Intellectual Property Valuation Considerations

Introduction and Overview
There are many reasons why I am asked to value an owner/operator’s intellectual property assets. All of these individual owner/operator reasons are generally grouped into the following categories of motivations: transactions, financing, taxation, regulatory compliance, bankruptcy, financial accounting, litigation, or strategic planning.

First, this post summarizes many of the objectives to conduct the intellectual property valuation, the elements of the intellectual property valuation assignment, and the data gathering and due diligence process. Second, this post describes and illustrates the three generally accepted intellectual property valuation approaches, specifically: cost approach valuation methods, market approach valuation methods, and income approach valuation methods. Finally, this post comments on the valuation synthesis and conclusion process.

Objectives to why I am often asked to conduct the IP valuation
It is always critical that I should understand the objective of the analysis. The owner/operator or the legal counsel should specifically define which one(s) of the following intellectual property opinions I am being asked:

1. to estimate a specifically defined value for the subject intellectual property;
   
2. to measure lost profits, lost value, or some other type of economic damages to the intellectual property;
3. to conclude an arm’s-length price for the inter-company transfer of intellectual property between corporations;
4. to estimate a license agreement fair royalty rate between independent arm’s-length parties;
5. to provide an opinion on the fairness of an intellectual property sale, license, or other transfer transaction from a financial perspective;
6. to estimate the intellectual property remaining useful life;
   
7. to estimate a relative exchange ratio for two bundles of intellectual property; and
   
8. to analyze the development or commercialization potential of an intellectual property.
   

My engagement objective should be specified as one of the elements of the intellectual property assignment. Typically, this analysis purpose and objective is documented in an engagement letter between myself and the owner/operator (or between myself and the legal counsel). Such an engagement letter provides useful assignment (and sometimes legal) instructions to me. In addition, such a written engagement letter helps to reduce any future misunderstandings between myself and the owner/operator (or the legal counsel).

Common elements of the IP valuation assignment
In my experience, the first element of the valuation assignment is a complete definition of the subject intellectual property. That definition statement should specify what patent, copyright, trademark, or trade secret is the valuation  subject. This definition should include the registration number and country for the patent, copyright, or trademark (if registered). This definition statement should also describe any commercial intangible assets that should be considered along with the subject intellectual property. For example, should the trademark analysis include advertising materials, trade dress, domain names, etc? Should the patent analysis include product/process engineering drawings, other technical documentation, and related proprietary technology?

The second element of the valuation assignment is a description of the bundle of legal rights subject to analysis. The assignment statement should specify which of the following (or which other) bundles of legal rights I should include in the intellectual property valuation:

1. fee simple interest
   
2. term/reversion interest
   
3. life/residual interest
   
4. licensor/licensee interest
   
5. territory (domestic/international) interest
   
6. product line/industry interest
   
7. sub-license rights
   
8. use rights
   
9. development rights
   
10. commercialization/exploitation rights
    
11. rights to enhancements, research and development efforts, new developments, etc.
    
12. rights to legal protection, promotional activities, advertising expenditures, etc.
    

The third element of the valuation assignment is a description of any intellectual property license or contract that is in effect. If there is a license or agreement (contested or otherwise) associated with the subject intellectual property, then I should be made aware of the contract terms. I have (but will not list here) common intellectual property contract terms.

The fourth element in the valuation assignment is the standard (or definition) of value that I am being asked to conclude. The standard of value typically relates to the question: Value to whom? The different standards of value often correspond to different reasons to conduct the intellectual property valuation. Often, the standard of value is determined by a statutory, regulatory, or administrative requirement. Therefore, the owner/operator (or, commonly, the legal counsel) will instruct me as to the appropriate standard of value to use in the assignment. Some of the common alternative standards of value include fair value, fair market value, intrinsic value, or residual value.

The fifth element of the valuation assignment is the valuation date. The owner/operator (or the legal counsel) will instruct me as to the appropriate 'as of' date on which to conclude the defined value. There is typically a transaction, legal, or regulatory reason to select a particular analysis 'as of' date.

Finally, I also needs to know the purpose of the valuation. The purpose of the valuation typically considers the following elements:

1. What will the intellectual property valuation be used for?
   
2. Who will rely on (or receive a copy of) the valuation?
   
3. What form and format of an intellectual property valuation report is required?
   
4. Are there any legal instructions (e.g. specific statutory or regulatory definitions, or reporting requirements) that I should consider?
   

Data gathering and Due Diligence
Before I can select and apply the valuation approaches, methods, and procedures, I have to perform a due diligence with respect to the owner/operator’s intellectual property. In my experience, the legal counsel may participate in this due diligence process. This is particularly the case if the intellectual property valuation relates to a transaction, financing, or litigation matter. My due diligence procedures relate to identifying and obtaining information for the valuation, economic damages, or transfer price analysis. Therefore, my due diligence process is a supplement to, and not a substitute for, legal counsel's legal due diligence process.

First, I will typically gather and analyze information related to the intellectual property current owner/operator. The information will typically relate to both the historical development and the current use of the intellectual property.

I then have to consider the market potential of the intellectual property outside of the current owner/operator. For example, I may consider the following factors from the perspective of an alternative (e.g. hypothetical willing buyer) owner/operator:

1. a change in the market definition or in the market size for an alternative owner/user
   
2. a change in alternative/competitive uses of the intellectual property to an alternative owner/user
   
3. the ability of the intellectual property to create inbound/outbound license opportunities to an alternative owner/user
   
4. whether the current owner can operate the intellectual property and also outbound license the intellectual property (in different products, different markets, different territories, etc.)
   

I also review and challenge any owner/operator-prepared financial projections and any owner/operator-prepared measures of intellectual property economic benefits. In particular, I may test the achievability of such projections and the reasonableness of the economic benefit measures against industry, guideline company, or other benchmark comparisons. In addition to comparing the owner/operator historical and projected results to the selected
guideline public companies (if any exist), I will also compare the owner/operator results to published/available industry data sources. Such a comparison assists me to assess the reasonableness of the owner/operator’s financial projections and/or the owner/operator’s assessment of any intellectual property economic benefits.

Generally accepted IP valuation approaches and methods
There are three generally accepted intellectual property valuation approaches: the cost approach, the market approach, and the income approach. I will typically consider, and attempt to apply, all three approaches in the intellectual property valuation. This is because the application of multiple approaches provides me with multiple value indications. These multiple value indications often (or rather should) reconcile into a reasonable range of intellectual property values. Ideally, the multiple intellectual property value indications provide mutually supportive evidence of my final value conclusion.

However, most intellectual property valuations are primarily based on only one valuation approach. For each intellectual property valuation, I will select the approach (or approaches):

1. for which there are the greatest quantity and quality of available data;
   
2. that best reflect the actual transactional negotiations of market participants in the owner/operator industry;
3. that best fit the characteristics (e.g., use, age, etc.) of the specific intellectual property, and
   
4. that are most consistent with my practical experience and professional judgment.
   

Within each valuation approach, there are several valuation methods that I can select and apply. Within each method, there are also numerous procedures that I can perform. Therefore, valuation procedures are performed within a valuation method to conclude a value indication and valuation methods are applied within a valuation approach to conclude a value indication.

I may perform two or more valuation methods within a single approach. For example, I may perform three different income approach methods and then reconcile the three value indications to conclude a single income approach value indication. At this point in the process, I will reconcile the various valuation approach indications (if more than one approach is used). This synthesis of the various valuation approach value indications will result in my final value conclusion for the owner/operator’s intellectual property.

Cost Method to IP valuation
All of the cost approach methods are based on the economics principle of substitution. That is, the value of intellectual property All cost approach methods apply a comprehensive definition of intellectual property cost, including consideration of an opportunity cost during the intellectual property development stage. In addition, the cost of the new substitute intellectual property should be reduced (or depreciated) in order to make the hypothetical new intellectual property comparable to the actual 'old' intellectual property.

Unlike many commercial intangible assets, intellectual property assets are not fungible (define: able to replace or be replaced by another identical item). That is, the marketplace cannot actually replace the existing intellectual property with a hypothetical replacement intellectual property because the 'old' intellectual property is, for instance, a legally protected intellectual property. A patent, for instance, is not a fungible intangible asset. Rather, a patent (by definition) is a unique intellectual property. A buyer cannot go to the marketplace and buy a perfectly identical substitute patent. The buyer may buy a functionally similar patent or the buyer can develop a new non-infringing invention. However, a perfectly identical substitute patent would, by definition, infringe on the subject patent. Therefore, although the cost approach is used in intellectual property valuation, it may have certain application limitations.

The Market Approach Method to IP valuation
All market approach methods are based on the two economics principles of efficient markets and of supply and demand. That is, the value of the subject intellectual property may be estimated by reference to prices paid in the marketplace for the arm’s-length sale or license of a comparable (or a guideline) intellectual property. A comparable intellectual property is very similar to the subject property. The comparable intellectual property is approximately the same age, is at approximately the same place in its life cycle, and is used about the same way that the subject intellectual property is used. The comparable property may be used in the same industry, performing about the same function, at about the same size company as the subject property. Sales or licensees of comparable intellectual property provide direct pricing evidence to me about the subject intellectual property. Accordingly, I may be able to apply mean or median pricing metrics to the subject intellectual property.

In contrast, a guideline intellectual property is generally similar (but not identical to) the subject property. The guideline intellectual property should be subject to the same general risk and expected return) investment elements as the subject intellectual property. However, compared to the owner/operator intellectual property, the guideline intellectual property may be operated in a different industry, at a different size company, with a different function, etc. Nonetheless, sales or licenses of guideline intellectual property still provide meaningful (albeit indirect) pricing evidence to me about the subject intellectual property.

In order to obtain pricing evidence from the guideline intellectual property transactions, I will compare the guideline properties to the subject intellectual property. This comparison is often based on such measures as relative growth rates, relative profit margins, relative returns on investment, etc. These comparative analyses will allow me to select subject-specific valuation pricing metrics. I will consider comparable uncontrolled transaction pricing data related to comparable property and to guideline property sales or licenses. I will consider the comparable uncontrolled transaction data in order to extract pricing multiples or capitalization rates that can be applied to the owner/operator intellectual property.

Income Approach to IP valuation
All income approach methods are based on the economics principle of anticipation. That is, the value of any investment is the present value of the income (Free Cash Flow) that the owner expects to receive from owning that investment. All income approach methods involve a projection of some measure of owner/operator income over the intellectual property lifetime. This income measure may relate to the income earned from operating the intellectual property in the owner/operator business enterprise (i.e. operating income) and/or the income earned from outbound licensing of the intellectual property from the owner/licensor to an operator licensee that will pay a royalty  (or some other payment) for the use of the intellectual property (i.e. ownership income). This intellectual property-related income projection is converted to a present value by the use of a risk-adjusted discount rate.

Summary of valuation approaches
In summary, cost approach methods are particularly applicable to the valuation of recently developed intellectual property. In the case of a relatively new intellectual property, the owner/operator development cost and effort data may still be available (or may be more subject to an accurate estimation). In addition, cost approach methods are also applicable to the valuation of in-process intellectual property.

Market approach methods are particularly applicable when there are a sufficient quantity of comparable (almost identical) intellectual property transaction data or guideline (similar from a risk and expected return perspective) intellectual property transaction data. These transactions may relate to either sale or license transactions. I will attempt to extract market-derived valuation pricing metrics (e.g. pricing multiples or capitalization rates) from these transactions in order to apply to the corresponding metrics of the subject intellectual property.

Finally, income approach methods are particularly applicable to situations in which the subject intellectual property is used to generate a measurable amount of income. That income can either be operating income (when the intellectual property is used in the owner’s business operations to increase revenue or decrease costs) or ownership income (when the intellectual property is licensed from the owner/licensor to an operator/licensee in order to produce royalty income).

IP valuation synthesis and conclusion
In the valuation synthesis and conclusion process, I will typically consider the following question: Does the selected valuation approach(es) and method(s) accomplish my assignment? That is, does the selected approach and method actually quantify the desired objective of the analysis, such as:

• defined value
  
• transaction price
  
• third-party license rate
  
• an intercompany transfer price
  
• an economic damages estimate
  
• an opinion on the intellectual property transaction fairness
  

I typically also consider which valuation approaches and methods deserve the greatest consideration with respect to the intellectual property remaining useful life (referred to as its RUL). The intellectual property's remaining useful life is an important consideration of each valuation approach. The final (and arguably most important) procedure in the entire analysis is for me to defend the value (or damages, transfer price, royalty rate, etc.) conclusion in a well documented valuation report, which will tell a narrative story that:

1. defines the elements of (or components of) my assignment;
   
2. describes my data gathering and due diligence procedures;
   
3. justifies my selection of the generally accepted intellectual property valuation approaches, methods, and procedures;
4. explains how I performed the valuation synthesis process and reached the final value conclusion; and
5. defends my intellectual property value conclusion.

That concludes the post. I hope you have enjoyed this post and have a better grip on IP valuations. Please feel free to contact me if you have any additional questions or opinions to raise.

Myles Rennie
Be Extraordinary!