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Sep 30, 2014

A Primer for Valuation Catalogs

Featuring Mandeep Sihota

Originally appeared in Law Journal Newsletters’ Entertainment Law & Finance, Sept. 2014, www.ljnonline.com. Reprinted with permission.

Interest in the value of intellec­tual property created and held by musicians has been increasing in recent years. Some artists approach­ing retirement age look to cash out of their music assets by selling their holdings to a growing pool of in­terested buyers. Interested buyers include alternative investment man­agers, such as private equity and hedge fund advisors, looking for as­sets that can offer their investors a stable stream of income. Other art­ists are trying to take advantage of estate and gift regulations to mini­mize the taxes paid by their estates.
 
The rights to a music catalog can be held outright by the artists, with­in a pass-through legal entity, such as a limited liability company or partnership, or within a corporate entity or trust. How are these music assets valued?
 
Music Catalog
 

To accurately value an artist’s mu­sic catalog, a review of the following documents is a good starting point:
  • List of song/composition titles with their respective publica­tion dates;
  • Tax returns of the person or en­tity receiving the royalties for five to seven years preceding the valuation date;
  • Annual royalty statements as collected and documented by performing rights organizations for five to seven years preceding the valuation date;
  • Relevant agreements (e.g., li­censing, publishing, etc.); and
  • Record contracts, including de­tails of any advances.
 
If past royalties have not been ac­curately captured and paid, the worth of the copyrights held within the mu­sic catalog may be undervalued.
 
Upon collection of all available data, it is analyzed to parse the mu­sic catalog’s earnings by year, song, publication date, royalty type and the region in which the royalties were earned. Once the data is de­constructed, the appropriate valua­tion methodologies are considered.
 
The three generally recognized ap­proaches for valuation are the cost, market and income approaches.
 
The “cost approach” is based on the notion that the value of an as­set is approximated by quantifying the market value of the tangible and intangible assets, net of liabilities. Since the value of a music catalog is tied to its future earnings potential, the cost approach is generally not appropriate to measure the value of a music catalog.
 
The “market approach” uses a comparison of ratios of publicly traded or privately held assets in similar industries and financial posi­tions as the subject asset. In connec­tion with the valuation of a music catalog, the market approach the­ory is used to develop a range of market multiples applicable to the music catalog’s royalty stream. This range of market multiples can then be used as a valuation input under the income approach.
 
The “income approach” estimates the value of a music catalog based on the annual royalty stream the music catalog is expected to gen­erate in the future. If earnings are expected to remain stable into per­petuity, the annual income stream is capitalized (capitalization of earn­ings). If earnings are expected to change substantially from year to year or the holding period of the asset can be reasonably estimated, the discounted-cash-flow method is applied as further described below.
 
The capitalization-of-earnings, us­ing market multiples found under the market approach, and discount­ed-cash-flow-methods under the in­come approach are often employed to arrive at the value of a music catalog. Under both methods, repre­sentative or future expected royalty earnings must be determined.
 
A music catalog’s earnings can change based upon unpredictable popularity. What is considered “in” during one year can become stale and unappealing in a subsequent year. Ideally, a five-to-seven-year look-back of historical data is re­viewed to map out the trend of his­torical royalty streams. This can help provide guidance in determining fu­ture expectations.
 
The number of songs driving roy­alty income is an important consid­eration as well. A music catalog that derives a substantial portion of total royalties from one song may not be as attractive as a music catalog that generates earnings from multiple songs.
 
Once these elements are consid­ered, a representative future earn­ings expectation is determined and then used in the capitalization-of-earnings, discounted-cash-flow methods, or both.
 
Capitalization-of-earnings meth­odology is based on the premise that the value of an asset is equal to the present value of the income stream enjoyed by its owners in the future. The multiple to be applied to the representative earnings power, to a certain degree, is subjective and a matter of judgment. The applica­ble multiple depends on a number of factors, including the remaining copyright life of the compositions, the existence of catalog “standards,” statutory increases in mechanical rates, new recording configurations, international expansion of intellec­tual property rights, new avenues of exploitation at home and/or abroad, and the trend of earnings.
 
Multiples for music catalogs cur­rently can range between five and 15. However, multiples can be low­er in the event that the composer does not exclusively own all of the publishing rights or higher in the event of a bidding war. Once the multiple is chosen, it is applied to the representative earnings power to arrive at a value for the music catalog.
For example, if the representative future royalties are expected to be $200,000 annually and the selected multiple is 8, the catalog would be valued at $1,600,000 ($200,000 x 8) using this method.
 
The discounted-cash-flow method is based on the economic principle of expectation. That is, the value of an asset to a hypothetical buyer or a hy­pothetical seller is estimated by pro­jecting the present value of the future economic benefits or cash flows. The present value of future cash flows is calculated through the application of a market-derived discount rate to es­tablish a value of the assets. The dis­counted-cash-flow method also con­siders the life of the asset. As such, the future benefit stream discounted back to the valuation date, at a rate reflecting risk, should approximate the value of the asset.
 
Furthermore, once the expira­tion of the copyright for each song is determined, a diminution factor should be considered. The diminu­tion factor considers the applicable growth or decline of future earn­ings, and a discount rate associates the risks of achieving the projected level of earnings. To develop a dimi­nution factor and discount rate, con­sideration is given to:
 
  • Historical trends in royalty earn­ings;
  • The makeup of the music cata­log, including the number of songs and concentration of earnings;
  • Popularity of the songs in the music catalog as of the valua­tion date;
  • That copyright termination rights increase the risk that a decedent’s heirs may be able to exercise their right to revert ownership of the music cata­log from a third-party owner to themselves; and
  • The size of the music catalog.
 
Once the diminution factor is es­tablished, it is used to decrease the projected annual royalty stream. A discount rate is applied to mea­sure the present value of the pro­jected annual royalties. The sum of the present value of the cash flows for the discrete projection period is considered to be representative of the value of the music catalog.
 
For example, if the remaining life of the copyright is 10 years, the expected royalties in year one are $200,000, the diminution factor is 5% annually and a 10% discount rate is applied, the value of the cata­log would be as shown in the table below.
 
  Expected Present
Year Royalties Value @ 10%
1 $      200,000 181,818
2 190,000 157,025
3 180,500 135,612
4 171,475 117,120
5 162,901 101,149
6 154,756 87,356
7 147,018 75,444
8 139,667 65,156
9 132,684 56,271
10 126,050 48,598
     
  Total PV $  1,025,548