David Anderson is principal of David Anderson & Associates, a Philadelphia forensic accounting firm that provides a full range of fraud investigation, fraud deterrence, litigation support and expert witness testimony services in Philadelphia and the Delaware Valley.
Business valuation experts often are asked to value intangible assets of companies. A major component of such assets is intellectual property, which is defined by the World Intellectual Property Organization as creations of the mind such as inventions; literary and artistic works; designs; and symbols, names and images used in commerce. The four most well-known categories of intellectual property are: patents, copyrights, trademarks, and trade secrets. This blog post will focus on valuing trade secrets.
To obtain a better understanding of trade secrets, I spoke with Charles S. Marion, Esq., an intellectual property and business litigation partner with the Philadelphia law firm of Pepper Hamilton, LLP. He defined a trade secret as information that derives economic value for not being generally known or readily accessible by others, and for which the owner has taken steps to protect its secrecy. He cited the formula for Coca-Cola and the recipe for Kentucky Fried Chicken as two of the more well-known examples of trade secrets.
When I asked why someone would not just patent the intellectual property instead of keeping it a trade secret, Marion provided several reasons, most notably:
- The limited patent monopoly (up to 20 years from the time an application is filed);
- The expense of applying for the patent in the United States;
- The expense of applying for the patent in other countries throughout the world; and that
- The patent could provide enough detail to allow a competitor to reverse engineer it and design an alternative that would allow the competitor to avoid infringing on the patent.
- For example, Marion said a trade secret can exist universally and, if protected properly, can last forever – again citing the Coca-Cola formula.
Marion said that until May 2016, trade secrets generally were protected under state laws (usually under the Uniform Trade Secrets Act). However, about a year ago, the Defend Trade Secrets Act (“DTSA”) was signed into law creating a federal cause of action for misappropriation of trade secrets. The DTSA allows for injunctive relief, monetary damages, and civil seizure of property as potential remedies for companies from whom trade secrets have been misappropriated. The DTSA also provides for whistleblower protection.
Marion said about 20 states have adopted the doctrine of inevitable disclosure, under which a former employer may be able to prevent its former employee from working in certain areas for its new employer (and the former employer’s competitor) where doing so would inevitably result in the former employee using or disclosing trade secrets and other confidential and proprietary information or know how the former employee learned and used while working for the former employer. Marion said the act most often applies to software designers and engineers who leave one company for another.
Marion further stated that if a company wishes to file trade secret litigation to prove its case, it will eventually be required to disclose its trade secret, subject to differing levels of confidentiality (such as attorney’s eyes only and/or subject to a protective court order).
In valuing a trade secret, the business valuation expert must be able to identify each specific trade secret as a separate asset. The value of the trade secret is equal to the economic benefit the owner receives from the ownership or use of the trade secret. This could include:
- Sales or market share related to the trade secret;
- Price premiums or cost savings related to the trade secret;
- Licensing fees received; and/or
- Royalties avoided from having to be licensed from others.
With a trade secret, these economic benefits can be enjoyed for as long as the trade secret can be maintained and if it remains relevant (for example, if a dial telephone contained a trade secret, its economic benefit would have been lost as dial telephones were phased out).
The business valuation expert may work closely with an intellectual property attorney such as Marion to answer such questions as:
- Does the property qualify as a trade secret under either state or federal law?
- Is the information not generally known?
- Has the owner taken reasonable steps to keep it a secret, including:
- using encryption and password protection on electronic files;
- using confidentiality and non-competition agreements; and
- taking other necessary steps to protect the trade secret after a knowledgeable employee leaves the company?
As with any valuation, the business valuation expert uses the same three valuation approaches: income, asset and market:
- Under the income approach, the expert must be able to quantify the specific economic benefits derived, such as increased revenue, increased profits and/or reduced costs as well as the expected time frame over which the economic benefits are derived.
- Under the asset approach, the expert must be able to quantify either the historical costs of the trade secret or what it would cost to recreate the trade secret as of the valuation date.
- Under the market approach, the expert must be able to identify market transactions for comparable trade secrets.
For trade secrets, the market approach is usually the most difficult method to use, as public information is usually not available regarding the sale of a trade secret and, even if such information is available, the trade secret may not be directly comparable to the trade secret being valued (for example, if the public information is about a formula/recipe for a salad dressing, how closely comparable is this to either Coca-Cola’s formula or Kentucky Fried Chicken’s recipe?).
Additionally, the asset approach will usually yield the lowest value because it does not consider the ongoing economic benefits of the trade secret. As a result, most trade secret valuations rely upon the income approach as their most likely basis for valuation. Also, as discussed above, the business valuation expert must determine a reasonable time frame over which the trade secret’s economic benefits are expected. This can be especially difficult for technology trade secrets due to the increased pace of technological innovation.
If you require the services of a Certified Valuation Analyst or any other forensic accounting services in Philadelphia and the Delaware Valley, please contact the Philadelphia forensic accounting firm of David Anderson & Associates by calling David Anderson at 267-207-3597 or emailing him at firstname.lastname@example.org.
About David Anderson & Associates
David Anderson & Associates is a Philadelphia forensic accounting firm that provides a full range of forensic accounting services in Philadelphia and the Delaware Valley. The experienced professionals at David Anderson & Associates provide forensic accounting, business valuation, fraud investigation, litigation support, economic damage analysis, business consulting and outsourced CFO services. Company principal David Anderson has more than 30 years of experience in financial and operational leadership positions and is a Certified Public Accountant, a Certified Fraud Examiner and a Certified Valuation Analyst.