What Is the Relief From Royalty Method?

The relief from royalty method is a valuation approach used to determine the worth of intangible assets like patents, trademarks, and proprietary technology. Its principle is to calculate an asset’s value based on the hypothetical royalty payments the owner avoids by owning it instead of licensing it from a third party. This technique blends market and income approaches by using market data to find a suitable royalty rate and then forecasting the asset’s future revenue stream, which is discounted to a present-day value.

Core Components of the Calculation

Projected Revenue

The foundation of the calculation is the projection of future revenues directly attributable to the intangible asset. This forecast of sales from products or services relying on the asset should be based on historical performance, market growth, and economic conditions. For example, when valuing a trademark, one would project revenue from all products bearing that brand. The time horizon for these projections is dictated by the asset’s remaining useful life.

The Royalty Rate

The notional royalty rate represents the percentage of revenue that would be paid in an arm’s-length transaction to license the asset. To determine this rate, analysts research databases of licensing agreements for comparable assets to find a rate that reflects the specific industry and territory. Factors influencing the royalty rate include the asset’s strength and exclusivity, the profitability of the products it supports, and prevailing industry rates. For instance, royalty rates for pharmaceutical patents are higher than those for consumer product trademarks due to different market dynamics.

The Asset’s Remaining Useful Life (RUL)

The remaining useful life (RUL) is the estimated time period over which an asset is expected to generate economic benefits, defining the duration for the calculation. The RUL is determined by legal, technological, or economic factors. For a patent, the RUL is limited by its statutory life, which is 20 years from the filing date in the United States. For assets like well-established trademarks, the RUL may be considered indefinite, in which case a terminal value is calculated to capture value beyond the forecast period.

The Applicable Tax Rate

The applicable tax rate is used to calculate the after-tax cash flows from the hypothetical royalty payments. Because royalty payments are tax-deductible, the “relief” from these payments must be adjusted for taxes to reflect the true economic benefit. The calculation uses the company’s effective corporate tax rate to convert pre-tax royalty savings into an after-tax amount, representing the real savings realized.

The Discount Rate

The discount rate is the rate of return used to convert future after-tax royalty savings into their present value, accounting for the time value of money and risk. The Weighted Average Cost of Capital (WACC), which is the company’s blended cost of capital, is often used. The discount rate may be adjusted to reflect the specific risks of the intangible asset itself, as a more uncertain revenue stream warrants a higher discount rate and results in a lower present value.

The Valuation Process

Forecast Royalty Payments

The first step is to calculate the stream of hypothetical royalty payments over the asset’s remaining useful life. This is done by applying the royalty rate to the projected revenue for each year. For instance, if projected revenue is $10 million and the rate is 5%, the royalty payment is $500,000. This process is repeated for every year within the RUL to determine the gross savings.

Apply Taxes

Next, the annual gross royalty savings are adjusted for taxes. Each year’s forecasted payment is multiplied by (1 – the corporate tax rate) to find the after-tax royalty savings. This adjustment is necessary because by owning the asset, the company forgoes the tax deduction it would have received from paying royalties. The resulting after-tax figure is the true economic benefit.

Calculate Present Value

After establishing the series of future after-tax savings, their present value is calculated. This is done by applying the discount rate to each year’s after-tax saving to determine its worth in today’s dollars, reflecting that a dollar today is worth more than a dollar tomorrow. The sum of these discounted values represents the value of the intangible asset before considering any additional tax benefits from amortization.

Incorporate the Tax Amortization Benefit (TAB)

A final adjustment is the addition of the Tax Amortization Benefit (TAB). The TAB is the present value of tax savings a company will realize from amortizing the intangible asset for tax purposes. Under U.S. tax law, an acquired intangible asset’s value can be deducted over a statutory period, reducing taxable income. This future stream of tax deductions has a present value, which is added to the present value of the royalty savings to determine the asset’s final value.

Common Applications

• Financial Reporting: This method is used for purchase price allocations under Accounting Standards Codification (ASC) 805. When a company is acquired, the purchase price must be allocated to the identifiable assets, including intangibles like trademarks and patents. The values determined through this method are then recorded on the acquirer’s balance sheet to ensure financial statements accurately reflect the value of all assets.
• Tax Planning and Compliance: The method is used in transfer pricing to support royalty rates charged between related corporate entities in different tax jurisdictions. It helps demonstrate that rates are comparable to market rates, as required by tax authorities. It is also used for other tax-related valuations, such as for estate and gift tax purposes or when contributing an intangible asset to a corporation.
• Litigation Support: In legal disputes involving patent or trademark infringement, this method can calculate economic damages. It is used to determine a reasonable royalty that an infringer should have paid to license the intellectual property, which can serve as a basis for awarding damages to the asset owner.
• Strategic Decision-Making: Companies use this method for internal planning to decide if it is more advantageous to acquire an asset or license it. It provides a financial metric to compare the costs and benefits of ownership. A company can also use this method to set an appropriate royalty rate when licensing its own technology or brand to others, informing strategies for commercial agreements.