Zachary C. Reichenbach CFA, CPA/ABV
Manager, Ellin & Tucker
Businesses in the United States have a trade secret problem. Four out of five senior executives say their business’ trade secrets are an important and/or essential part of their business.¹ The majority of businesses in the U.S. do not know if their trade secrets have been stolen and do not have action plans in responding to thefts of trade secrets.² According, to the U.S. Department of Commerce, trade secret theft costs U.S. businesses approximately $300 billion annually which is a significant.³
Knowing and understanding your business’ trade secret is important but it is equally important to know the value of your trade secret. This knowledge is helpful for business planning and also in case the trade secret is stolen.
According to 18 U.S.C. §1839(3), a trade secret is defined as all forms and types of financial, business, scientific, technical, economic or engineering information. Trade secrets are typically owned by a company and information about the trade secret is not usually known outside that particular company. In many instances, the trade secret provides a company with a competitive advantage and provides some sort of economic value to a company. Some additional characteristics of trade secrets are as follows:
- Trade secrets are not known outside of the particular company
- They are valuable to the owner and possible competitors
- It costs time, effort and money to develop trade secrets
- These are known only by employees and others involved in the company
- It is difficult for others to acquire or independently duplicate these secrets
- They are subject to reasonable measures to guard the secrecy of the information
Almost every business has some form of trade secrets. Trade secrets take the form of manufacturing processes, inventions, software source code, and business knowledge of a particular industry. For example, many investment management firms have financial models that they use to value particular businesses and assets. The financial models created by these firms have the potential to be a trade secret. In the event a competitor obtains these financial models, the competitor could stand to gain economic value through their use.
Another example of a trade secret could be a company’s algorithm. Take Google for example. They developed a search algorithm and continue to refine it but this trade secret makes it the top search engine in the world. Without this algorithm, Google likely would not be the company it is today. Another example of trade secrets are Coca Cola and Kentucky Fried Chicken. Each business has a recipe that has helped it develop sales and profits over the years. Each recipe is valuable to the business and is a direct driver of sales. In the event that a competitor of any of these companies steal their trade secrets, then this is an advantage and economic value to the competitor.
Many companies do not know the value of their trade secret even though their trade secret might be the driving factor in generating sales for the company. The trade secret might be synonymous with a company; however, management might not know the value of their trade secret. There are many reason for knowing the value of the Company’s trade secret, including:
- Transaction Purposes: A company might be able to sell its trade secret and/or license the trade secret for a royalty. In this instance, the value of the trade secret would affect the purchase price to the acquirer and/or the licensee fee paid by the licensor.
- Financial Statement Reporting Purposes: The Accounting Standards Codification, Topic 805 (ASC) determines the accounting for business combinations, including the valuation of identifiable intangible assets. Trade secrets are considered identifiable intangible assets and thus need to be valued for financial statement purposes.
- Strategic Planning Purposes: Knowing the value of a trade secret might help the company’s management identify opportunities for the business and opportunities for growth in the industry.
- Bankruptcy Purposes: If the company owns a trade secret and has filed for bankruptcy, the bankruptcy court might want to know the value of the company’s trade secrets.
- Litigation Purposes: A company might be in litigation for a variety of reasons, including the misappropriation of their trade secret. For example, a former employee might have stolen the company’s trade secret prior to leaving the company. As a result, the court might need to determine the value of the trade secret in order to assess the damages.
As you can see, there are a variety of reasons for determining the value of trade secrets. There are three widely accepted approaches to value a trade secret: the market approach, the cost approach and the income approach. Each method is summarized below.
Market Approach
The market approach uses market data to derive the value of a trade secret. Market data can be in two forms. The first form is through historical, comparable acquisitions of trade secret from other companies. A company might sell its trade secrets to another company for a specific price and that price for the trade secrets can be used to value the subject company’s trade secret. The other form of market data is using historical, comparable license agreements where a trade secret is licensed to another company for a fixed or variable fee. The data from the comparable license agreements may indicate the value of the trade secret based on the terms of the license agreement.
The market approach is difficult to use in valuing trade secrets, as there is limited market data available on trade secrets. Trade secrets are specific to a company and an industry and finding market data is often difficult. In addition, available data is usually not complete and some of the detailed information may not have been disclosed. As a result, it can be difficult to find market data that discloses all the information necessary to value a trade secret.
Both scenarios are present-valued back to the valuation date using a discount rate. The difference from owning the trade secret versus licensing the trade secret results in the value of the trade secret.
Cost Approach
The cost approach considers the costs associated with creating the trade secret. Valuing trade secrets under the cost approach utilizes the costs (i.e. reproduction costs) that it would take for a competitor to recreate the trade secret. These costs should be adjusted for inflation, replacement cost, and obsolescence. Therefore, the total adjusted costs associated with reproducing the trade secret is the value of the trade secret.
The cost approach is often difficult to use in valuing trade secrets, as it is difficult to estimate the costs associated with reproducing the trade secret. It is also challenging to identify the costs for a competitor to recreate the trade secret. Many companies with trade secrets created them a long time ago and have most likely evolved them over the years. Identifying the cost and estimating the amount can be a difficult or impossible task.
Income Approach
The income approach uses the present value of cash flows generated by the company’s trade secret to determine the value of the trade secret. This is the most common approach when valuing trade secrets. The two most common methods under the income approach for valuing trade secrets are the incremental value method and the relief from royalty method.
Under the incremental value method, also known as the “with and without” method, the timing and amount of future cash flows is determined under two scenarios: the “with” scenario and the “without” scenario. For the “with” scenario, the cash flows and timing of cash flows are determined under the assumption that the company owns the trade secret. For the “without” scenario, the cash flows and timing of cash flows are determined assuming the company does not have the trade secret or if the trade secret were public knowledge.
There are variations in income and expenses for each scenario which needs to be carefully analyzed. Typically, the “without” scenario will have less income and, as a result, cash flows since the company does not own the trade secret. In addition, certain costs such as security costs associated with protecting the trade secret might not be incurred in the “without” scenario. The cash flows in both scenarios are present valued back to the valuation date using a discount rate that is considered for each scenario.
The relief from royalty method is similar to the incremental method in that it utilizes two scenarios; however, the alternative scenario is derived differently. In the incremental method, the alternative scenario is the “without” scenario. In the relief from royalty method, the alternative scenario adjusts the cash flows to assume that the company licenses the trade secret versus owning it. In this scenario, a royalty expense is included in the analysis. Both scenarios are present-valued back to the valuation date using a discount rate. The difference from owning the trade secret versus licensing the trade secret results in the value of the trade secret.
To determine what the royalty rate would be in the relief from royalty method, various databases could be used to determine what the market average royalty rate is for the industry. The subject company’s historical license agreements, to the extent they exist, can also be used as a proxy to determine what the royalty rate would be if the company were to hypothetically license the trade secret.
In conclusion, there are a variety of reasons to value trade secrets and there are a number of different methods to use in the valuation process. Each method has its advantages over others and the method used could be dependent on the purpose in which the trade secret is being valued. Knowing the value of the trade secret could be the critical piece that allows the business to recover its trade secret and not be one of the many firms in the U.S. to have their trade secrets stolen. More importantly, knowing the value might help prevent businesses from being one of the many companies that contribute to the $300 billion annually in trade secret theft costs.⁴
References
1. Baker McKenzie, “Companies Failing to Protect Their Trade Secrets”, (http://www.bakermckenzie.com/en/newsroom/2017/06/companies-failing-to-protect-their-trade-secrets/). Accessed on October 26, 2017.
2Ibid.
3. Statistic from U.S. Department of Commerce (http://www.commerce.gov); article titled: “Protecting America’s Secret Sauce: Trade Secret Protection for American Innovators.” Accessed on October 26, 2017.
4. Statistic from U.S. Department of Commerce (http://www.commerce.gov); article titled: “Protecting America’s Secret Sauce: Trade Secret Protection for American Innovators.” Accessed on October 26, 2017.