Application of Intellectual Property Valuation Approaches

APPLICATION OF INTELLECTUAL PROPERTY VALUATION APPROACHES

Valuation of an intellectual property (IP) is done for a number of different reasons. These may include assessment of a technology in terms of an investment, estimating expected returns for a technology development for which an investment has already been made, setting price during selling and/or licensing deals for developed technology, mergers and acquisitions, licensing in others’ technology, licensing out own technology, financial reporting, and so on. The value from an IP is the future economic benefit that can be realized at the present time. A number of different factors and considerations are taken into account to begin the valuation exercise. Some of these considerations include:

Is the IP asset in use, or not in use
What is the IP asset’s ability to exclude competition from the market. In other words, what is the strength of the asset
Validity of the asset
Are there any infringement issues with respect to the usage of the IP asset? Alternately, is there a Freedom-To-Operate?
Is there any infringement by others on the IP assets in question? What is the detectability of any infringement if it does occur?

There are so many other factors that need to be considered, and this is not intended to be a comprehensive list in any way. Depending on the situation and circumstances, the relevant set of factors are taken into account, and answers provided for it so that a meaningful valuation may be conducted.

The valuation, especially for start-ups, may be very enhanced, as most of start-ups’ value is vested within their IP assets. Further, the entrepreneurial team have a deep emotional connection with the IP assets as they would have typically spent countless hours and their own resources in developing the technology and protecting the IP assets. Consequently, their viewpoint may not be very objective in this respect.

As noted before, valuation is often done for the purpose of conducting a transaction, such as an acquisition or selling or licensing. In these cases, the valuation exercise provides a value that serves as a starting point for negotiations to conclude a transaction, and in fact, in many instances, it has been found that the value is different from the price paid. As stated earlier, especially in the case of start-ups, value exceeds the actual price paid.

The typical methods for IP valuation are as follows: (Inventing the Future: An Introduction to Patents for Small and Medium-sizedEnterprises. WIPO publication No. 917. Page 37)

Income method: Most commonly used patent valuation method. The method focuses on the expected income stream that the patent holder would get during the lifetime of the patent
Replacement Cost method: Establishes the value of the patent by calculating the cost of developing a similar asset either internally or externally
Market method: Based on the value of comparable transactions made in the market
Option-based methods: Based on the option pricing methods initially developed for use in pricing stock options

Among these, the most commonly used methods include the Market method, Income method and the Replacement Cost method. These will be discussed further for further applicability and their limitations. Knowledge of the applicability and limitations is key to their appropriate usage, else erroneous values will result, which will prove useless in the relevant context. The details about each of these methods are given elsewhere, and the reader should refer to that chapter for more information.

MARKET METHOD

The Market Method is also sometimes referred to as Comparables Method and sometimes interchangeably used with the Transaction Method. In this method, an equivalent transaction in a relevant ‘market’ is taken into account, and the value used in that transaction is applied here directly. For example, for a technology involving telephone instruments, the value will considered to be equivalent to a similar technology involving telephone instruments. The time frame of the earlier transaction is also very important, as large time gap may have led to considerably different market conditions and consumer preferences, which will render the two transactions difficult to be ‘comparable’. Consequently, the closer the two transactions in question, the better will be the value of the IP being estimated.

Values obtained from the Market method are considered ‘real’ values of a transaction, as they are based on real transactions that occurred earlier. Hence, there is a sense of a true value associated with the actual transaction, which gives rise to a sense of confidence to the parties involved in the valuation. This is in direct contrast to the values obtained from other methods, which are considered to be ‘guesstimates’ rather than ‘practical’ values.

Market method is most useful in some specific situations. For example, where there is a large volume of patents involved in a transaction, this method finds tremendous use. This is because the time involved in evaluating the contribution of each patent or even a portfolio of patents towards a particular technology is difficult. Instead, it is easier to point to a relevant equivalent transaction and ascribe a similar value to the set of patents as well.

Similarly, during the development of technology standards such as GSM or MPEG etc., a large number of developers worked towards contributing to the standards. Typically, these kinds of technologies are given ownership to one organization or a consortium that has been created exclusively for upholding the standards and licensing to all the users of the technology. In this case, any new entrant who has developed a technology that can be incorporated into the existing standards will be given a licensing fee that is based on the already agreed upon licensing earlier. Except in highly exceptional circumstances, the prevailing licensing fee is based on the value established by the Market method, and is rarely, if ever, changed for one particular party. In this manner, transactions that need to happen may be effected faster by arriving at a value using the Market method.

However, the Market method has limitations. One of the biggest drawbacks of this method is in the fact that every new technology has something “novel & inventive”, thus, by definition, is unique. As a matter of fact, every form of IPR has something unique about it, else it cannot obtain any form of IPR protection at all. Consequently, nothing is truly ‘comparable’ to the new development in principle. The comparable transaction used to arrive at the value can only be considered a close equivalent, which might be the best available option. For example, a medicine used for headaches may be considered the equivalent for any medicine-related technologies, which may span medicines for obesity, diabetes, HIV etc. Such an equivalent transaction may not accurately reflect the technology at hand. This is especially true for breakthrough technologies, which based on the equivalent transaction will be bracketed under a broad header such as ‘medicines’, which would be unfair to the development. Also, historical random transactions may lead one in the wrong direction. For example, IBM has had a history of giving a non-exclusive license of its patents in exchange for a 1% royalty, regardless of the technology or the impact in the market. Such a historical transaction may force everyone to provide a 1% royalty for a non-exclusive license of their own patents. The situation and circumstances of IBM’s transactions and the manner in which they arrived at this number needs to be carefully evaluated before applying this value.

Details of transactions may be obtained from a variety of sources, and subsequently, each transaction has to be studied carefully for their appropriate relevance towards the situation at hand, and the valuation may then be done using the Market method. Some leading mews & business publications such as WSJ, BusinessWeek carry this kind of information. Alternately, proprietary databases and industry specific journals & publications carry this kind of information as well. Other useful sources of transaction information include previous court judgments or SEC Filings. However, given the volume of information readily available from a variety of internet sources, things can get very confusing for an incumbent attempting a valuation exercise. Experts andconsultants, especially those who were actually involved in or closely associated with a particular transaction, are still considered the best source of market data.

REPLACEMENT COST METHOD

Replacement Cost method is another IP valuation method used often. A quick definition of this method would be the cost of conducting the R&D associated with the technology development. Viewed from another perspective, this method involves estimating the cost of repeating the exact same set of activities related to the R&D that led to the development of technology in question. Essentially, this method provides for a reimbursement of the costs incurred for the development.

The Replacement Cost method finds tremendous use when valuing IP emanating from technologies requiring high early investment. This method is also useful during valuation of technologies involving multiple trial and error experiments that comprise lots of “negative” results. The typical industries where this method is more relevant include pharmaceutical, drug discovery, heavy machinery etc.

It will be understood easily that the cost of development may NOT be proportional to the effect on the market. That is, the cost of development in some instances may be a small sum, in the form of, for example, mixing a few readily available ingredients using household items. However, the effect may be a revolutionizing product. This kind of a scenario is especially true in technologies like software, IT etc. where the actual incurred costs include a computer (usually a sunk cost, or relatively nothing) followed by a few man hours of developing algorithm, programming, debugging & beta testing. The software developed may have tremendous impact on the application by saving hours or reducing waste or reducing expense etc. This kind of impact is not taken into account by the Replacement Cost method.

INCOME METHOD

The Income method is based on the future income to be paid up as today’s value and is calculated as the Net Present Value (NPV). The formula used for this purpose is as follows:

NPV = A/(1+r)n

wherein ‘A’ is the income estimated over a period of time ‘n’, ‘n’ is the number of years and ‘r’ is risk rate. To arrive at a proper NPV, several estimated need to be made. The time frame to be considered may be a shorter time frame than the life of the IPR in question, but instead a smaller window that is within the life of the IPR. The ‘n’ needs to be looked at based on business estimates and the length of stay in market. Alternately, with other numbers known and a required NPV given, ‘n’ is estimated to understand the time taken to achieve a certain value.

The first estimate that is required is the projected income over the period of time. This projected income takes a number of other factors into account, such as the market size, market share, pricing of the product or service involved, and so on. All these are projected estimates based on some historical assessment and/or feedback based estimates, or arrived at in some other known manner.

The important factor is the value of ‘r’, the risk rate. It is a probabilistic estimate of success, and is represented generally as a fractional number that ranges between 0 and 1. Alternately, for ease of communication, it may be expressed as a percentage. This risk rate is dependent largely on the extent of technology development and the stage it is at during the time of valuation (ideas stage, prototyping done, customer feedback obtained and product fine-tuned to their requirements etc.). Other factors that are taken into account for arriving at a risk rate include market barriers, customer appreciation, competition etc. Table 1 gives a generalized view of the risk rate based on the extent of technology development.

Stage of Development / Approximate Risk Rate
Major Developments (typically IPO or Exit Stage) / 20–35%
Significant Developments / 30-40%
Small Projects / 40-60%
Ideas Submitted (Start-ups) / 50-75%
Raw Ideas (Seed Stage) / >80%

Table 1. Risk Rate as viewed from an investment perspective.

From: “A Method for Valuing High-Risk, Long-Term Investments: The Venture Capital Method,” Harvard Business School Case Study, 9-288-006, 1987, Rev. 6/89, Cambridge, MA, USA

In a typical valuation scenario, experts go with a baseline value (such as the value chosen from the table given above based on the extent of technology development) and then add or subtract numbers depending on some of the considerations such as market exclusivity achieved and tremendous benefit to the customer (positive factors), or alternate solutions and competition in the market (negative factors) to arrive at a value. In these situations, an experts’ knowledge and experience, along with their well-honed instinct will come into play.

Income method is particularly useful as it gives a projected value over a potentially long period of time. It finds great use in making ‘go/no-go’ decisions towards investments in developing technology, especially breakthrough-like or risky technologies. The value obtained from this method can be quite accurate when used properly in the short term.

However, given the probabilistic nature of this method, the whole method hinges on heavy speculation, which can be mitigated to some extent by taking into account justified values and reasonable estimates. However, the error of the value is still quite difficult to assess. The accuracy, while good in the short term, decreases over a longer period of time, as it is very difficult to make speculations over that time period.

Thus, each method used in the valuation of IP has its merits and demerits for a given situation. Hence, one of the first steps of an IP valuation exercise is to identify the relevant method of valuation, and provide justification for the choice of the method. This in itself requires some experience to begin with as the method used is critical towards getting a more accurate value at the end. Some of the basic requirements for choosing a method include the reasons for valuation, context of valuation, the technology domain, historical data if available for that particular IP itself, market size, market share expected (or already cornered, if available) and so on. This would then set the tone for the rest of the valuation exercise. Ultimately, an IP valuation is done to obtain the value derived from future economic benefits due to the ownership of the IPR through diligent efforts and expenditure of considerable amounts of time and resources. The value obtained would then justify such an expenditure, which in itself provides a measure of satisfaction to some extent. The ultimate goal is to realize the true value in the market that has been projected through these valuation exercises.