SPEEM method for determining royalty rates when CTM fails.

We can determine the royalty rate in various ways, depending on whether data on comparable uncontrolled transactions is available. In the first case, we use the comparative method in the market approach (CTM). For this purpose, we use commercial databases of licensing or M&A transactions.

In the absence of comparable data, it is permissible to use “valuation techniques” in the income approach. One such method is the Single Period Excess Earnings Method (SPEEM).

In each case, we must realise the following steps:

• Identification of the IP and its fields of exploitation
• Analysis of the license agreement and the roles of the transaction parties (functions, assets, risks)
• Estimation of the role of IP and other assets in the profit-generating process
• Establishing comparability criteria
• Conducting a transaction data search
• Adjustment for specific license agreement regulations

Origin and application of the SPEEM method

Valuation standards define the Excess Earnings Method/Multi-period Excess Earnings Method (EEM/MEEM). We use this method to value intangible assets (e.g., goodwill, brand, customer relationships, know-how) by capitalising (EEM) or discounting (MEEM) future cash flows/excess earnings (IVS 210 Intangible Assets).

We will use this method to determine or verify the royalty rate when:

• The CTM method’s results for determining royalty rates require additional validation. For example, when there are few licensing transactions, or they are poorly comparable.
• There is a lack of comparable data due to the IP’s unique characteristics and/or its fields of exploitation. For example:
  • The IP has a low level of market readiness,
  • The IP is associated with a unique technology, product, or service,
  • The license agreement contains specific provisions.

Classical versus percentage version of the SPEEM method

In the “classic” version, it is necessary to establish data in monetary terms. It includes: average revenue, operating profit, and the market value of tangible assets.

Procedure for the classic version:

• We determine normalised revenue and profit (average values ​​from previous years. We adjust them for one-time items or for the forecast of the license agreement term.
• We identify the need for tangible assets to support the licensed asset. It requires determining the fair market value of the necessary working capital and fixed assets.
• We determine the desired return on tangible assets. We use the fair rate of return as a percentage of the assets’ value.
• We calculate the excess profit generated by the IP portfolio. This portfolio includes complex intangible assets classified as goodwill. This step reduces normalised profit by the return on tangible assets.
• We determine the percentage share of the licensed asset in the IP portfolio. We have to assess the asset’s weight in generating excess profit.
• We calculate the portion of excess profit generated by the licensed asset.
• We determine the royalty rate by relating the result of the previous operation to revenue or profit. It means the basis for calculating royalty payments is based on the agreement.

In the percentage variant of SPEEM, we replace the amount data with percentage indicators. It means that we are tacitly assuming a linear relationship between the key parameters of the model.

Where:

R_% is the royalty rate expressed as a percentage of net revenue (excluding VAT).

EBIT_% is the projected profitability ratio for the IP Portfolio’s operational use.

PS_% is the IP Portfolio’s share of operating profit generated from intangible assets.

r_wc is the cost of capital required on working capital.

WC_% is the working capital requirement ratio (WC/365) in days.

r_as is the cost of capital required on fixed assets.

FAT_% is the fixed asset turnover ratio (1/FAT) – where FAT is the fixed asset turnover ratio.

An example of using SPEEM in the percentage version

The subject of the license is industrial property rights that protect new active substances used in feed additives. License to use IP (brand + know-how + patents) in the field of dietary supplements and feed additives. Informational terms:

• Full license – all fields of exploitation, long term, royalty rate calculated as a percentage of revenue.
• Lack of historical data. An innovative product was introduced to the market by a strong licensee, a company from the licensor’s international capital group.
• New market niche. The capital group has not previously been present in the animal feed additives market.
• The CTM method yielded a wide range of royalty rates, from 3% to 12%, with a median of 7%. Only five licensing transactions were used as comparables.

In our opinion, there was a significant risk of determining the transfer price based on the CTM method results. We decided to verify or refine the result using an alternative approach (applying a valuation technique).

Source data and calculation

We obtained the needed financial indicators and transaction parameters from financial and transaction databases. We assumed the values ​​for individual model variables to be ranges. Ranges are based on interquartile data for the portfolio of industry entities and comparable transactions. A stochastic model was used, with key parameters modelled as random variables.

We present the results of processing 5,000 scenarios in the table and graphs.

The economically rational royalty rate is 90% likely to be between 4.71% and 7.15%. The narrower interquartile range is 5.3% to 6.4%, with a median of 5.8%.

We clarified the CTM method result using the SPEEM method in the income approach.

Pros & Cons of Using the SPEEM Method

The SEEM method has both strengths and weaknesses.