A Primer for Valuation of Music Catalogs

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 value of a music catalog is dependent on the ability to generate monies in the form of royalties. Accordingly, 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.

It is important to review and understand the royalty earnings (both domestic and international) of a music catalog in order to determine its representative earnings base. 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 magnitude of the change in annual earnings over this look-back period is gauged to determine if historical royalties have remained flat, trended upward, trended downward, or exhibited volatility (rising and falling year-over-year). Of course, music catalogs with stable and consistent earnings tend to be more valuable than those whose earnings fluctuate year-over-year or are declining annually. 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 or,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.

[IMGCAP(1)]

Whether the capitalization-of-earnings method, the discounted-cash-flow method or another method is applied, understanding the makeup of the underlying royalty streams is critical to measuring the value of a musician's music assets.

Mandeep Sihota, CFA, ASA, is a principal based in New York City in the Valuation and Forensic Services Practice of Citrin Cooperman (www.citrincooperman.com), an accounting and advisory firm. She provides services related to music catalog valuations, intellectual property valuations and economic damages. She leads the valuation services team, and manages the preparation and delivery of valuations of businesses, private equity and income-generating assets such as royalty assets and derivatives.

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 value of a music catalog is dependent on the ability to generate monies in the form of royalties. Accordingly, 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.

It is important to review and understand the royalty earnings (both domestic and international) of a music catalog in order to determine its representative earnings base. 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 magnitude of the change in annual earnings over this look-back period is gauged to determine if historical royalties have remained flat, trended upward, trended downward, or exhibited volatility (rising and falling year-over-year). Of course, music catalogs with stable and consistent earnings tend to be more valuable than those whose earnings fluctuate year-over-year or are declining annually. 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 or,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.

[IMGCAP(1)]

Whether the capitalization-of-earnings method, the discounted-cash-flow method or another method is applied, understanding the makeup of the underlying royalty streams is critical to measuring the value of a musician's music assets.

Mandeep Sihota, CFA, ASA, is a principal based in New York City in the Valuation and Forensic Services Practice of Citrin Cooperman (www.citrincooperman.com), an accounting and advisory firm. She provides services related to music catalog valuations, intellectual property valuations and economic damages. She leads the valuation services team, and manages the preparation and delivery of valuations of businesses, private equity and income-generating assets such as royalty assets and derivatives.