual properties

In the 4 years since the publication of The Handbook of Advanced Business

Valuation (the de facto predecessor of this book), the business valuation discipline

has advanced as a profession Various professional organizations continue to developand promulgate professional standards Many more analysts have obtained profes-sional training and earned certifications and designations Many more empiricaldatabases and automated data sources have become available to valuation practi-tioners And, there is a greater consensus in the professional community with regard

to generally accepted approaches, methods, and procedures

Nonetheless, numerous conceptual controversies still remain, even among themost prominent practitioners And, “new and improved” data sources graduallyreplace traditional data sources In fact, these factors are among the primary reasons

to write this book In addition, over time, both (1) governmental and regulatorychanges and (2) judicial precedent affect business valuation practitioners This bookattempts to reflect the current overall effect of these cumulative changes

The last several years have seen an exponentially increased interest in tual properties, particularly as they relate to transactions, taxation, financial report-ing, bankruptcies, financings, and litigation Intellectual properties are a specificallyidentified subset of general commercial intangible assets Intellectual propertiesencompass a specifically identified bundle of legal rights As a result of this bundle

intellec-of legal rights, intellectual properties have commercial value Intellectual propertieshave commercial value to their owners, and intellectual properties have commercialvalue to their users This book explores the economic attributes—and the economicinfluences—that (1) create value, (2) destroy value, and (3) transfer value in intel-lectual properties

In the case of a general intangible asset, value is often created only when theowner is also the user of the asset However, this is not the case with an intellectualproperty where the owner can be (and often is) a different party than the user In thisway, an intellectual property is analogous to a parcel of industrial or commercial realestate That is, the owner of the real estate can be (and often is) a different party thanthe user of the real estate This ability to separate ownership (i.e., the lessor posi-tion) from use (i.e., the lessee position) is one of the important attributes that cre-ates value in real estate This ability to separate ownership (i.e., the licensor position)from use (i.e., the license position) is also one of the important attributes that cre-ates value in intellectual properties

To continue with the real estate analogy, it is not uncommon for the cialization process to involve at least three parties: (1) the property developer (whospecs out the site and builds the mall, office building, etc.), (2) the property

commer-xxxv

owner/landlord (who buys the building from the developer and then manages theproperty), and (3) the property tenants (who lease the building from the owner/landlord and use the property as just one element of production in their own indus-trial or commercial enterprises) With an intellectual property, it is not uncommonfor the commercialization process to also have at least three parties: (1) the propertydeveloper (who creates the material, device, or design and applies for the patent, copy-right, or trademark), (2) the property owner/manager (who protects, coordinates,and commercially exploits the property), and (3) the property user (who incorpo-rates the property as just one element of production in their own industrial or com-mercial enterprises) Another party—the funding/financing source—is also common

to the commercialization of real estate and intellectual property

In addition to its discussion of business valuation, this book also explores thefactors that create value in an intellectual property These factors include the bundle

of legal rights associated with the creation and ownership of the property In tion, there are elements internal to the property (albeit intangible elements) thatcreate value And, there are elements external to the property that create value Howthese elements are different for each type of intellectual property is explored Sincesupply and demand ultimately affect the value of any asset, the factors of supply anddemand that influence intellectual property are considered

addi-This book presents a process for the analysis of intellectual properties addi-Thisprocess includes the following components:

1 A description of the specific intellectual property and definition of the specific

legal rights subject to analysis

2 An assemblage of the descriptive and quantitative data that relate to (a) the

development, (b) the historical use, (c) the current use, (d) the expected futureuse, and (e) the potential future use(s) of the subject

3 A catalog of the factors that may influence the supply and demand for the

sub-ject, including legal, technological, functional, economic, financial, and petitive factors

com-4 A model for the qualitative assessment of the subject both (a) in absolute terms

and (b) in comparison to current alternative or potential competitive properties

5 A model for the quantitative assessment of the specific influences that affect the

value of the subject, including (a) historical creation costs and current recreationcosts, (b) historical income generation and future income-generating capacity,and (c) independent market-extracted transaction pricing of alternative, com-petitive, and comparative properties

6 A framework to synthesize all of these qualitative and quantitative analyses

into either (a) a defined value conclusion, (b) a transaction assessment, or (c) arecommendation regarding an investment, financing, taxation, commercializa-tion, or legal decision

This process emulates the economic decision making of intellectual propertydevelopers, owners, and users

This book also explores the factors that diminish value in an intellectual erty Numerous actions can cause damage to an intellectual property and/or lostprofits to the property owner Some of these actions are under the control of theproperty owner Sometimes, intellectual property owners will deliberately cause orallow their property to degenerate These actions are usually taken in order to benefitthe owner’s newer and/or more valuable intellectual properties Sometimes, intel-lectual property owners simply let the value of their property diminish over time

prop-Such value diminution is often due to technological or economic neglect, such as alack of research or promotional investments These actions (or inactions) are usu-ally taken when the owner has superior alternative investment opportunities and isfaced with a capital rationing decision.

Many actions that cause damage to an intellectual property are outside of thecontrol of the property owner When (1) the party responsible for causing the damageand (2) the action(s) responsible for causing the damage are identified, the propertyowner may initiate a legal claim That legal claim will typically request a judicialruling that the responsible party (1) stop the damage-causing action and (2) paycompensation to the property owner The requested compensation is usually related

to the amount of economic damages to the intellectual property and/or lost profits(or other lost economic rents) to the property owner

The party causing the damages could have any number of relationships with theintellectual property owner, including the following:

1 A current or potential competitor

2 A customer or supplier (or similar trade relationship)

3 A joint venturer or partner (or similar contractual relationship)

4 A current (or past) employee or agent

5 A creditor or other banking relationship

6 A local, federal, or foreign governmental agency

In such controversial matters, the analysis of intellectual property lost profits/economic damages is important (1) to the plaintiff/claimant, (2) to the defendant/respondent, and (3) to the finder of fact The plaintiff/claimant wants a well-reasonedand well-supported analysis in order to prove liability and damages The defendant/respondent wants a rigorous and comprehensive analysis in order to (1) prepare andpresent an appropriate defense and (2) negotiate a reasonable settlement of theclaims And, the finder of fact wants an unbiased and fully documented analysis inorder to (1) assign culpability to the appropriate party and (2) order a compensatoryand/or punitive award

This book describes approaches, methods, and procedures for intellectual propertyeconomic damages analyses These procedures can be used as a touchstone by the par-ties involved in a dispute Such a touchstone can be used to assess the amount of reliancethat lawyers and judges should place on the analyses that come before them

This book also explores the factors that affect the transfer pricing for tual property The two most common types of intellectual property transactions thatinvolve a transfer price are (1) a license of a specified bundle of property rights for

intellec-a specified period of time intellec-and (2) intellec-an outright sintellec-ale of the fee simple interest cally) in the property In such transactions, a price has to be determined for the pay-ment by the licensor to the licensee or by the buyer to the seller In addition, thereare less common types of intellectual property transactions, including gifts, contri-butions, abandonments, and like-kind exchanges A transfer price may have to beassigned to these latter types of transactions even if no money is exchanged betweenthe parties This assignment of a transfer or transaction price is often necessitated

(typi-by financial accounting or a taxation requirement

Intellectual property transactions take place between related parties and unrelatedparties Transfer prices between unrelated parties are usually set by the marketplace.That is, the independent licensor and licensee each negotiate in their own best inter-ests The license price agreed to by independent parties negotiating at arm’s lengthgenerally indicates a fair license price for the subject transfer Likewise, the sale price

agreed to by an independent buyer and seller negotiating at arm’s length generallyindicates a fair sale price for the subject transfer.

However, transfer prices between related parties are not set by the marketplace

In fact, the forces of supply and demand may have no effect at all on the transferprice Examples of related parties include the following:

1 Brother/sister corporations (under common parent corporation ownership)

2 A parent corporation and its wholly owned subsidiary

3 A domestic corporation and its foreign affiliate corporation (e.g., domestic

parent/foreign subsidiary or foreign parent/domestic subsidiary)

4 An individual intellectual property developer and his or her closely held

corporation

5 Two divisions or departments within the same corporation

With such related parties, intellectual property transfer (license or sale) prices

do not necessarily reflect market influences And, such related party transfer pricestypically are not based on arm’s-length negotiations Such related party transferprices may be more influenced by a motivation to achieve a desired accounting ortaxation objective than by a motivation to reflect the impact of market forces onarm’s-length bargaining However, related party transfer prices may be set so as toequate to arm’s-length prices

Related parties may elect to use arm’s-length prices in intercompany or party license/sale transfers The parties may decide to use arm’s-length transferprices because they more accurately allocate the true level of economic incomebetween brother/sister companies, parent/subsidiary corporations, and so on Or,the parties use arm’s-length transfer prices because they are required to (1) undergenerally accepted accounting principles (GAAP) or (2) under state, federal, orinternational taxation laws

inter-This book presents a framework that may be used by related parties to emulatethe arm’s-length price negotiation process of independent third parties This bookpresents practical procedures that may be used to estimate what a fair, arm’s-lengthtransfer price would be for the license or sale of an intellectual property The intel-lectual property transfer price conceptual framework and analytical procedures dis-cussed in this book generally reflect the applicable requirements of Internal RevenueCode Section 482

In the new millennium, the market value of many industrial and commercial panies is comprised principally of the value of their intellectual property capital And,

com-in this com-information age, the market value of many companies is based primarily onthe value of their intellectual property Domestic and international businesses, largeand small, rely on their intellectual property to allow them to be first to the mar-ketplace, to have a competitive advantage, and to earn above-normal levels of prof-itability And, both businesses and individuals are much more inclined than everbefore to protect and defend their intellectual property rights through all legal means.Intellectual property transfers (through either license or sale) are now a commoncomponent of the commercial landscape Historically, intellectual properties werecommercially exploited by owner/developers In the last few years, the global econ-omy has provided many more opportunities to commercialize intellectual property.The ability to divide and transfer (through license or sale) intellectual propertyrights allows for the realization of greater value by the intellectual property owner.And, that realization allows for the creation of greater wealth to be shared by theintellectual property owner and users

From an economic history perspective, we can identify the types of property (andproperty rights) that have created wealth in the last few centuries We can trackwhen—and why—the types of properties that create wealth have changed over time.When we consider the major source of capital formation at the turn of the millen-nium, we can see that the type of property that has created the most wealth in thelast few decades is intellectual property.

The history of what we would recognize as modern economics in the westernworld begins in the seventeenth century At that time, the economies of Europe andthe United States were changing from principally agricultural to industrial The pri-mary economic school of thought of the day was the mercantilist school Mercan-tilists concluded that the primary source of wealth during the sixteenth andseventeenth centuries was gold and silver (and, to a lesser extent, other metals such

as copper and iron) This conclusion could be empirically proved on a nationalbasis; the wealthiest countries in the western world had large stockpiles of gold andsilver And, this conclusion was also true, directly and indirectly, on a personal level.Wealth for individuals could be measured directly by a family’s holdings of gold andsilver And, individual wealth was created indirectly by the ownership of businessesthat owned, mined, or traded in gold and silver Accordingly, at this point in eco-nomic history, capital formation was primarily associated with the ownership ofmines And, mines and mining are one form of real estate ownership rights

In the eighteenth century, the physiocratic school of economics was the temporary wisdom This school of thought, originating in France, believed that land

con-in general and agricultural land con-in particular was the prcon-incipal source of national andindividual wealth By the eighteenth century, it was easy for any country to acquirestocks of gold and silver, even if they had no mines All they had to do was tradetheir agricultural production for the precious metals And, this national source ofwealth creation was also the primary source of individual wealth accumulation.Families that owned the source of agricultural production (i.e., land) were the wealth-iest in contemporary society So, during the eighteenth century, agricultural landwas recognized as the primary source of capital formation

In 1776, The Wealth of Nations, Adam Smith’s monumental work, was

pub-lished Many economic historians credit Adam Smith with being the father ofmodern economics Unquestionably, he was the father of the classical school ofeconomics Smith accepted some of the physiocrats’ theories For example, the con-cept of laissez-faire, a national economic policy that calls for minimal governmentregulation of economic activities, is often attributed to Smith Actually, the lais-sez-faire policy was originated by the French physiocrats In any event, Smith’sclassical school identified three sources of wealth creation: land, labor, and cap-ital These are the three factors of production that contribute to national wealth aswell as to individual wealth So, by the end of the eighteenth century, it was widelyrecognized that the sources of income (and the associated accumulation of wealth)were landowners’ ownership of both industrial and agricultural land, workers’ownership of their own labor, and capitalists’ ownership of industrial factoriesand equipment

In the early nineteenth century, several classical school economists expanded

on Smith’s theories David Ricardo studied the distribution of income betweenlandowners, workers, and industrialists In particular, Ricardo identified that, ulti-mately, returns to land, labor, and capital would have to be out of balance This isbecause, over time, there is (1) a fixed supply of land and (2) an expanding supply

of labor and capital

Robert Malthus studied the expanding population trends in the early nineteenthcentury He concluded that lower income returns (and lower wealth generation)would be associated with the labor component of production This was becauselabor (i.e., the western world’s total workforce) was expanding (1) at a faster pacethan capital was expanding and (2) at a faster pace than the remaining supply of landwas decreasing.

John Stuart Mill is recognized as a conceptual leader at the closing stages of theclassical school By the second half of the nineteenth century, Mill agreed with theclassical theory that the three factors of production (and, therefore, wealth) were land,labor, and capital However, his study of historical data convinced him that returns

to these three factors were always out of balance Moreover, Mill concluded that thedistribution of income (both national and personal) would always be out of balanceand, therefore, unfair So, by the 1850s, Mill concluded that governments wouldhave to intervene in the economic system in order to more rationally allocate incomeamong the three sources of wealth

During the second half of the nineteenth century, Karl Marx also studied thissame inefficiency in the allocation of national and personal income (wealth) amongthe three factors of production From the 1840s, landmark Marx publications advo-cated the labor theory of economics Marx believed that landowners and capitalists(the owners of industrial factories and machinery) exploited workers by not givingthem a fair return on their labor Marx predicted that capitalism was only an evo-lutionary phase of economic development, soon to be replaced by a labor-basedeconomic system

In 1936, John Maynard Keynes, authored the landmark General Theory of

Employment, Interest, and Money This textbook is critically important to even the

most cursory review of modern economic theory As a result of Keynes’ theories,the Keynesian school replaced the classical school as the accepted explanation forchanges in wages and prices in the mid-twentieth century However, the Keynes’ textdoes not specifically focus on the creation and allocation of wealth (personal orsocietal) On the other hand, first published around the same time, a finance text-book does focus on the creation of wealth in the twentieth century

In 1934, Benjamin Graham and David Dodd authored Security Analysis This

groundbreaking finance text explained the creation of wealth through the ment analysis of securities Securities, of course, represent indirect ownership inter-ests in capital—that is, the means of production However, in the twentieth century,most of the wealth creation (and certainly virtually all of the personal wealth cre-ation) related to the ownership of securities Business institutions became success-ful through the management of land, labor, and capital (still the three components

invest-of income production) And, individuals created wealth through the ownership invest-ofthe securities of these business institutions

The Graham and Dodd model still works at the beginning of the twenty-firstcentury However, in the last several decades, one component of capital has becomeincreasingly important in the wealth creation process: intellectual capital The end

of the twentieth century has been called the information age, the computer age, thecommunications age, and the technology age When one considers all of these namescollectively, it is easy to conclude that the last few decades can be considered theintellectual property age In addition to controlling land, labor, and traditional cap-ital (factories and equipment), the most successful business institutions today alsocontrol great stores of intellectual capital Intellectual capital includes copyrights,patents, trademarks, and related intellectual property

The Graham and Dodd Security Analysis methodology has evolved in recent

years This is because the traditional Graham and Dodd fundamental analysis ofbusiness institution financial statements does not always capture all of that institu-tion’s intellectual capital However, security prices do seem to capture (and, somemay say over-reward) the value of intellectual capital Wealth creation relates toboth (1) the indirect ownership of intellectual property (through the securities of insti-tutions that successfully profit from their intellectual capital) and (2) the direct own-ership of intellectual property (by individual intellectual property creators)

In summary, the analysis of intellectual capital is an essential element in a ness enterprise valuation That analysis may be explicit or implicit However, the twoanalytical disciplines are conceptually (and professionally) linked This book focuses

busi-on the commbusi-on quantitative and qualitative analyses of business valuatibusi-on and lectual property analysis, particularly with regard to valuation, economic damages,and transfer price analyses

intel-Part I

Business Valuation Technical Topics

Chapter 1

The Equity Risk Premium

Roger J Grabowski and David W King

Introduction Realized Return or Ex Post Approach The Selection of the Observation Period Which Average: Arithmetic or Geometric?

Expected ERP versus Realized Equity Return Premiums Noncontrolling Ownership or Controlling Ownership Interest Returns? Forward-Looking Methods

Bottom-Up Methods Projected Real Equity Returns Surveys

Other Sources Realized Returns and the Size Effect Criticisms of the Small Stock Effect The January Effect

Bid/Ask Bounce Bias Geometric versus Arithmetic Averages Infrequent Trading and Small Stock Betas Delisting Bias

Transaction Costs

No Small Stock Premium Since 1982Summary and Conclusion

Common stocks are riskier investments than government securities Financial theoryholds that investors in common stocks expect a superior return over the expected yield

on government securities as a reward for incurring the extra risk The equity risk

pre-mium (ERP) (sometimes referred to as the market risk prepre-mium) is defined as the

extra return (over the expected yield on government securities) that investors expect

to receive from an investment in a diversified portfolio of common stocks

The ERP is defined as

ERP = R m – R f where R mis the expected rate of return on a fully diversified portfolio of common

equity securities and R fis the rate of return expected on an investment free of defaultrisk, or the risk-free rate

The ERP is a forward-looking concept The ERP is an expectation, as of the uation date, of a rate of return for which no “market quotes” are observable.While one can observe return premiums realized over time by referring to his-

val-torical data (i.e., the realized return approach or the ex post approach), such lated return premiums are only estimates for the expected ERP Alternatively, one

calcu-can directly derive implied forward-looking estimates for the ERP (1) from data

on the underlying expectations of growth in corporate earnings and dividends or (2)

from projections by equity analysts (i.e., the ex ante approach) The goal of either the ex post approach or ex ante approach is to estimate the true expected ERP as of

the valuation date Even then, the expected ERP can be thought of in terms of (1)

a normal or unconditional ERP and (2) a conditional ERP based on current

prospects.1The ERP is an important component in applying the income approach to valu-ation It is one component of most models for estimating the equity discount rate(i.e., rate of return on equity capital or cost of equity capital) including (1) the cap-ital asset pricing model (CAPM), (2) the build-up model, (3) some versions of arbi-trage pricing theory (APT), and (4) the Fama-French three-factor model Estimatingthe ERP may be more important than many other decisions analysts make in apply-ing these theories For example, the effect of a decision that the appropriate ERP inthe CAPM is 4 percent instead of 8 percent will generally have a greater impact onthe concluded discount rate than alternative theories of the proper measure of othercomponents—for example, beta One academic study looked at sources of error inestimating expected rates of return over time and concluded:

We find that the great majority of the error in estimating the cost of capital

is found in the risk premium estimate, and relatively small errors are due tothe risk measure, or beta This suggests that analysts should improve esti-mation procedures for market risk premiums, which are commonly based onhistorical averages.2

Science, April 1998, pp 485–500.

There is no one universally accepted standard for estimating the ERP A widevariety of return premiums are used in practice and recommended by academicsand financial advisors.

Realized Return or Ex Post Approach

Practitioners agree that ERP is a forward-looking concept However, many tioners use historical data to measure it, under the assumption that historical dataare a valid proxy for current investor expectations The realized return approachemploys the return premium that investors have, on the average, realized over somehistorical holding period (i.e., the historical realized premium) The justificationfor using the historical realized premium is based on two propositions: (1) that thepast provides an indicator of how the market will behave in the future and (2) thatinvestors’ expectations are influenced by the historical performance of the market

practi-If period (say, monthly) returns are serially independent (i.e., not correlated) and ifexpected returns are stable through time, then the arithmetic average of historicalreturns provides an unbiased estimate of expected future returns A more indirectjustification for use of the historical approach is the proposition that, for whateverreason, securities in the past have been priced in such a way as to earn the returnsobserved By using the historical realized premium in applying the income approach

to valuation, one may, to some extent, replicate this level of pricing

The selection of an appropriate government security for the risk-free rate is afunction of the expected holding period for the investment to which the discount rate(i.e., the rate of return) will apply For example, if the analyst is estimating theequity return on a highly liquid investment and the expected holding period is poten-tially short-term, then the yield on a Treasury bill may be an appropriate instrument

to use in measuring the historical realized premium

In this book, we are directing our observations principally to the valuation ofclosely held businesses/securities and intangible assets/intellectual properties Theseinvestments are generally thought of as being long-term investments Therefore,there is general consensus in the valuation community that the return on a long-term government bond should be used as the benchmark in calculating the histori-cal realized premium The measure of the risk-free rate is not controversial once theproper term (i.e., long-term versus short-term) of the investment is determined This

is because the expected yield-to-maturity on Treasury securities is directly able in the marketplace.3Accordingly, the differences in approach to estimating theERP effectively hinge on the measure of expected return on stocks

observ-In applying the realized return method, the analyst selects the number of years

of historical return data to include in the average One school of thought holds thatthe future is best estimated using a very long horizon of past returns Another school

of thought holds that the future is best measured by the (relatively) recent past

with the benchmark security used in developing the ERP For example, in this book, we are measuring ERP in terms of the premium

on a long-term government bond, because the data cited herein have been developed comparing equity returns to the income return (i.e., the yield promised at issue date) of long-term government bonds.