If you are a business owner and are either currently considering selling your business or may sell it later on, you will want to carefully consider intangible assets in your business valuation. While these assets have value you don’t want to leave on the table, you will also want to ensure you account for them in the most tax-favorable way you can.
Intangible assets, such as patents, trademarks, and copyrights have long existed. In more recent years, other types of intangible assets have gained legal recognition, such as internet domains and social media presences.
The categories of intangible assets, with examples, include:
- Marketing-related – (trademarks, trade names, brand names, logos)
- Technology-related – (process patents, patent applications, technical documentation, technical know-how)
- Artistic-related – (literary works, musical compositions, copyrights, maps, engravings)
- Data processing-related – (proprietary computer software, software copyrights, automated databases)
- Engineering-related – (industrial design, product patents, trade secrets, engineering drawings and schematics, blueprints, proprietary documentation)
- Customer-related – (customer lists, customer contracts, customer relationships, open purchase orders)
- Contract-related – (favorable supplier contracts, license agreements, franchise agreements, noncompete agreements)
- Human capital-related – (trained and assembled workforce, employment agreements, union contracts)
- Location-related – (leasehold interests, easements, air rights, water rights)
- Goodwill-related – (institutional goodwill, professional practice goodwill, personal goodwill, celebrity goodwill, business going-concern value)
The art of valuation
In general, if a company derives much of its value from intangible assets, it typically warrants a higher risk adjusted rate of return. What that means is an owner of the subject business should achieve a higher return on investment compared to investing in a similar business that has much of its value tied up in physical assets, such as property and equipment. Think of it this way, if you invested your money into General Motors, then you should expect to earn a lower return on your money than if you invested in Apple. Apple has more intangible assets and higher investment risk.
The determination of the appropriate risk adjusted rate of return may come down to idiosyncratic factors. Patents, for example, provide differing levels of protection, depending on their remaining term. A longer remaining life could increase the discounted cash flow. By contrast, that same patent might lead you to reduce your estimated cash flow if it were nearing expiration. How many years does it have left to run, what’s the nature of the competitive landscape, and does a firm’s process generate additional patents over time? Factors such as these will be analyzed to determine what the appropriate risk adjusted rate of return should be as well as the resulting value of intangible assets.
Accounting rules require the recording of goodwill and intangible assets that are acquired in a business combination. Most, if not all, internally developed intangible assets are created over time and are never recorded on a company’s balance sheet. Therefore, there is no place a seller will find his business’s intangible assets recorded, except documentation kept in office files of contracts and related legal documentation that would identify a business owner’s rights. Even if an owner had acquired these assets in a previous business combination, accounting and tax rules allow for writing off the acquisition price over time or if the value is impaired. The result is they may no longer exist on the balance sheet, but even if they did, asset values change over time with changes in the economy and legal status. Thus, all too often sellers only consider goodwill during the sale process and potentially leave money on the table if intangible assets are overlooked.
A business owner thinking about selling his company needs to first think about what makes his business tick. Is it a trained workforce, supplier contract, franchise agreement, location, rights related to a patent, or some other factor. Make a list of potential assets for discussion. Then review internal files and speak to an intellectual property attorney to determine what legal rights the company has. Once a complete list is compiled, then an owner can discuss this list with a qualified professional to ensure that any asset of value is considered in a potential sale. Afterward, a valuation professional can assist with determining values for both the asking price for the business and an allocation of selling price, which will need to be formalized by both the buyer and seller upon a successful sale.
Taxation – how you structure the sale is key
The taxation of all intangible assets is like that of goodwill; it receives capital gain treatment, which means it is taxed at a lower rate than ordinary income taxed at an individual’s marginal rate. For 2022 at the federal level, the maximum capital gains rate is 20 percent while the maximum ordinary income tax rate is 37 percent. This, of course, assumes that the seller structures the sale of the business as an asset sale and liquidates the assets held by the corporation in the process. If the seller is structuring the transaction as a stock sale, then the stock sale will receive capital gain treatment also. The difference is that the actual asset is not sold in a stock sale, only the individual shares of stock change hands while the corporation retains the assets.
A new outlook
This article has highlighted the fact that business owners need to exercise care in the way they think about their business and the assets that contribute to its value. With a new outlook, business owners can move forward and consider what intangible assets they may have rights to and be ready for the ultimate day when a sale is in the works so maximum value can be achieved and help to start their next chapter.
For a deeper dive into the role of intangible assets in your personal circumstances, R&A CPAs has highly qualified professionals—including experts in business valuation—to assist you. Give us a call.