Approaches to Valuing Cost Sharing Buy-Ins
- Buy-in payments are often associated with a cost sharing arrangement (CSA) transaction.
See § 1.482-7 for regulations regarding cost sharing arrangements between related
- Participants should receive arm’s length compensation (a “buy-in”) for “pre-existing”
intangibles that are contributed to a CSA.
- The buy-in should be treated as an intercompany transfer of intangible property
and valued according to § 1.482-7(g)(2).
Valuing Buy-Ins: Analytical Concepts
Isolating the Value of the Pre-Existing Intangibles
Nature of the Intangible
- How do you draw the line between pre-existing intangibles and the covered intangibles
jointly developed by the participants?
- This may be less of a problem with discrete forms of intangible property (pharmaceutical
R&D), but it can be significant problem when intangible property has continuous
qualities or when improvements are incremental (software, some electronics).
- Pre-existing intangibles may reduce the cost of developing the covered intangibles.
A core technology may enable the company to “stand on the shoulders of giants.”
- Pre-existing intangibles may also decrease the time needed to develop the covered
intangibles. Being first, or early, to market may convey substantial benefits.
- In general, pre-existing intangibles may allow resources to be redeployed to other
- Revenue Enhancing vs. Cost Reducing
- Discrete vs. Continuous Generations
- Can be useful in determining a “stock” value of previous intangible expenditures.
- The stock values can then be used as either a proxy asset value (see Capitalized
Cost approach below) or as a means of splitting profits in a residual profit split
Useful Economic Life
Form of Payment
- The definition of useful economic life has been a topic of disagreement between
the IRS and taxpayers.
- A shorter useful economic life will result in a smaller total buy-inpayment.
- How long could the pre-existing intangibles generate intangibleincome with additional
- Would the covered intangibles be possible without the pre-existingintangibles?
- As covered intangibles are exploited (e.g. in products, productionprocesses), to
what extent are the pre-existing intangibles used?
- If the useful economic life can be determined with some accuracy,it can help define
the line between pre-existing and coveredintangibles.
Cost of Capital
- Lump sum payment, installments based on lump sum with interest,or running royalty.
Some valuation methods naturally produce alump sum or royalties. It is possible
to convert between forms.(See examples under Foregone Profits Method below.) (See
FSA200023014 regarding choice of forms.)
- Many of the buy-in valuation methods rely on present valuecalculations. Care must
be taken in selecting an appropriate cost ofcapital.
- Typical estimates include a firm-specific weighted average cost ofcapital, a company’s
hurdle rate if documented, an industryweighted cost of capital, a return on equity
or debt, or rates fromstock analysts’ reports.
- Debt Rate
- Equity Rate
- Beta: Company's vs. Comparables', Product Line vs. Whole Company
- Equity Risk Premium
- Time Period
- Geometric vs. Arithmetic Averages
- Survey Data
- Other Methods (e.g., Supply Side and Demand Side)
- Should profits be measured before or after intangible development expenses?
- If after intangible development expenses, important todistinguish between expenses
for current period andamortization of capitalized expenses.
- Gestation period or Service lag – the time betweenwhen an intangible expense is
made and when it is putinto service.
- Does the buy-in capture any “opportunity value” associated with the pre-existing
- What type of rights in pre-existing intangibles are conveyed?
Buy-In Valuation Approaches
- The 482 regulations cover the named intangible valuation methods – CUT, Profit Split,
- However, often more complicated approaches are used to value buy-ins due to the
- The remainder of this presentation focuses on the most common buy-in valuation approaches
- Each of these methods, however, may be further customized.
Capitalized Cost Method
- If a routine intangible is being valued (e.g., barriers to entry are low and the
probability of successfully creating the intangible is very high), a capitalized
cost approach may warrant attention.
- This is an extension of a company’s “make-or-buy” decision. If risks and other barriers
are low, a company will be indifferent between making or buying at the margin since
capitalized costs should be consistent with the market price.
- Unlike a total cost method, a capitalized cost approach takes into account a return
on intangible investment as well as possible obsolescence.
- Costs are capitalized by adding a capital charge to each year’s development expenses.
A portion may also be subtracted each year for amortization or obsolescence.
- The balance of capitalized costs at a point in time is the “asset” value of the
intangible. In a buy-in context, this can then be subject to step two of the twopart
valuation approach in 482–7(g)(2).
- This method may not produce a reliable value for risky to develop/replicate intangible
assets. The distribution of an intangible’s market price should widen in relation
to its development costs as risk increases.
- Risk adjusted discounting does not necessarily solve this problem.
- This method would also be less reliable if a company was willing to pay a substantial
premium to purchase the intangible today rather than suffer any delays due to internal
- Relies on internal historical data rather than external data or projections, and
internal historical data may be more readily available.
- Can serve as a sanity check for other methods.
- For example, if there are valuable intangibles and the residual profit split method
produces a valuation below that of the capitalized cost method then this may be
an indication that the RPSM has been misapplied.
- Assumes that cost can be a proxy for value. This assumption is rarely valid for
Declining Royalty Method
- Determine initial royalty rate using either CUT or CPM.
- Decline royalty over time by a fixed schedule or the relative shares of intangible
stock (expense) values.
- Can leave as a royalty schedule or use projected financials to calculate a lump
- A quick ramp down of royalties implies a short useful economic life, which implies
a smaller buy-in payment.
- Does not depend upon the participant's actual operating profits.
- May not accurately account for opportunity value associated with pre-existing intangibles.
- Comparability of CUTs are diminished if they do not convey rights to exploit intangibles
for further development.
- Sensitive to useful life and amortization assumptions.
Foregone Profits Method
- What the Donor would expect to earn if it did not donate the intangibles
- What the Donor expects to earn after it donates the Intangibles
- Routine profit for foregone routine activities
- Can also view this from the recipient's perspective
- Regulations (482-4(d))
- Unspecified methods -- (1) In general. Methods not specified in paragraphs (a)(1),
(2), and (3) of this section may be used to evaluate whether the amount charged
in a controlled transaction is arm's length. Any method used under this paragraph
(d) must be applied in accordance with the provisions of § 1.482-1. Consistent with
the specified methods, an unspecified method should take into account the general
principle that uncontrolled taxpayers evaluate the terms of a transaction by considering
the realistic alternatives to that transaction, and only enter into a particular
transaction if none of the alternatives is preferable to it. . . . Therefore,
in establishing whether a controlled transaction achieved an arm's length result,
an unspecified method should provide information on the prices or profits that the
controlled taxpayer could have realized by choosing a realistic alternative to the
controlled transaction. . . . (emphasis added)
- Example. The following example illustrates an application of the principle of this
- USbond is a U.S. company that licenses to its foreign subsidiary, Eurobond, a proprietary
process that permits the manufacture of Longbond, a long-lasting industrial adhesive,
at a substantially lower cost than otherwise would be possible. Using the proprietary
process, Eurobond manufactures Longbond and sells it to related and unrelated parties
for the market price of $550 per ton. Under the terms of the license agreement,
Eurobond pays USbond a royalty of $100 per ton of Longbond sold. USbond also manufactures
and markets Longbond in the United States.
- In evaluating whether the consideration paid for the transfer of the proprietary
process to Eurobond was arm's length, the district director may consider, subject
to the best method rule of § 1.482-1(c), USbond's alternative of producing and selling
Longbond itself. Reasonably reliable estimates indicate that if USbond directly
supplied Longbond to the European market, a selling price of $300 per ton would
cover its costs and provide a reasonable profit for its functions, risks and investment
of capital associated with the production of Longbond for the European market. Given
that the market price of Longbond was $550 per ton, by licensing the proprietary
process to Eurobond, USbond forgoes $250 per ton of profit over the profit that
would be necessary to compensate it for the functions, risks and investment involved
in supplying Longbond to the European market itself. Based on these facts, the district
director concludes that a royalty of $100 for the proprietary process is not arm's
- Provides for a fair game, fair gamble by cost-sharing participants (no ex ante windfall
for either participant)
- Recipient generally benefits if actual profits exceed expectations.
- Relies on forecasted data for taxpayers
- If company may not use forecasts:
- Stock analysts routinely forecast future profits
- One can use historical company data, industry projections
- Need to determine the reasonableness of the forecasts
- Can use CPM or other benchmark data to calculate routine profits for participants.
- After computing stream of each year’s projected foregone intangible profits, can
specify buy-in as:
- Yearly projected foregone profits, payable each year.
- Royalty rate each year computed as that year’s projected foregone profits divided
by that year’s projected sales.
- Present value lump sum based on the projected foregone profits.
- Fixed or declining royalty rate based on present values of projected foregone profits
and projected sales.
- The largest component of the buy-in value may be the “terminal value,” which can
be extremely sensitive to the cost of capital used (higher cost of capital yields
a lower terminal value).
- Reflected in Projected Decline in Intangible Profits Over Time
- Models may include two, three, or more time stages,each with different characteristics
(e.g., differentrates for sales growth or R&D growth)
- Consider profitability assumed in terminal value
- Reflected in Assumption that Abnormally High Growth Rate Will level Off
- Compare with economy / industry
- This method can better capture the opportunity value from using pre-existing intangibles.
- Variant on standard valuation methodology used by valuation professionals.
- Requires predicting future results.
- Sensitive to cost of capital and useful life assumptions.
Profit Split Method
- This may be the most common approach presented by taxpayers.
- Calculate the participant’s financial results that include its use of the pre-existing
- Then remove the routine profit component. Can use a CPM or other benchmark data
to extract the participant’s routine returns.
- The remaining profits can be split between the participants based on various measures
of their past and on-going contributions to the development of the pre-existing
and covered intangibles. For instance, their respective capitalized or non-capitalized
intangible development costs can be used.
- Care must be taken to calculate profits attributable only to the pre-existing intangibles.
- Sensitive to useful life, amortization assumptions.
- Using intangible development costs (IDCs) to split profits assumes that all such
expenses should have equal weight.
- But the value of past R&D/IDCs may be proven, whereas the value of future R&D/IDCs
- Adjustment may be warranted to correct the equal weighting assumption for R&D/IDCs
- “The reliability of this method could be particularly adversely affected if capitalized
costs of development are used to estimate the value of intangible property because
such costs may bear no relation to market value, calculation of such costs may
require allocation of indirect expenses between the relevant business activity and
the controlled taxpayer’s other lines of business, and capitalizing costs requires
assumptions regarding the useful life of intangible property.” (emphasis added)
(Preamble to Section 482 Regulations)
- Therefore, the reliability of profit split method may decrease if the intangibles
being donated are highly valuable compared to capitalized costs but the costs shared
intangibles are not.
- Naturally includes commensurate with income adjustments to the royalty, provided
one can reliably split the residual profit.
Types of Acquisitions:
- Internal Acquisitions
- One of the CSA participants has purchased technology that it has made available
to the cost-sharing participants.
- Provides a direct measure of a component of the buy-in.
- Comparable Acquisitions
- A third party has acquired the same or similar intangibles.
- Normal rules on comparability apply.
Direct Acquisition Method
- Calculation of the value of the covered intangibles:
Market value of the acquired
Less: Value of the acquired company's tangible assets
Less: Value of irrelevant intangibles
Equals: Value of covered intangibles
Comparable Acquisition Method
- This method typically requires a valuation multiple approach. Examples include price
to sales, cash flow, or assets.
- The valuation multiple is then applied to the same base for the participant to estimate
a market price, which then is used to calculate a buy-in value as in the Market
Capitalization Method discussed below. (The participant may have no market price
of its own because it is closely held or is part of a larger entity with combined
- Advantage: uses third party sales of technology.
- However, as with any valuation multiple approach, scaling can be a problem.
- Small acquired companies with little sales (perhaps in start-up or high growth phase)
can yield skewed multiples.
- Provides a market valuation for the buy-in.
- This approach does not require separate estimate of useful economic life, the appropriate
cost of capital, or the gestation period.
Market Capitalization Method (MCM)
- Theoretically, a company’s market value should be the present value of its expected
- MCM is a “top down” approach that arrives at the value of the transferred intangibles
by netting out everything else.
- One of the biggest challenges is valuing what to exclude.
- A Commonly Used Formula is: Total Market Capitalization (Market value of shares
outstanding) + Liabilities (Book Value) - Book Value of Assets (Gross
or Net Value) = Market Value of Firm Intangible Assets - Non-compensable
Intangibles = Value of pre-existing Intangibles
- The market value of firm intangible assets is typically allocated across a set of
identified intangible assets (compensable and non-compensable).
- If intangible development costs can be identified, the capitalized cost method can
be used to calculate the stock values of the identified intangible assets.
- The market value of the firm’s assets is then allocated across the intangible stock
values on a pro-rata basis.
- The market value of firm intangible assets allocated to the pre-existing intangibles
made available to the cost sharing participant(s) is the buy-in value.
- If a non-compensable intangible can be valued reliably on an absolute basis using
a cost capitalization method, its value may simply be subtracted from the market
value of firm intangible assets rather than be placed into the intangible allocation
- Control Premium
- The starting value of the analysis, the total market capitalization, represents
a minority valuation. Should a control premium be added to convert it into a controlling
- The buy-in is easy to calculate as of the start date of the CSA.
- In theory, the value is determined by investors with unbiased expectations of future
- MCM results may be compared to foregone profits method results to assess the reliability
of internal company projections (inside vs. outside knowledge).
- This method is less dependent upon separate estimates of the company’s cost of capital
and the intangible’s gestation period and useful economic life.
- In a bubble market the price may deviate from valuation fundamentals. But perhaps
an adjustment can be made.
- Market valuation can fluctuate significantly from month to month, and such fluctuations
may appear to be unrelated to its pre-existing intangibles. One solution may be
to use average stock prices instead of a single stock price to smooth out the variation.
- The allocation base specified may improperly omit certain items. If so, the values
of any omitted intangibles will be allocated across the specified intangibles. This
problem may be avoided through careful analysis of the taxpayer and its functions.
- Not clear how periodic adjustment would be administered. But other methods also
provide this challenge.