Introduction
To understand how to maximise the value of intellectual property rights, it is first necessary to understand the factors that affect the value of those rights.
IP Valuation Methodologies
There are numerous valuation methodologies which can be used to value intellectual property. No one methodology is appropriate in all circumstances.
The selection of an appropriate methodology will be depend
upon the circumstances surrounding the valuation, including the
type of IP being valued, the purpose of the valuation, and the
availability of data.
In general, a primary methodology will be selected and used to
value the intangible asset. The methodology selected will
depend on the specific circumstances surrounding the
transaction. Alternative methodologies will also be used to
test the accuracy of the value obtained using the primary
methodology. This will allow the valuer to assess the
reliability of the value indicated by the preferred valuation
methodology whilst recognising that all valuation methodologies
have inherent limitations.
Three basic theories of valuation are used for valuing
intellectual property: cost, market and income approaches.
Cost-based
In essence, the value of the intellectual property is the
cost to replace or recreate that intellectual property. This
method looks at the historical cost incurred to develop and
create the intellectual property. A purchaser or licensee can
avoid these costs by purchasing or licensing the intellectual
property from the owner.
The relevant costs may include research and development
(labour, materials and overheads), testing and regulatory
approval costs, IP protection costs, equipment and other
capital investments, a profit margin based on the usual profit
the developer would expect to make on material, labour and
overhead costs, plus a component for entrepreneurial incentive
representing the amount of economic benefit required to
motivate the developer to enter into the development process.
The entrepreneurial incentive component is essentially a
measure of the opportunity cost of undertaking the development
in terms of diverted resources. Once the components of cost
have been determined, it is necessary to adjust for
obsolescence. The types of obsolescence relevant to intangible
assets include functional obsolescence (inability to perform
the function for which it was originally designed),
technological obsolescence (improvements in competitive
technologies) and economic obsolescence (external factors that
prevent the technology from earning a fair rate of return over
its useful life).
There are many inherent problems with the cost approach. The
most significant is that it fails to reflect the earnings
potential of the intellectual property. The value of
intellectual property is derived from its earning potential,
and not its cost. The cost approach assumes that the fair value
of the asset will be the same as its cost, and that there is a
direct relationship between cost and prospective profits.
However, cost does not necessarily equate to value. Clearly
there is potential for a high valuation to be placed on less
successful assets on which high levels of expenditure have been
directed and vice versa.
If the intellectual property offers significant economic
advantage in an active market, the use of the cost method is
likely to understate its value. If, on the other hand,
development has been inefficient or lengthy, the use of the
cost method might overstate its value. Also, for many
identifiable intangible assets, it may not be possible to
develop a replacement, or it may not be possible to estimate
the replacement cost.
In its favour, the cost approach is useful as a readily
calculated bottom-line valuation.
Market-based
Using the market approach, the value of the intellectual
property is determined by the arm's length price paid
in comparable transactions. This is based on the theory that a
licensee or purchaser will not be willing to pay more than the
amount others have paid for similar intellectual
property.
The major requirements of this approach are that there is an
active public market in which there is an exchange of
comparable assets, together with good access to information
regarding how the assets were exchanged (such as price and
surrounding circumstances). Needless to say, there is often
very little information in this regard available in the public
domain. The transactions will also need to have been conducted
at arm's length. The value of many types of
intellectual property stems from the fact that the intellectual
property is unique. A patent, for example, is a unique asset
and consequently comparable transactions may not be
available.
The market approach is often used to establish "ball
park" values, especially for running royalties. The
difficulty with this approach is that it is often very
difficult to locate a suitable "comparable"
transaction. It can be difficult to compare deals with multiple
forms of compensation, such as equity, milestone payments,
provision of associated goods/services and running royalties.
However, the method is attractive as it credible, and
objective.
Income-based
The income approach measures the cash flow associated with
ownership of the intellectual property. The value of the
intellectual property is the net present value of the expected
future income streams that the intellectual property is likely
to generate. The parameters that determine the value include
the size of the income stream, the duration of the income
stream, and the risk associated with realisation of the
income.
There are numerous variations of the income approach. One
common method to value this cash flow is the royalty savings
approach. The royalty savings is the amount that a company
would be willing to pay to use the intellectual property. A
royalty rate is used to measure the amount that would be paid
for the use of the intellectual property. The value of the
intellectual property is the present value of the royalty
payments saved through ownership.
The inherent difficulty with the income approach is that poor
assumptions relating to the parameters in the net present value
calculation will lead to meaningless results. The method
requires forecasts of income from the IP, duration of that
income stream and an estimation of a discount factor to
represent the degree of risk associated with the income stream.
Determining the discount factor is an important part of the
income approach, and even small variations in the discount rate
can result in large differences in the final value.
At the most basic level, the discount factor must take into
account the fact that $1 in the hand today is worth more than
$1 at some point in the future (due to inflation and economic
risk). The rate must reflect the risk associated with the
investment in the technology. Analysts equate the discount rate
to the cost of capital appropriate for an investment in the
subject intangible.
Whether the technology is being valued as part of a going
concern or as a discrete economic unit will also impact on the
size of the discount rate. The discount rate used for valuing
the technology as part of a going concern will be less than the
discount rate used for valuing the technology as a discrete
economic unit in an exchange.
A common mistake made in valuing intellectual property using
the income approach is to use the total value of the income
from the business unit utilising the IP rather than the
incremental income attributable to the IP itself. Falling into
this mistake means the valuer has failed to account for the
complimentary assets that have contributed to generation of the
income, such as tangible assets, staff know-how, marketing
assets and such like. In effect, the valuer has valued the
entire business unit, rather than any particular piece of IP
within that unit.
Valuation issues
Considerable business judgement is necessary in any
valuation approach. This judgement must be based on the
analyst's specific understanding of the IP to be
valued, the individual transaction, and the valuation process,
and a general understanding of the business within which the
transaction is occurring.
The value of an intangible asset should not be evaluated in
the abstract. It must be assessed within the context of its
use. Some of these factors include:
- What exactly is the intellectual property, and how does the protection it affords add value to the business?
- What is the useful economic life of the intellectual property (rather than say its legal life)?
- What is the strength of the intellectual property? Is the intellectual property completely new, or a modification of existing intellectual property? How broad are the patent claims for example?
- What is the likelihood of technological change, and what are the capital requirements for such change?
- Are there alternative technologies and/or competitive pressures? Are there any substitutes available and, if so, at what cost?
- What effect will the skills and depth of management have on the exploitation of the intellectual property?
- How will the market respond to the new technology? Will there be a resistance to change? Will there be any regulatory restrictions/difficulties?
- Are there any strategic factors at play that make the IP more valuable in the hands of the acquirer?
Summary
Ultimately, intellectual property is worth what someone will
pay for it at any given point in time. As such, any valuation
is merely a negotiation tool. Understanding the underlying
assumptions and theories behind the various valuation
methodologies will assist greatly in negotiations for the sale
or licensing of intellectual property.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.