Draft of chapter to be included in an upcoming 2015 WIPO publication:

Intellectual Capital Readiness: The Use of Intangibles to Access Capital Markets—

An Introduction for Business and Investors.

Chapter 6

Intellectual Property Valuation

William J. Murphy and John L. Orcutt

Thoughtful decision-making is the essence of a well-run business, and valuation is a prerequisite for such thoughtful decisions. The old management adage—you can’t manage what you don’t measure—remains true today. In business, sound decision-making involves placing reasonable values on assets to identify the best decision among competing, but uncertain, choices. While valuing assets has always been important for businesses, the assets needing valuation have dramatically changed. Intellectual property is replacing tangible assets as the key source of wealth creation[footnoteRef:1] (Box 6.1). Companies that understand their intellectual property and its value make better decisions and are more successful. [1: Gordon V. Smith and Russell L. Parr, Intellectual Property: Valuation, Exploitation, and Infringement Damages 3 (2005); John J. Ballow, Robert J. Thomas, and Göran Roos, “Future Value: The $7 Trillion Challenge,” Journal of Applied Corporate Finance 16:71 (2004). See generally Kevin A. Hassett and Robert J. Shapiro, “What Ideas are Worth: The Value of Intellectual Capital and Intangible Assets in the American Economy,” Sonecon Studies (Sept. 2011). ]

Box 6.1

Importance of Intellectual Property

The U.S. Patent and Trademark Office (USPTO) and the U.S. Department of Commerce released a comprehensive report titled, Intellectual Property and the U.S. Economy: Industries in Focus, in 2012. Among the reports principal findings were:[FN1]

· The entire U.S. economy relies on intellectual property in some form, because “virtually every industry either produces or uses it.”

· Seventy-five out of 313 total U.S. industries were found to be intellectual property-intensive.

· Intellectual property-intensive industries accounted for “$5.06 trillion in value added, or 34.8 percent of U.S. gross domestic product (GDP), in 2010.”

· Intellectual property- intensive industries directly accounted for “27.1 million American jobs, or 18.8 percent of all employment in the economy, in 2010.” They also indirectly supported an additional “12.9 million more supply chain jobs throughout the economy. In other words, every two jobs in IP-intensive industries support an additional one job elsewhere in the economy. In total, 40.0 million jobs, or 27.2 of all jobs, were directly or indirectly attributable to the most IP-intensive industries.”

FN1 USPTO and U.S. Department of Commerce, Intellectual Property and the U.S. Economy: Industries in Focus (2012), available at http://www.uspto.gov/news/publications/IP_Report_March_2012.pdf.

Despite intellectual property’s continuously growing economic importance, valuation analysis has not kept pace. For too many companies, their valuation analyses remain focused on tangible assets and ignore intellectual property. This is not because managers fail to appreciate the importance of intellectual property to their business. Rather, the failure stems from a misguided belief that such analyses are too difficult, too expensive, and too inaccurate. As a result, many companies do not measure a large portion of their assets, meaning they do not adequately manage them.[footnoteRef:2] [2: See Ballow, Thomas, and Roos, supra note 1. The authors explain that a failure of traditional accounting to keep pace with intellectual property assets has caused:a significant portion of corporate assets [to] go under-recognized and underreported. And because it is difficult—some would say impossible—to manage what is not being measured, many of the assets that are most responsible for creating value in today’s economy are not managed as well as they could be.]

This chapter seeks to demystify intellectual property valuation and provide a practical guide for managers seeking to better understand some of their most valuable assets. It explains the basics for valuing intellectual property in a plain manner—free from legalese and technical minutiae—and includes numerous examples to illustrate the various concepts. More specifically, this chapter explains:

· What value means.

· How valuation helps improve the full array of decisions associated with intellectual property.

· How to run income-, market-, and cost-based valuation analyses.

· The rise of surrogate measures and their potential role in valuation analyses.

· Valuation for early-stage intellectual property, including when held by startups in need of investment capital.

· The role of decision trees and real options analysis in a valuation.

· Select accounting issues that relate to intellectual property.

What Does “Value” Mean?

Box 6.2

Profits are the Benefits Measured in a Valuation Analysis for Businesses

A valuation analysis seeks to measure the net benefits an asset will generate for its holder. In the business context, the holder will usually be a for-profit firm. Generating profits is their fundamental purpose, so profits are the benefits measured in a valuation analysis.

To be precise, “cash flows” rather than “profits” are often used when conducting a valuation analysis. This distinction will be discussed later in the chapter.

A valuation analysis seeks to determine an asset’s value, which begs the question: what does “value” mean? In the business context, an asset’s value stems from its ability to generate future profits (see Box 6.2). Value is the measure of the future profits the asset is expected to generate for its holder. It is probably useful to point out that value and price are often different things (see Box 6.3). An asset’s value is determined by its utility to a specific holder, while price is determined by the asset’s supply and demand relationship in the marketplace. Consider the following example:

Box 6.3

Value v. Price—Does Newspaper Reporting have any Value?

The newspaper industry, with its dramatic circulation decline, offers an example of the potential divergence between value and price. David Simon, executive producer of The Wire and one-time newspaper reporter, wrote an opinion piece for the Washingon Post questioning whether newspaper reporting has any value, since consumers are not interested in buying newspapers.

Isn't the news itself still valuable to anyone? In any format, through any medium—isn't an understanding of the events of the day still a salable commodity? Or were we kidding ourselves? Was a newspaper a viable entity only so long as it had classifieds, comics and the latest sports scores? It's hard to say that, even harder to think it. By that premise, what all of us pretended to regard as a viable commodity—indeed, as the source of all that was purposeful and heroic—was, in fact, an intellectual vanity.[FN1]

Simon is wrong to think newspaper information has no value (i.e., it is “an intellectual vanity”). Newspaper information continues to have considerable value. However, with the advent of the Internet the supply of information increased exponentially, which changed consumers’ willingness to pay for news. News’s value did not change, but its price did.

FN1 David Simon, “Does the News Matter to Anyone Anymore?”, Washington Post (Sunday, Jan. 20, 2008).

Acme contemplates buying an asset that will generate $1,000 of present-valued future profits. The asset’s value to Acme is $1,000, and Acme should be willing to pay a price up to $1,000 for it. What if the asset’s supply/demand dynamics cause its price to be $500? This does not mean the asset’s value to Acme is only $500. It just means Acme will get a good deal when it buys the asset.

When we discuss value in this chapter, we are referring to an asset’s actual value (or its real value), not its price. We are referring to the actual profits the holder expects to receive from the asset. Because these profits will be received over time, they must be discounted back to present value to account for the time value of money and the risk of actual profits being less than forecasted. The value of a business asset can therefore be described as follows:

An asset’s value is equal to the present value of the forecasted profits it will generate for its holder.

So far, our discussion of value has focused on business assets generally, rather than specifically addressing intellectual property assets. We purposefully did this because intellectual property assets are a form of business asset and follow the same fundamental valuation principles as other business assets.

The value of an intellectual property asset is equal to the present value of the forecasted profits it will generate for its holder.

Valuing intellectual property rights is comparable to valuing any other business asset. Any valuation analysis fundamentally involves two steps: (1) identify the ways in which the asset will generate profits for the holder; and (2) measure the benefits and add them together. What is different about intellectual property, however, is the way it generates profits for its holders and the critical need for lawyers to be involved in the valuation process. There are three basic forms of intellectual property—patents, trademarks, and copyrights—each of which has its own particular ways for generating profits. Table 6.1 summarizes some of the more common ways.

Table 6.1

Common Ways to Generate Profits from Intellectual Property

Patents

· Practice invention and premium price the product

· License patent and associated know-how

· Sue others for infringement

· Use patents as collateral or securitize their cash flow

· Reduce licensing costs through cross-licensing strategies

· Increase goodwill by signaling technological strength

Trademarks

· Premium price trademarked product

· Increase sales by lowering search costs for customers

· License trademark and associated goodwill

· Sue others for infringement

· Use trademarks as collateral or securitize their cash flow

· Improve sales and profit margins by preventing imitators from free-riding on goodwill

· Use trademark associated with patented product to bolster sales after patent expiration

Copyrights

· Sell the copyrighted work

· License the right to reproduce, prepare derivative works, distribute copies, perform, or display the copyrighted work

· Generate revenue from compulsory licensing schemes

· Sue others for infringement

· Use copyrights as collateral or securitize their cash flow

· Encourage increased creativity by insuring reward

· Prevent unauthorized copying and use that can erode revenue

The value of intellectual property assets comes from their associated bundle of property rights. Acquiring, managing, and transferring property rights helps businesses achieve competitive advantage and generate profits. Property rights create potential value by distinguishing between owners (those who control the property and its benefits) and non-owners. For tangible assets, the border between owners and non-owners is usually clear. In fact, the word property often conjures visions of the neat boundaries associated with real property. Borders can be laid out on a map, fences can be erected, and the land’s metes and bounds can be described at the local land registry office. Intellectual property does not lend itself to such neat boundaries. The specialized nature and descriptive imprecision of intellectual property complicates valuation because determining the boundaries of intellectual property assets generally requires a specific legal expertise. For example, a patent’s boundaries are determined by its claims. Outside those with specialized patent training, understanding the precise implications of patent claims and their effect on future profits is nearly impossible. Intellectual property assets, therefore, cannot be properly valued without assistance from lawyers. One of the issues we will discuss in this chapter is how to combine the economic and financial expertise of business persons with the intellectual property expertise of lawyers to generate better valuations.

Introduction to the Basic Valuation Methodologies

There are three general methods for valuing any asset.

1. Income methods seek to measure the actual benefits an asset will generate. The discounted future economic benefits (DFEB) analysis is the most common form of income method, and the discounted cash flow (DCF) analysis is the particular approach most often used. Income methods require forecasting the net benefits (e.g., profits) an asset will generate for its holder and discounting those benefits back to present value. The income method is the only one of the three valuation methodologies that seeks to directly measure an asset’s actual value.

2. Market methods determine value by looking at comparable transactions to see how other buyers and sellers have priced similar assets. Rather than determine the asset’s utility to any specific party, market methods generally rely on the collective wisdom of self-interested buyers and seller’s entering into arm’s-length transactions.

3. Cost methods determine value by looking at the cost to develop or acquire the asset in question, or a similar asset. Cost methods use development or acquisition costs as a proxy for an asset’s value.

Detailed explanations of these valuation methods—including step-by-step examples—will be presented later in this chapter. The three methods have given rise to an array of different valuation techniques. However, each technique can be traced back to one of the three basic methods. For example, real options analysis (see Box 6.4) garners a lot of attention in intellectual property valuation circles and is sometimes described as a new valuation method. In reality, a real options analysis—which will be discussed later in the chapter—is an addition to the basic income method analysis. Table 6.2 lists a few of the more common valuation techniques and sorts them into income, market, and cost methods.

Box 6.4

Real Options Analysis is a Form of Income Method

Like any income method, real options analysis seeks to approximate an asset’s future utility to its holder. The only difference is that real options analysis tries to explicitly capture future flexibility and choices associated with the asset. Having the ability to defer a decision to a later date when more information may be available is valuable. Real options analysis includes this decision deferral value in its analysis.

Table 6.2

Common Examples of Income, Market, and Cost Methods

Income Methods

Market Methods

Cost Methods

· Discounted cash flow

· Discounted future economic benefit

· Cost saving method

· Risk-adjusted net present value method

· Real options analysis

· Monte Carlo simulations

· Competitive exchange

· Comparable transactions

· Surrogate measures

· Cost of development

· Cost of reasonable alternatives

Valuation, Decision-Making, and the Power of “Satisficing”

Valuation analyses are not irregular or extraordinary events in a well-run business. Instead, valuation is a constant process used to guide decision-making. This is because informed decisions require valuation. Every decision involves choosing between alternatives with different values. Consider the following patent decisions and the valuation work required to make them thoughtfully:

Box 6.5

Bias toward Over-Patenting

Patent commentators have pointed out that intellectual property managers often suffer from an over-patenting bias.[FN1] The managers worry about being victims of hindsight bias. If the invention turns out to be valuable and was not patented, the managers could be held responsible and their careers will suffer. One commentator famously stated, “When in doubt, file an application!”[FN2] For companies with hundreds of inventions per year (or more), such biased decision making can be very wasteful.

Sound valuation analysis can eliminate much of this sloppiness and reduce the waste from excess patenting. A similar bias, and waste, often occurs with paying maintenance fees. Once again, sound valuation analysis reduces the problem.

FN1 Robert Pitkethly, “The Valuation of Patents: A Review of Patent Valuation Methods with Consideration of Option Based Methods and the Potential for Further Research,” Judge Institute Working Paper 21/97, 4 (1997).

FN2 Philip W. Grubb, Patents for Chemists 48 (1982).

· Deciding whether to obtain an initial country patent: Assume a firm must decide whether to obtain a collection of patents to protect its new invention. Assume further the cost to obtain the patents in an initial country (usually the firm’s home country) will be $75,000. It would be irrational to obtain the patents unless their value projects to be $75,000 or more (see Box 6.5).

· Deciding whether to pursue a multi-country patent strategy: Patent protection is accomplished on a country-by-country basis. A patent is awarded by a country’s government and grants protection within that country’s borders. If the firm wants protection in additional countries, it must apply for patent protection in those additional countries. The invention will be part of the public domain in each country where patent protection is not obtained and can be freely manufactured, used, or sold. The firm must decide which countries merit patent protection. Assume the cost to obtain patent protection in China will be $50,000. It would be irrational to obtain the Chinese patents unless the firm expects their value to be $50,000 or more.

· Developing commercialization strategies: Once a firm has obtained some patents, it must decide how to commercialize them. Should the firm practice its patented inventions, license the patent rights to third parties, or do both? If a firm decides to license one or more patents, it must decide on a licensing strategy. Will it license the patents on an exclusive or nonexclusive basis? Will the licenses include significant restrictions (such as field-of-use limitations or geographic limitations)? None of these choices can be made thoughtfully without understanding the value of the various options.

· Pricing patent-right transfers: Should the firm try to buy or license patented technology from a third party? If yes, what price should it pay? If the firm is considering transferring its own patent rights, how much should it charge? Pricing intellectual property licenses (which is typically expressed in the form of a royalty rate) is a significant concern for many businesses.

· Mining and managing the patent portfolio: Patent portfolios can generate significant value for firms, but they can also be expensive and inefficient if improperly managed. Is the firm paying maintenance fees for low-value patents? Does the firm have valuable patents that are not core to its business, and could generate better returns by transferring them to third parties? Are the firm’s inventions adequately protected? Each of these questions requires understanding the value of the patents and how to maximize it. Patent portfolio management also raises concerns about whether the firm has adequate internal control procedures to account for and manage its patents?

Box 6.6

Cost of Defending a Patent Infringement Claim in U.S.

In its 2013 annual survey, the American Intellectual Property Law Association reported the following costs for defending a patent infringement claim in the United States:[FN1]

FN1 AIPLA, 2013 Report of the Economic Survey, available at http://www.patentinsurance.com/custdocs/2013AIPLA%20Survey.pdf.

· Deciding how much to invest in patent enforcement or defense efforts: Enforcing patent rights against an infringer—or conversely defending an infringement claim— can be very expensive (see Box 6.6). Thoughtfully deciding how much to invest in such efforts requires understanding the value of the patent rights in question.

Creating, managing, commercializing, and maintaining intellectual property involves countless decisions. Most of the above decisions are equally applicable to each form of intellectual property. A firm must decide the countries where it will obtain trademark protection. It must also decide how much to invest in its trademark enforcement efforts, and whether to a run a licensing program for its trademarks. Other contexts where intellectual property valuation is a prerequisite to sound decision-making include:

· Valuing a company: With intellectual property becoming the dominant assets for so many firms, it must be valued to generate accurate company valuations. Company valuations are needed when investing in a company (see Box 6.7), acquiring a company, selling a company, or forming a joint venture.

Box 6.7

Startups, Venture Capital, and Intellectual Property Valuation

High-technology startups are some of the most important companies in any given economy. In the United States, they create a disproportionate amount of the country’s economic growth, innovations, and net new jobs. For these companies to grow and flourish, they need capital. Venture capital firms are a critical source of capital for startups.

Having a strong intellectual property portfolio is crucial to obtaining venture capital funding.[FN1] For many startups, intellectual property assets are their only legal assets. Therefore, when the venture capital firm values the startup to determine whether to make an investment, the valuation is little more than a valuation of the startup’s intellectual property.

FN1 Mario W. Cardullo, “Intellectual Property – The Basis for Venture Capital Investments,” World Intellectual Property Organization [undated].

· Using intellectual property as collateral to secure a loan: Using collateral to secure loans increases lending efficiency. Collateral reduces uncertainty about the borrower’s ability to repay the loan, which reduces the interest rate charged by lenders thereby lowering borrower’s cost of capital. Tangible assets (such as land, buildings, and machinery) have long served as collateral. With the growing importance of intellectual property, borrowers want to use it as collateral and lenders realize they must adapt to this new environment. Placing a value on the intellectual property is a condition precedent to accepting it as collateral.

· Securitizing intellectual property: Another method firms can use to improve their capital raising efficiency is asset securitization. Asset securitization programs seek to transform illiquid, cash-flow generating assets into immediate cash that can be reinvested. In a typical program, a firm will pool the cash-flow generating assets (such as credit-card receivables) into a special purpose vehicle (SPV) and have the SPV sell debt securities to investors. The debt securities’ principal and interest payments are paid with the cash flow generated by the assets placed in the SPV. If reasonably accurate valuations can be made, intellectual property could be an important source for future securitization vehicles (see Box 6.8).

Box 6.8

Intellectual Property can be Ideal for Securitization

In Patent Valuation: Improving Decision Making through Analysis, Murphy, Orcutt, and Remus explain:

The promise of intellectual property as a securitizable asset class has not escaped the attention of intellectual property holders or the capital markets. On the one hand, intellectual property assets are ideal for the securitization process. Many intellectual property assets have the following general characteristics:

· They are illiquid.

· They can provide a rich source for cash flows, typically from licensing payments.

· They can benefit from the risk isolation aspects of asset securitization because different investors may be interested elements of the intellectual property assets.

· They can benefit from the risk reduction that comes from pooling.

On the other hand, uncertainty regarding ownership (particularly potential lien creditors) and complications in making the valuation determinations have caused the capital markets to proceed cautiously with intellectual property asset securitization products.

William J. Murphy, John L. Orcutt, and Paul C. Remus, Patent Valuation: Improving Decision Making through Analysis 326-327 (2012).

· Tax planning strategies: Intellectual property is a popular focus of global tax planning strategies. Such tax planning strategies frequently involve transfer pricing to shift income from a high-tax to a low-tax jurisdiction (see Chapter 7 for a discussion of intellectual property tax considerations). A transfer price is the price at which goods are services are sold between entities within an organization. A transfer price should reflect either (a) what the seller would charge an arm’s length buyer or (b) what the buyer would pay to an arm’s length seller. However, the desire to lower the overall organization’s tax liabilities may cause the parties to manipulate the transfer price. Not surprisingly, tax authorities often challenge the soundness of such transfer prices. This means valuations are needed to support the transfer prices.

· Accounting requirements: When intellectual property is developed or acquired, its value may need to be accounted for on the firm’s balance sheet. As research and development departments grow, and as firms’ appetites for acquiring intellectual property portfolios grow, the need to value developed/acquired intellectual property grows. Moreover, most publicly-traded companies must follow purchase price allocation rules when buying another company. Purchase price allocation rules require the buyer to identify, value, and recognize the selling company’s assets, many of which may be intellectual property assets. In addition, managerial accounting for internal use necessitates consideration of intellectual property value for effective management and controls.

Table 6.3 provides a summary list, organized by decision category, of common intellectual property business decisions that can be improved through valuation.

Table 6.3

Common Intellectual Property Business Decisions that Require Valuation

Creation/Protection

Commercialization

Management

· Which technologies/creative works should the firm seek to develop?

· When should the firm seek intellectual property protection?

· Where should the firm seek protection? Should the firm pursue an international protection strategy?

· How much money should the firm dedicate to its intellectual property protection budget?

· What is the best strategy for monetizing the firm’s intellectual property?

· Maintain intellectual property rights and/or transfer them to third parties?

· If transferring the rights, what is the optimal strategy (e.g., assign, license exclusively, or license non-exclusively)?

· When is the best development stage for transferring the intellectual property rights?

· Does the firm possess under-utilized intellectual property that should be licensed to third parties?

· What is the firm’s return on investment for its intellectual property assets?

· Is the firm paying maintenance fees for non-core intellectual property?

· Is the firm’s intellectual property adequately protected?

· Does the firm have adequate internal control procedures to account for and manage its intellectual property?

Pricing

Financing/Mergers & Acquisitions

Disputes

· What price should the firm pay to buy/license-in intellectual property rights?

· What price should the firm demand to sell/license-out intellectual property rights?

· What is the value licensing restrictions (e.g., exclusive v. non-exclusive or use restrictions), and should they effect the price?

· Should payments be in the form of upfront fees, future royalties, or both?

· Assuming significant intellectual property assets, what is a firm’s value when:

· Raising equity capital?

· Buying the company?

· Selling the company?

· Forming a joint venture?

· Can the firm use its intellectual property to collateralize a loan?

· Can the firm securitize its intellectual property assets?

· When should the firm enforce its intellectual property rights against others?

· Should the firm sue or use an alternative dispute resolution technique?

· How much should the firm invest in in identifying and combatting potential infringers?

· When should the firm defend against intellectual property infringement claims?

· How much should the firm invest in cross-licensing strategies?

· How can the firm be sure it is receiving the proper royalty payments?

Tax

Accounting

· What is the most tax efficient location for the firm’s intellectual property assets?

· What is an appropriate transfer price for the intellectual property?

· How does a firm account for:

· Internally-developed intellectual property assets?

· Intellectual property assets acquired individually from third parties?

· Intellectual property assets acquired in a business combination (e.g., purchase price allocation)?

Most agree that a valuation analysis can help companies make better decisions. However, critics complain such analyses are nice in theory, but too impractical for daily use. They argue valuation analyses are too complicated, expensive, and inaccurate to be used for most decisions. Moreover, the decision maker can intuitively make many of these decisions without the need for formal valuations. Such criticisms are misguided.

1. Why do I need valuation analyses when I can make most of the decisions intuitively? Intuition is a powerful decision-making tool. Managers must often make decisions without the luxury of “orderly rational analysis.”[footnoteRef:3] Complex problems often involve incredible amounts of data to gather and interpret, motivating managers to take mental short cuts to reach decisions. While intuition can have a place in managerial decision making,[footnoteRef:4] there are obvious pitfalls. One of the biggest pitfalls—and one that valuation analysis helps address—is the human mind’s inability to handle more than a few separate factors when making a decision. Intuitive thinkers often believe themselves capable of handling innumerable disparate factors when making decisions, but research shows they do not. Perhaps the most cited study in this body of research is a 1956 paper by psychologist George A. Miller that noted people had a hard time remembering more than roughly seven unrelated pieces of data when making one-dimensional judgments.[footnoteRef:5] Subsequent researchers have cautioned that Miller’s proposed cognitive limits of “seven plus or minus two” factors might be overly generous. One report suggests the average human capacity to consider multiple factors is closer to four.[footnoteRef:6] Whatever the actual number, most people struggle to fully and correctly incorporate a large number of factors when making decisions. Worse, most people fail to appreciate how bad they are at the task. [3: Herbert Simon, “Making Management Decisions: The Role of Intuition and Emotion,” Academy of Management Executive 57 (Feb. 1987).] [4: See e.g., Kurt Matzler, Franz Bailom, and Todd A. Mooradian, “Intuitive Decision Making,” MIT Sloan Management Review (Oct. 2007), available at http://sloanreview.mit.edu/article/intuitive-decision-making/.] [5: George A. Miller, "The Magical Number Seven, Plus or Minus Two: Some Limits on Our Capacity for Processing Information," Psychological Review, 63, 81-97 (1956). “[T]he span of absolute judgment and the span of immediate memory impose severe limitations on the amount of information that we are able to receive, process, and remember.” ] [6: Nelson Cowan, “The magical number 4 in short-term memory: A reconsideration of mental storage capacity,” Behavioral and Brain Sciences 24, 87–185 (2000).]

Valuing intellectual property assets requires assessing numerous disparate factors. Consider a typical patent valuation. The valuator should consider the future business performance of the patented product (which involves a host factors), the technical strength of the product (as well as the evolution of related technologies), and the legal quality of the patent itself (which involves a host of additional factors). There can easily be tens, if not hundreds, of factors influencing the analysis. Valuation techniques help decision makers to correctly incorporate far more information when making decisions.

2. Valuation analyses are too complicated, expensive, and inaccurate. We hope to demonstrate in this chapter that valuation analyses do not need to be overly complicated. There is a tendency among valuators to make valuations appear more, rather than less, complicated. While this can improve the valuator’s stature, it discourages managers from undertaking valuations. Valuation analyses are not a one-size-fits-all endeavor. There are approaches that are more complex and expensive, but there are just as many approaches that are elementary and inexpensive to perform.

The more problematic concern is that valuation analyses are inaccurate. There is some truth to this criticism. Valuation is an inherently inexact undertaking. Valuation never leads to a single, absolutely correct determination of an asset’s value. But focusing on the inexact nature of valuation misses the bigger picture. The goal of valuation is seldom to obtain information for perfectly-informed decisions. The goal is more often to cost-effectively obtain better information for better informed decisions. Inexact, but still useful, information can significantly improve decision making.

Business managers want to make good decisions. Sometimes, this gets confused with a desire to make the best possible decisions (referred to as optimal decision making). Optimal decision making sounds appealing. Who doesn’t want to make the best decision? It turns out that optimal decision making is usually impractical and not the best strategy. When one takes into account the vast number of decisions firms must make and the information-gathering required to identify the best choice, the limitations of optimal decision making limitations become evident. As the number of decisions and complexity increase, so too do these limitations. Nobel-prize-winning economist Herbert Simon observed that business managers often do not seek optimal solutions. Instead, they use an approach he referred to as “satisficing.” With a satisficing strategy (see Box 6.9 for the origination of the term “satisfice”), the decision maker establishes a threshold for what is a good enough outcome, and then collects enough information to identify the first option to produce such an outcome. At that point, the decision maker chooses the good enough outcome and moves on to its next decision. Satisficing allows the decision maker to save time, energy, and resources, and avoid “wandering in circles.”[footnoteRef:7] Satisficing is not the same thing as settling. As one business management consultant explains: [7: Priacta Website, Optimizing, Settling, and Satisficing: Making Efficient Decisions, http://www.priacta.com/troblog/2011/05/09/teamwork/optimizing-settling-and-satisficing-making-efficient-decisions/.]

Box 6.9

Origin of the Term “Satisfice”

Herbert Simon is credited with coining the term “satisfice” or “satisficing.” Some suggest Simon invented the word by combining the terms “satisfy” and “suffice.” Others assert Simon did not invent the word “satisfice,” but instead employed an old Scottish term.

Settling means choosing what you already have simply because it is easy and available. Optimizing often leads to settling, because the process exhausts the people involved. When the team is too tired to care, they tend to reach for quick solutions, without careful attention to goals and objectives. Satisficing, on the other hand, focuses on a “good enough” solution while working toward specific goals.[footnoteRef:8] [8: Id.]

Because of the number and complexity of intellectual property decisions firms must make, the satisficing strategy is usually the best strategy. There will be a few very important decisions that demand more extensive, accurate valuation efforts. Major funding decisions, major intellectual property acquisition or disposition decisions, and bet-the-company litigation decisions are examples that tend to favor an optimizing strategy. For any other decision (e.g., Should the firm accept a patent examiner’s patent claim rejection or challenge it? Should the firm pay its patent maintenance fees?), satisficing is the preferred strategy.

When critics complain that valuation analyses are too complicated, expensive, and inaccurate, it usually stems from their failing to appreciate the difference between optimizing and satisficing decision-making strategies. Does it make sense to conduct an elaborate DCF analysis to determine whether to pay a patent maintenance fee? Probably not. Fortunately, numerous satisficing techniques exist to make valuation analyses sufficiently cheap and efficient to improve the less important decisions.

Valuation Mechanics

This section of the chapter explains some of the more common valuation techniques for intellectual property. To make the materials most useful to the reader, a number of examples are provided to illustrate actual valuation mechanics. In doing this, we have tried to account for the need to employ satisficing solutions and note specific areas where satisficing solutions may be useful.

Income Methods

Income methods seek to measure the actual benefits (see Box 6.10) an asset will generate. There are many different valuation techniques that fall under the category of income methods, including the DCF method, the payout discount model, the cost saving method, the risk-adjusted net present value method, and real options analysis (see Box 6.11). While each technique measures benefits somewhat differently, they all fundamentally require the valuator to do two things:

Box 6.10

Focus is on Net Benefits

When discussing “benefits” throughout this chapter, we are referring to net benefits. We are referring to the benefits that are left after subtracting the costs incurred to generate them.

1. Develop projections of the anticipated benefits; and

2. Discount those benefits back to present value.

Box 6.11

Valuation Techniques that Fall Under the Category of Income Methods

Some of the more common valuation techniques that qualify as income methods are:

· Discounted cash flow (DCF) method = calculates the net present value of the cash flow a holder projects to generate from an asset (or group of assets).

· Payout discount model (PDM) = calculates the net present value of the future payouts (e.g., dividends or royalty payments) a holder projects to generate from an asset (or group of assets).

· Cost saving (CS) method = calculates the net present value of the cost savings projected to come from holding an asset (or group of assets). The royalty relief method is a classic example of CSM. The royalty relief method calculates the royalty payments a firm would save by owning an intellectual property (or group of intellectual property rights) rather than licensing the rights from a third party.

· Discounted future economic benefit (DFEB) method = calculates the net present value of any economic benefit (e.g., accounting profits, future payouts, or cost savings) a holder projects to generate from an asset (or group of assets).

· Risk-adjusted net present value (rNPV) method = adjusts the DCF, PDM, CS, or DFEB calculation by including probability adjustments for the projected benefits.

· Real options analysis = Like any income method, real options analysis seeks to approximate an asset’s future utility to its holder. The only difference is that real options analysis tries to explicitly capture future flexibility and choices associated with the asset. Having the ability to defer a decision to a later date when more information may be available is valuable. Real options analysis includes this decision deferral value in its analysis.

The DCF analysis is the most common form of income method. A DCF analysis calculates the net present value of the cash flows a firm projects to generate from an asset (or a group of assets). Free cash flow is the purest benefit a firm generates. Because most companies use the accrual accounting method (see Box 6.12), their profits have been earned but not necessarily collected. Those profits only represent real value if converted into actual cash. Free cash flow tracks the actual cash benefit a firm receives. While free cash flow is the purest measurement of a firm’s benefit, it can be difficult to calculate when valuing intellectual property. A common way to calculate free cash flow is

Box 6.12

Accrual Accounting Method

Under accrual accounting, revenues are recognized when earned, even though payment may not be received until many months later. For example, when a firm sells its products, it should recognize revenue for the sales on shipment, even if the customers are not expected to pay until a later date (e.g., 30 or 60 days later). Under accrual accounting, expenses are recorded when incurred (i.e., when the purchased goods or services are received), even if the company will not actually pay for the goods or services until a later date.

FCF = net income (after tax)

+ noncash charges (such as amortization and depreciation)

– net capital expenditures

– changes in net working capital

+ changes in long-term debt

These types of numbers are accounted for at a company level, but not necessarily at an individual asset level. Therefore, trying to determine the free cash flow that comes from an individual intellectual property asset, or even a collection of intellectual property assets, can be challenging and require significant accounting maneuvers. This extra accounting work seldom improves the accuracy of the valuation analysis, but does discourage many from trying to conduct a valuation in the first place by making the process overly complicated.

To avoid this extra complication, benefits other than free cash flow can be analyzed with the basic DCF technique. Two of the more common benefits employed are:

Box 6.13

Accounting Profits

Two of the more commonly used profit measures for a DCF calculation are net income (after tax) and operating profit.

· Net income (after tax) represents a firm’s earnings after deducting operating expenses, write-offs, interest expenses, depreciation and amortization charges, and taxes.

· Operating profit represents a firm’s earnings after deducting operating expenses, but before deducting write-offs, interest expenses, depreciation and amortization charges, and taxes.

1. Economic payouts (such as royalty payments on intellectual property licenses).

2. Some form of accounting profit (such as net income or operating profit) (see Box 6.13).

We tend not to use the DCF nomenclature. Since we most often find ourselves using economic payouts or accounting profits for the analysis rather than free cash flows, we refer to the standard discount method as a discounted future economic benefit analysis (DFEB).[footnoteRef:9] [9: William J. Murphy, John L. Orcutt, and Paul C. Remus, Patent Valuation: Improving Decision Making through Analysis 122 (2012).]

The Basic DFEB Calculation

The basic formula for a DFEB analysis is:

where

PV = present value

EB = economic benefit (such as free cash flow or operating profit)

EB1,2,3, etc. = economic benefit in the first, second, third (and so on) periods

EBn = economic benefit in the last period benefits are to be received

r= discount rate

Running a DFEB calculations requires only two inputs. The valuator must (1) project the expected benefits by period that will accrue to the holder of the valued assets and (2) come up with a discount rate. The analysis seeks to identify the present value of the actual benefits the assets will generate and add them together. The following examples help demonstrate how the model works.

Example 1—Portfolio of Patents that will be Practiced

Acme, a technology company, has been presented with an opportunity to acquire a patent portfolio for $1.0 million. The portfolio would allow Acme to manufacture and sell a new electronic component (the Device). Acme projects selling the Device for seven years, at which time the technology will become obsolete and Acme would stop producing the Device. Acme has forecasted the extra operating profits for the seven-year period and elected to use a 25 percent discount rate.

Future Year

1

2

3

4

5

6

7

Total

Projected extra operating profits

$0.5

million

$1.5

million

$2.5

million

$2.0

million

$1.0

million

$1.0

million

$0.5

million

$9.0

million

Present value at a discount rate of 25%

$0.4

million

$0.96

million

$1.28

million

$0.82

million

$0.33

million

$0.26

million

$0.1

million

$4.15

million

The underlying math for the calculation is:

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Total PV

Based on the portfolio’s selling price, this looks to be a valuable acquisition opportunity for Acme. Even if the acquisition involves significant (a) transaction costs to buy the portfolio and (b) tax liabilities on the profits, the portfolio projects to generate well more than $1.0 million of present-value benefits for Acme.

Example 2—Licensing a Trademark

QualityProducts (QP) manufactures and sells high-quality clothing. QP is considering licensing one of its trademarks and associated goodwill to a subcontractor for five years. The subcontractor would pay QP a royalty rate of 5 percent of net sales associated with the brand. Licensing the trademark will cause QP to lose some sales to the subcontractor. QP has projected the future royalty payments as well as the lost operating profits from the lost sales. Acme is using a 20 percent discount rate for its calculations.

Royalty Payments

Future Year

1

2

3

4

5

Total

Projected net sales by subcontractor

$1.0

million

$1.5

million

$2.0

million

$2.0

million

$2.0

million

5% royalty payment

$50,000

$75,000

$100,000

$100,000

$100,000

$425,000

Present value of royalty payment at a discount rate of 20%

$41,667

$52,083

$57,870

$48,225

$40,188

$240,033

The underlying math for the calculation is:

Year 1

Year 2

Year 3

Year 4

Year 5

Total PV

Lost Operating Profits

Future Year

1

2

3

4

5

Total

Projected lost operating profits

$75,000

$100,000

$100,000

$100,000

$100,000

$475,000

Present value at a discount rate of 20%

$62,500

$69,445

$57,870

$48,225

$40,188

$278,228

The underlying math for the calculation is:

Year 1

Year 2

Year 3

Year 4

Year 5

Total PV

The projected royalty payments are not sufficient to compensate QP for the projected lost profits, so QP should not do the deal as structured. QP should ask for a higher royalty rate or an upfront fee, possibly $75,000, to cover the shortfall.

Example 3—Lending against a Copyright Portfolio

RealAnimal Productions (RAP) is a successful producer of wildlife documentary videos that it licenses to companies for cable television broadcasts. RAP wants to borrow $150,000 from its bank. As collateral for the loan, RAP has offered to pledge its portfolio of copyrights in a series it produced on dangerous amphibians. The bank wants to determine if the portfolio provides sufficient collateral. In valuing the portfolio, the bank makes the following projections:

· RealAnimal can license the series for $10,000 for each cable broadcast showing, and there will be fifteen showings in years one and two, eight showings in years three and four, and six showings in year five.

· At the end of the five years, there is a residual value of $200,000 for the portfolio of copyrights.

Based on its past experience with RealAnimal Productions, the bank is comfortable using a 20 percent discount rate. The bank’s rule of thumb for adequate collateralization is the collateral should be worth three times the loan amount at the time the loan is made. Using these assumptions the bank makes the following calculations.

Future Year

1

2

3

4

5

Residual

Total

Projected earnings

$150,000

$150,000

$80,000

$80,000

$60,000

$200,000

$700,000

Present value at a discount rate of 20%

$125,000

$104,167

$86,806

$38,580

$24,113

$80,376

$459,042

The underlying math for the calculation is:

Year 1

Year 2

Year 3

Year 4

Year 5

Residual

Total PV

Based on the projections and the bank’s collateralization threshold, the projected value of the copyright portfolio is sufficient (barely) to support the $150,000 loan.

Developing Projections

The above examples assumed the future benefits and the discount rate. In reality, the valuator must develop those numbers. The math for a DFEB analysis is not challenging. What is challenging is projecting the benefits and developing the discount rate. It requires the inherently inaccurate task of predicting the future (see Box 6.14). Appreciating the inaccuracy potential, and employing mechanisms to cope with it, are critical to effective valuation analyses.

Box 6.14

Studies Show the Difficulty in Predicting the Future

Numerous empirical studies show how challenging it is to predict the future—even for experts. Philip Tetlock, a psychology professor at the University of Pennsylvania, wrote a book titled Expert Political Judgment about experts’ ability to predict future political and world events. He asked 284 experts to make tens of thousands of predictions that he tracked over twenty years. The results were not encouraging. In an interview, Tetlock explained:

[E]xperts thought they knew more than they knew. [T]here was a systematic gap between subjective probabilities that experts were assigning to possible futures and the objective likelihoods of those futures materializing … With respect to how they did relative to, say, a baseline group of Berkeley undergraduates making predictions, they did somewhat better than that. How did they do relative to purely random guessing strategy? Well, they did a little bit better than that, but not as much as you might hope …[FN1]

Jerker Denrell and Christina Fang, professors at Oxford and NYU respectively, conducted an empirical study on the ability of managers to predict that something will become a “big hit” with their paper, Predicting the Next Big Thing: Success as a Signal of Poor Judgement.[FN2] Denrell and Fang explain that successful makers of bold predictions often suffer from the poorest judgment.

Managers and entrepreneurs are often assessed on their ability to forecast the success of new ventures. Managers evaluate new products and ideas, make bets on which of them will succeed and advance in their careers by predicting successful new products and technologies. Entrepreneurs who can “see what is next” and successfully invest in the “next big thing” become rich and may end up on the cover of business magazines.

Successfully predicting that something will become a big hit seems impressive and the individuals who get it right are often hailed as “seers.” Underlying the admiring accounts of farsighted individuals is the assumption that managers and entrepreneurs who accurately predicted that a new venture would be successful (i.e., the next big thing), are likely to be better forecasters. Intuitively, an accurate forecast is more likely to have been made by a forecaster who has better judgment and is better able to evaluate the situation. Here we argue that there is a simple reason why this intuition may be wrong. Rather than being an indication of good judgment, accurately forecasting a rare event such as business success may in fact be an indication of poor judgment. The reason is that a forecaster with poor judgment is more likely than a forecaster with good judgment to predict the rare and extreme event of a product becoming successful.[FN3]

On a lighter note—but showing the frustration inaccurate predictions can generate—a bill was introduced in Romania in 2011 to fine fortune tellers and witches whose predictions proved inaccurate. [FN4]

FN 1. New Freakonomics Radio Podcast: The Folly of Prediction, available at http://freakonomics.com/2011/09/14/new-freakonomics-radio-podcast-the-folly-of-prediction/.

FN 2. Jerker Denrell and Christina Fang, “Predicting the Next Big Thing: Success as a Signal of Poor Judgment,” Management Science 56:1653 (Oct. 2010).

FN 3. Id.FN 4. “Romania looks to fine witches when predictions fail,” NBSNews.com, http://www.nbcnews.com/video/nbcnews.com/41670794#41670794.

Projecting Profits

Identify the Benefits A valuation analysis fundamentally involves two steps. First, identify the ways in which the asset will generate profits for the holder. Second, measure the benefits and add them together. Let us begin with the first step.

Intellectual property rights can generate both direct and indirect benefits for holders. When the intellectual property asset generates a direct cash flow to the holder, it is a direct benefit. For example, a patent gives its holder the right to exclude others from making, using, or selling the invention. This exclusionary right can generate direct cash flow to the holder through premium pricing, licensing revenues, assignments, and litigation revenue. Indirect benefits are additional benefits that eventually boost the holder’s bottom line, but take a more circuitous route. Using patents as the example once again, they can indirectly boost a firm’s profitability by improving its cross-licensing leverage (see Box 6.15), which reduces licensing expenditures. Table 6.4 provides a list of common ways to generate both direct and indirect benefits from patents, trademarks, and copyrights.

Box 6.15

What is Cross-Licensing?

Cross-licensing is a form of defensive patent licensing strategy. When one firm needs to obtain a patent license from another firm, it may be able to avoid paying royalties (or lower the royalty payment) if it has patents the other firm needs. Cross-licensing can be described as “you can use my patents and I can use yours.” Cross-licensing is often used as a defense against patent infringement litigation.

In many high-technology industries, the collection of patents amongst competitors can be quite extensive making it difficult to avoid plausible infringement claims. Cross-licensing is one strategy to navigate this problem.

Table 6.4

Common Ways to Generate Direct or Indirect Benefits from Intellectual Property

Common ways to generate cash flow

Directly

Indirectly

Patents

· Practice invention and premium price the product

· License patent and associated know-how

· Sue others for infringement

· Cross-licensing

· Increase goodwill by signaling technological strength

Trademarks

· Premium price trademarked product

· License trademark and associated goodwill

· Sue other for infringement

· Prevent imitators from free-riding on goodwill

· Use trademark associated with patented product to bolster sales after patent expiration

Copyrights

· Sell the copyrighted work

· License the right to reproduce, prepare derivative works, distribute copies, perform, or display the copyrighted work

· Generate revenue from compulsory licensing schemes

· Sue others for infringement

· Encourage increased creativity by insuring reward

· Prevent unauthorized copying and use that can erode revenue

One valuation challenge intellectual property assets pose is the breadth of ways they can generate value. On the one hand, it is easy to undervalue (and to underinvest in) intellectual property by failing to appreciate all the different ways it can benefit the holder. On the other hand, it is also easy to overvalue value (and to overinvest in) intellectual property by looking at the myriad ways it can benefit the holder and unjustifiably assume the occurrence of multiple benefits without appreciating their true potential and constraints.

Depending on the reason for the valuation, the valuator may be able to limit her focus to a few specific benefits, or may need to value as many potential benefits as possible. For example, if a bank wants a conservative value estimate for a copyright portfolio being used as loan collateral, the valuator may reasonably decide to focus solely on the direct cash flows the portfolio is already producing and ignore other possible benefits. If the purpose of the valuation is to determine the overall value of the intellectual property, a broader inquiry may be required.

Measuring the Benefits—Overview Once the sources are identified, the valuator must project the amount and timing of the benefits from each source. This is typically done by projecting the asset’s annual benefits for the remainder of its economic life. We will address the topic of economic life for the various forms of intellectual property later in this chapter. For this part of the chapter, we will focus on how to develop the annual benefit projections.

Most Profit Forecasts Start with Revenue Projections The standard procedure for projecting profits is to begin by forecasting the relevant revenues. Then, the costs for obtaining the revenues are deducted to arrive at the profit estimates. The costs are frequently estimated by calculating them as a percentage of forecasted revenues. The revenue forecasts, therefore, “drive the math for the entire projection exercise.”[footnoteRef:10] This procedure can be referred to as a “revenue-centric” approach to forecasting profits. The following example demonstrates how a revenue-centric forecasting model works. Assume Acme, a technology company, seeks to forecast operating profits for a new, patented technology (the Device) that it plans to manufacture and distribute. [10: Murphy, Orcutt, and Remus, supra note __, at 136.]

Step 1—project the revenues: Acme projects the Device will sell for five years, at which point it will become obsolete and stop selling. Acme generates the following revenue projections.

Future Year

1

2

3

4

5

Projected revenues

$500,000

$1,500,000

$2,000,000

$1,000,000

$500,000

Step 2—calculate production costs as a percentage of revenues: Production costs are the expenses paid to produce the good or service. For this example, Acme believes the production costs will start at 70 percent of revenues, but will quickly decline to 40 percent of revenues as the company learns how to manufacture the device more efficiently.

Future Year

1

2

3

4

5

Projected revenues

$500,000

$1,500,000

$2,000,000

$1,000,000

$500,000

Production costs:

As % of revenues

70%

55%

40%

40%

40%

Estimated costs

($350,000)

($825,000)

($800,000)

($400,000)

($200,000)

Gross profit

$150,000

$675,000

$1,200,000

$600,000

$300,000

Step 3—calculate operating costs as a percentage of revenues: Operating costs are the expenses involved with the day-to-day running of the company’s operation. Whereas production costs capture the costs to produce the firm’s goods or services, operating costs capture what it costs to turn the firm’s inventory of goods or services into revenue. Operating costs can be broken down into more specific line items, such as selling expenses, research and development expenses, and general administrative expenses. For this example, Acme believes the operating costs will be 25 percent of revenues.

Future Year

1

2

3

4

5

Projected revenues

$500,000

$1,500,000

$2,000,000

$1,000,000

$500,000

Production costs:

As % of revenues

70%

55%

40%

40%

40%

Estimated costs

($350,000)

($825,000)

($800,000)

($400,000)

($200,000)

Gross profit

$150,000

$675,000

$1,200,000

$600,000

$300,000

Operating costs:

Selling expenses (at 10% of revenues)

($50,000)

($150,000)

($200,000)

($100,000)

($50,000)

R&D expenses (at 7% of revenues)

($35,000)

($105,000)

($140,000)

($70,000)

($35,000)

Administrative expenses (at 8% of revenues)

($40,000)

($120,000)

($160,000)

($80,000)

($40,000)

Operating profit

$25,000

$300,000

$700,000

$350,000

$175,000

This exercise allowed Acme to project the operating profits for the Device. Acme projected the revenues, then subtracted production and operating costs as a percentage of those revenues.

Growing Revenues versus Decreasing Costs Profits can be generated in two ways:

1. by growing revenues more than costs; or

2. by decreasing costs more than revenues.

The revenue-centric approach is used when profits are expected to come from revenue growth. However, when profits are expected to come from cost cutting, a “cost-centric” approach to forecasting profits should be applied. With a cost-centric approach, the valuator assumes the intellectual property assets will reduce costs but have little, or no, influence on revenues. Industrial process patents offer a good example of an intellectual property asset that reduces costs. Consider the following example. Acme invented a new method for drilling holes for certain of its manufactured products (the Products). The patented process does not impact sales, but it does reduce production costs. To keep the example manageable, assume there is only five years left on the patent.

Step 1—project the revenues: Revenue projection are still the first step. Acme must project the Products’ revenues.

Future Year

1

2

3

4

5

Projected revenues for the Products

$1,000,000

$1,050,000

$1,102,500

$1,157,625

$1,215,506

Step 2—calculate the costs savings: For this example, Acme believes the patented process will reduce production costs by 5 percent. Acme should calculate the production costs for the Products based on their typical percentage of revenue, then reduce those production costs by 5 percent.

Future Year

1

2

3

4

5

Projected revenues for the Products

$1,000,000

$1,050,000

$1,102,500

$1,157,625

$1,215,506

Production costs:

As % of revenues (without patented process)

65%

65%

65%

65%

65%

Estimated costs (without patented process)

($650,000)

($682,500)

($716,625)

($752,456)

($790,079)

Five percent reduction from patented process

$32,500

$34,125

$35,831

$37,623

$39,504

Acme’s benefit projections are the five percent reduction in production costs for the next five year.

Sometimes the intellectual property is expected both to grow revenues and decrease costs. In those fortunate circumstances, the valuator must take account of the intellectual property’s influence on revenues and costs.

Isolating the Intellectual Property Benefit When a party conducts an intellectual property valuation, there can be confusion as to what is being valued. Are the intellectual property rights being valued, the firm’s underlying product or service, or both the rights and the product/service collectively? This problem is most acute for patents and trademarks. With copyrights, there is little need to separate the value of the rights from the attached product. This is because the attached product, such as a book, a song, or a movie, usually have little economic value apart from the copyright. When a book is sold, only a small portion of the value comes from the paper and binding. Almost all of the actual value is in the copyright.

Patents An invention, and its ability to generate benefits, is distinct from any associated patent rights. If a firm generates an invention for a commercial product, it can generate profits from selling the product regardless of whether it obtains a patent. Obtaining patent rights, however, allows the firm to generate additional benefits. Patent rights may allow the firm to premium price the product and/or license the patent rights to third parties. Depending on the purpose of the valuation analysis, it may or may not be important to separate the value of the patent rights from the invention. When venture capital firms value startups, for example, they generally do not try to isolate the value of the patent rights from the commercial product.[footnoteRef:11] A startup with patents “will be valued in the aggregate on its ability to generate future profits, and the VC is unlikely to conduct separate valuations for each of the patent-right/investment-use assets that make up the company.”[footnoteRef:12] [11: Id., at 10.] [12: Id.]

In other situations, the valuator may need to isolate the value of the patent rights and value them separately from the invention. There is no single method for separating the value of a patent from the underlying invention. Three commonly employed methods are the premium profit method, the premium pricing method, and the royalty savings method.

1. Premium profit method = This method compares the profitability of the patented product with comparable non-patented products. Superior profit margins for the patented product are then attributed to the patent.

Example: A patented product generates an operating margin (operating profits divided by revenues) of 45 percent, while comparable unpatented products generate 30 percent operating margins. Assuming the products are truly comparable, the superior profit margin (minus any patenting costs) can be attributed to the patent. When developing a DFEB model that seeks to account only for the value from the patent, the future benefits used in the model would be the superior profit margins.

2. Premium pricing method = This method compares the price of the patented product with comparable non-patented products. Higher pricing for the patented product is treated as coming from the patent’s premium pricing benefit. An example of the premium pricing method is given below for trademarks.

3. Royalty savings method = This method measures the savings from owning the patent rights rather than paying license fees to third parties.

Example: A manufacturing firm obtains a patent for a particular component in one of its products. Without the patent, the firm would likely have to pay a royalty of one percent of net sales to a third party who holds a patent on an alternative component. The savings from avoiding the licensing fees (minus any patenting costs) can be attributed to the patent. When developing a DFEB model that seeks to account only for the value from the patent, the future benefits used in the model would be these savings.

When the projected benefits come from licensing the patent rights rather than practicing the invention, there is no need to isolate the value of the patent rights from the invention. The licensing royalties represent the value of the patent rights as well as any accompanying know-how.

Trademarks As with patents, trademarks are a distinct value-generating asset from their underlying products, and there is no single method for separating the value of a trademark from its products. The premium pricing method can be used when a trademarked product competes against unbranded and essentially fungible products. For example, a grocery store may sell a branded laundry bleach as well as unbranded bleach. Assuming the composition of the products is fundamentally the same, any price difference can be attributed to the premium consumers are willing to pay for the quality assurance associated with the trademark. When a trademarked product competes against nonfungible unbranded products, perhaps due to a different formulation or other product difference, the value of the product difference would also need to be taken into account. Consider the following example:

Trademarked Product

Nonfungible

Unbranded Product

Price

$25 each

$17 each

Difference in product quality

$3 better

Relative price (after accounting for product quality difference)

$22 each

(since $3 comes

from its higher quality)

Price premium from trademark

($22 – $17 =)

$5 each

When developing a DFEB model that seeks to account only for the value from the trademark, the future benefits used in the model would be the price premium from the trademark. The more products covered by the trademark and the more substantial the product differences, the deeper the analysis required to identify the trademark premium.

The premium profit method and royalty savings method can also be used to isolate trademark value.

Using Historical Data Historical data is the basis for most predictive models. While some models are more sophisticated than others, most rely on historical data, or trends, to justify their projections. The valuator examines past performance to guide her projections for the valued assets’ future performance. Extrapolating future sales patterns from past performance is a common practice.

Example: Acme licenses one of its trademarks to a third party, Beta. The license allows Beta to affix the trademark to shirts it manufactures. In exchange, Beta pays Acme a royalty of 6 percent of its net sales from the trademarked shirts. Beta has been licensing the trademark for the last three years and is scheduled to license it for four more years. Acme wants to project the next four years of royalties. The following are Beta’s net sales of the trademarked shirts for the last three years.

Historic Performance

3 Years Ago

2 Years Ago

Last Year

Actual net sales

$1,000,000

$1,050,000

$1,113,000

Percentage increase

5%

6%

Past performance demonstrates demand for the trademarked shirts and moderate growth. However, Acme believes Beta’s production constraints will slow sales growth for the next few years. In addition, Acme’s marketing research shows demand for the shirts is softening and will begin to decline within three years. With this information, Acme generated the following forecasts:

Future Year Performance

1

2

3

4

Projected net sales

$1,157,520

$1,180,670

$1,168,863

$1,110,420

Percentage increase (decrease)

4%

2%

(1%)

(5%)

Projected royalty payments (at 6% of net sales)

$69,451

$70,840

$70,132

$66,625

Using historical data to generate projections is not problem-free. Everyone should be familiar with the adage, “past performance is no guarantee of future results.” While historical data is useful for forecasting performance, it is unwise to be overly confident in historical trends continuing into the future.

When Historical Performance Data is Missing Because intellectual property assets are often early-stage assets with little, or no, track record for generating profits, there may not be sufficient historical data for inferring future performance. One of the more common techniques to forecast revenues—and by far the simplest—is simple growth escalation. The valuator guesstimates the first year or two of sales and then applies an annual growth rate until sales reach maturity.[footnoteRef:13] The valuator assumes sales will grow continuously throughout the product’s life cycle until it saturates the market.[footnoteRef:14] The credibility of this assumption may be highly questionable. [13: Richard A. Michelfelder and Maureen Morrin, “Predicting Sales and Revenues for New Ventures with Diffusion Models,” in Gordon V. Smith and Susan M. Richey, Trademark Valuation: A Tool for Brand Management, 2d ed. 285 (2013).] [14: Id.]

Model Growth Curves Model growth curves provide a slightly more sophisticated approach to developing revenue forecasts. Frequently called sales curves (S-curves), they are meant to approximate a new product’s future performance based on the historical performance pattern of similar products or technologies. Model growth curves stem from product life-cycle theory, which explains that new products sales often follow a similar four stage pattern: (1) introduction; (2) rapid growth; (3) maturity; and (4) decline. Sales start slowly during the introduction as customers learn of the product. If customers like the product, sales increase rapidly to fill demand, plateau as demand is eventually satisfied, and finally decline because new products enter the market and displace the original product. Figure 6.1 shows the classic S-curve.

Figure 6.1

Classic S-Curve

[Insert Figure 6.1.]

Economists have developed more detailed permutations of the classic S-curve based on actual observations.[footnoteRef:15] In their book, Trademark Valuation: A Tool for Brand Management, 2d ed., Gordon Smith and Susan Richey describe some of these permutations, including the Gompertz model, the Fisher-Pry model, the Pearl-Reed model, and the Bass model.[footnoteRef:16] [15: Gordon V. Smith and Susan M. Richey, Trademark Valuation: A Tool for Brand Management, 2d ed. 161 (2013).] [16: Id. at 160-64.]

Building Revenue Forecasts from Scratch The biggest challenge for the valuator is forecasting the revenues that drive the profit forecasts. The market share approach and the unit sales approach are two common ways for developing revenue forecasts.

Market Share Approach The market share approach requires projecting, by year, the size of the relevant market and the percentage of that market the firm will capture. Forecasted revenues are calculated by multiplying the projected market size by the projected market share.

Consider the following example of the market share approach. Acme developed a specialized robotic device (the Device) for conducting stomach surgery. The Device allows surgeons to perform stomach surgery by placing a tube down the patient’s throat, thereby eliminating the need to cut the patient open. Acme generated the following forecasts for the next five years:

Year 1

Year 2

Year 3

Year 4

Year 5

Projected market size

$50

Million

$55

million

$60

million

$62

million

$63

million

Acme’s projected market share

1%

2%

7%

10%

12%

Acme’s revenue forecasts

$0.5

Million

$1.1

million

$4.2

million

$6.2

million

$7.6

million

Unit Sales Approach The unit sales approach involves projecting, by year, the number of units the firm will sell as well as the price of the units. Forecasted revenues are calculated by multiplying the projected unit sales by the projected price.

Assume Acme used the unit sales approach to forecast revenues for the Device.

Year 1

Year 2

Year 3

Year 4

Year 5

Projected unit sales

20

50

200

300

350

Projected unit price

$10,000

$10,000

$9,000

$9,000

$9,000

Acme’s revenue forecasts

$200,000

$500,000

$1.8

million

$2.7

million

$3.2

million

Projecting Future Royalties When firms license out their intellectual property assets, the typical benefit is a stream of future royalties. Most intellectual property licenses involve running sales royalty payments. With a running sales royalty, the licensee agrees to pay the licensor a percentage of the net sales that come from using the intellectual property. Therefore, projecting the licensee’s revenues is usually the first step for forecasting future royalties. Assume Acme agrees to license one of its trademarks to Beta. The license allows Beta to affix the trademark to shirts it manufactures in exchange for a 7 percent running royalty rate. Beta must pay Acme 7 percent of its net sales of the shirts. Projecting Acme’s future royalties begins with a forecast of Beta’s future sales. Projecting those sales will usually be done using the market share or unit sales approach discussed above.

Projection Period and Terminal Value A DFEB calculates the benefits of assets for their remaining useful life. An asset’s useful life is the period of time it generates profits for its holder. Few assets, including intellectual property, produce benefits in perpetuity. Therefore, the valuator must determine the period of time during which the valued assets are likely to produce benefits. The useful life for an intellectual property asset can end in two ways.

1. Expiration of Legal Life. The legal life of the intellectual property can expire. Intellectual property assets are created by legislation, and their duration may be limited by such legislation. In the case of patents and copyrights, they have finite legal lives (see Box 6.16). The remaining duration of their legal life establishes an upper limit on their useful life. If a patent has 10 years remaining on its term, its maximum remaining useful life will generally be 10 years. Trademarks do not have finite legal terms, so their useful life is not limited by a predetermined legislative term but instead by market, cultural, and societal considerations.

Box 6.16

Legal Life of Patents and Copyrights in the United States

Patents

· 20 years from the earliest filing date of the patent.

Copyrights

· Work created by an individual = Life of the author + 70 years

· Work created by an entity = 95 years from first publication or 120 years from creation, whichever expires first

2. General Obsolescence. An intellectual property asset’s useful life may also end before the expiration of its legal life. In the case of a patent, a superior technology may replace the patented technology before the expiration of its 20-year term or the product that employs the patented technology may stop selling. Demand for copyrighted materials may also dry up long before the expiration of the copyright term. Trademarks have the potential to generate benefits in perpetuity, but they too can become obsolete if the trademark, or its underlying product or company, loses favor with the public.[footnoteRef:17] [17: For an excellent discussion of obsolescence for trademarks, see Smith and Richey, supra note __, at 144-154.]

When running a DFEB analysis for intellectual property assets, the valuator must determine their probable useful life and generate projections for that period of time. If the valuator believes the useful life for a patent is seven years, she must generate benefit projections for the next seven years.

If the benefits stretch too far into the future, the valuator may not feel confident generating projections until the assets’ useful life is exhausted. For example, if the valuator believes a trademark has a useful life of 40 years, it would be unrealistic to generate benefit projections that far into the future. In fact, most valuators limit themselves to a five- or ten-year projection period. The valuator needs a mechanism to capture the benefits that may be generated after the period actually forecasted. This mechanism is referred to as a terminal value (or residual value). The valuator generates forecasts for those periods where she feels confident, then applies a terminal value to capture the value of the future benefits projected to be earned after her projection period (see Figure 6.2).

Figure 6.2

Terminal Value

[Insert Figure 6.2.]

Terminal value represents the benefits the asset should generate from the conclusion of the projection period until the end of its useful life. Terminal value is equal to the future benefits the firm will generate from using the asset, plus the asset’s salvage value, if any. There is no single way to calculate terminal value. The following are illustrations of possible methods for developing a terminal value.

· Stable growth method: This method takes the benefits from the final projection year and assumes they will grow at a constant rate going forward. The formula for the stable growth method is

The stable growth method can be used when (a) the asset’s benefits are expected to continue in perpetuity, or for a very long period of time (e.g., 50 years), and (b) the valuator believes the benefits will grow at something approximating a stable growth rate. The stable growth method can be applied to trademarks and copyrights with extended useful lives. However, it is not appropriate for patents since their useful lives do not extend far enough into the future to assume perpetual benefits.

· Terminal multiple method: This method seeks to estimate the sales price of the asset at the end of the projection period. The terminal multiple method uses a ratio analysis to do this. Ratio analyses will be discussed later in this chapter. For now, it is worth pointing out that asset sales are often priced based on a multiple of the asset’s projected performance. A commonly used multiple is sales price-to-earnings. If comparable assets are selling for 10x earnings, the valuator would apply that multiple to the final year of the projection period to estimate the sales price of the asset in that final year. In practice, the terminal multiple method is rarely used for intellectual property due to a lack of comparable transaction data.

· Performance possibilities method: Since the stable growth method and terminal multiple method seldom work for intellectual property, how does a valuator generate a terminal value? In our book, Patent Valuation: Improving Decision Making through Analysis, we proposed an alternative method called the performance possibilities method.[footnoteRef:18] Rather than try to come up with a complex equation that will likely be rendered meaningless by the inaccuracy of its inputs, we suggested using a visual exercise to address the terminal value issue. The valuator should try to draw the asset’s performance curve following the projection period. There are five probable performance possibilities for any intellectual property asset after the projection period: [18: Murphy, Orcutt, and Remus, supra note __, at 129.]

1. Benefits rise throughout its useful life

2. Benefits rise until reaching a plateau at which point they remain constant

3. Benefits increase and then decline

4. Benefits remain relatively constant

5. Benefits steadily decline

Instead of getting lost in the projection numbers, the valuator can simply draw what she believes will be the most likely performance outcome. The valuator can use insights from the curve to complete her benefit projections for the intellectual property asset’s useful life. Figure 6.3 shows a few different curves the valuator may draw. Using the curve that best fits expectations, the valuator can translate the drawn performance into actual numbers that can be modeled in the DFEB.

Figure 6.3

Sample curves for a patent expected to generate increased, and then decreased, benefits after the projection period

[Insert Figure 6.3.]

For intellectual property assets projected to generate benefits well into the future, terminal value can account for a significant percentage of present value. For trademarks and copyrights with long-term prospects, more care must be given to generating the terminal value. Because patents have a shorter legal life, terminal value tends to be less important when conducting a DFEB analysis. However, for early-stage patents that project to generate benefits for roughly ten years or more, terminal value can once again be very important.

Developing a Discount Rate

After projecting the stream of future benefits, the valuator must discount them back to present value. The standard discount formula is:

wherePV= present value

FV= future value

r= discount rate

t= period into the future

Because the benefits are received over time, the discount rate is used to account for the time value of money as well as the risk of the actual benefits being less than forecasted. Together, these components establish the rate of return the party needs to commit to the project.[footnoteRef:19] [19: For this summary discussion, we are describing the discount as involving two components: (1) the time value of money; and (2) a component for risks. When we describe the discount rate more fully, we explain that it actually has five distinct components: (1) enjoyment deferral; (2) opportunity costs; (3) inflation rate; (4) risk; and (5) illiquidity adjustment. For a complete explanation of the five components, see Murphy, Orcutt, and Remus, supra note __, at 151-154.]

Time Value of Money The time value of money stems from the principle that money received today is worth more than the same amount of money received in the future. There are two primary elements to the time value of money.

1. Lost opportunity costs. Deferring receipt means the money cannot be invested in other profitable projects (e.g., earning interest). The party sacrifices these lost opportunities while waiting to receive the money.

2. Inflation rate. Inflation eats away at the future benefits. Assuming a five percent inflation rate, receiving $1,000 at the end of the year is really worth only $952 today (or $1,000/1.05). Assuming a constant five percent inflation rate for ten years, $1,000 received at the end of the ten-year period would be worth only $614 today (or $1,000/1.0510).

Collectively, the lost opportunity costs plus the inflation rate represent a party’s risk-free rate. This is the rate of return a party should be able to generate during the deferral period, with virtually no risk, on the funds it commits to the project.

Risk Component Parties could choose to commit all of their funds to largely risk-free investments, such as U.S. Treasury bills. To induce parties to pursue riskier projects, there must be a return above the risk-free rate that justifies the greater risk. The entire DFEB exercise is based on projections of future benefits. There is risk the benefits will be less than projected. Because intellectual property assets are often early-stage assets with little (or no) track record for generating profits, the risk can be substantial and is frequently the largest component of the discount rate by a sizable amount. We provide a more detailed discussion of discount rates for early-stage intellectual property assets and how to deal with their substantial uncertainty below in Valuing Early-Stage Intellectual Property Assets