What Is the Royalty Relief Method in Asset Valuation?

Intangible assets, such as brand names, patents, and customer relationships, are often a company’s most valuable resources. Accurately determining their monetary worth is necessary for financial reporting, mergers and acquisitions, and tax compliance. The royalty relief method is a widely accepted valuation technique under the income approach that provides a logical framework for this purpose. It is used to value assets like trademarks, patents, and licensed software where a direct revenue stream can be identified.

Core Concept of the Royalty Relief Method

The royalty relief method is built on a hypothetical premise: what would a company have to pay in royalties if it did not own a specific intangible asset and had to license it from a third party? The value of owning the asset is, therefore, the total amount of these royalty payments that the company avoids, or is “relieved” from, paying. This approach quantifies the economic benefit of ownership by calculating the present value of these saved royalty payments over the asset’s lifespan.

This concept can be compared to the financial difference between owning and renting a home. A homeowner avoids a monthly rent payment, and the cumulative value of these avoided payments over many years represents a financial benefit of ownership. Similarly, a company that owns a brand name avoids paying a licensing fee to use it. The royalty relief method calculates the value of the brand by totaling these hypothetical, avoided payments and adjusting them to their current worth.

The method is considered a hybrid, combining elements of both the market and income approaches to valuation. It uses market-based data to determine a comparable royalty rate, reflecting what others pay for similar assets. It also incorporates the income approach by using the company’s own financial projections, such as future revenue and growth rates, to calculate the value derived from those avoided payments.

Gathering Key Inputs for the Valuation

Revenue Projections

The starting point is a forecast of revenues from products or services associated with the intangible asset. These projections should be grounded in the company’s historical performance, strategic plans, and an analysis of market conditions. For example, valuing a patent requires projecting sales of the associated product over the patent’s remaining life.

Applicable Royalty Rate

The royalty rate is the percentage of revenue that would hypothetically be paid to license the asset. Determining an appropriate rate involves researching comparable licensing agreements for similar assets in the same industry, often found in commercial databases. The selected rate must be defensible and reflect the asset’s specific characteristics, including its strength, market position, and any legal protections.

Asset’s Remaining Useful Life (RUL)

The remaining useful life (RUL) is the time period over which the intangible asset is expected to generate economic benefits. This period is defined by various factors. For a U.S. utility patent, the RUL is based on its legal term of 20 years from its filing date. For other assets, such as trademarks, the RUL might be influenced by technological obsolescence or market trends and could be considered indefinite.

Tax Rate and Tax Amortization Benefit (TAB)

Hypothetical royalty savings must be considered on an after-tax basis, using the company’s effective corporate tax rate. The valuation must also account for the Tax Amortization Benefit (TAB), which is the value of tax deductions from amortizing the asset’s cost if it were purchased. For tax purposes, many acquired intangible assets can be amortized over a 15-year period, creating a “tax shield” that enhances the asset’s fair market value.

Discount Rate

Future cash flows must be converted to their present value using a discount rate. This rate should reflect the specific risks associated with the intangible asset’s projected cash flows. A common starting point for determining this rate is the company’s Weighted Average Cost of Capital (WACC), which is often adjusted to account for the higher risk profile of a specific intangible asset.

Performing the Royalty Relief Calculation

The first step is to calculate the pre-tax royalty payments for each year of the asset’s remaining useful life by multiplying the projected annual revenue by the selected royalty rate. For instance, if projected revenue is $10 million and the royalty rate is 5%, the hypothetical royalty payment for that year would be $500,000. This calculation is repeated for every year within the asset’s RUL.

Next, these annual royalty savings are adjusted for taxes to reflect the actual cash benefit to the company. The gross royalty saving for each year is multiplied by (1 – the corporate tax rate). Using the previous example with a 25% tax rate, the after-tax royalty saving would be $500,000 multiplied by (1 – 0.25), which equals $375,000. This step is needed because royalty payments are tax-deductible, so the ‘saved’ payment provides a benefit net of the tax deduction that would have been realized.

With a series of after-tax royalty savings calculated for each future year, the next step is to determine their present value. Each year’s after-tax saving is discounted back to its value today using the selected discount rate. The sum of these individual discounted cash flows provides the initial value of the intangible asset before considering any additional tax benefits. This process accounts for the financial principle that money received in the future is less valuable than money received today.

The final step is to incorporate the Tax Amortization Benefit (TAB). The TAB represents the present value of the tax savings the company will realize by amortizing the asset’s value for tax purposes. This benefit is calculated and added to the present value of the after-tax royalty savings to give the final, full fair value of the intangible asset.