Approaches for Valuing Intellectual Property Assets

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Approaches for Valuing Intellectual Property Assets

Dr. Nithyananda K.V. | January 2021

INTRODUCTION

Any transaction or exchange of intellectual property assets (hereafter IP assets) for value requires that such assets be valued using appropriate approaches. Such valuation becomes necessary to derive zone of value where a mutually beneficial market for the IP asset exists. Such a zone of value for IP assets constitute the base ground on which negotiations between the prospective buyer and the intended seller would be carried out. Without such zone of value, either the seller or the buyer would suffer a considerable loss in transactions involving IP assets. However, it needs to be remembered that transaction here does not mean only buying and selling of IP assets; it could also involve transactions relating to licensing, lease, sale, buyback, securitization, collateralization, and other similar transactions involving IP assets.

There are various approaches to value IP assets. These approaches can broadly be classified into two categories: quantitative approach and qualitative approach. Under the quantitative approach, the value of IP asset would be ascertained based on financial data (either historical or projected) relating to the company and its IP assets. Under the qualitative approach, however, a lot of qualitative data including the judgment of the person valuing the IP asset, the legal conditions, and the status of the IP asset would be considered in arriving at the value of the IP asset. Both these approaches have their respective advantage and disadvantages. Each of these categories, have various approaches, which are listed in the table below.

QUANTITATIVE APPROACH

Cost Approach
Market Approach
Income Approach
Real Options based Approach

QUALITATIVE APPROACH

Qualitative Technique
Rating / Ranking Approach
Rule of Thumb Approach
Bibliographic Value Indicators These approaches and many others are commonly used in valuing IP assets. In this article, I would be discussing the five most commonly used approaches in valuing IP assets

1. COST APPROACH

The philosophy of this approach is very simple. It considers all the costs associated with the creating / recreating the available IP asset as its value. This approach is historical in its perspective. The costs considered in valuing the IP asset includes the amount spent towards the R&D developing the technology, the costs associated with protecting the IP rights (including legal fees, due diligence expenses, filing charges, maintenance, etc.), any direct and indirect expenditure incurred towards bringing the technology into its current state / condition, any consulting services hired for R&D, etc. Basically, it includes all the costs associated with re-creating the IP asset, installing it, testing it, and bringing it to an operational state, where it is fit to generate revenue for the IP owner.

One can adopt any of the two methods available under the cost approach: reproduction cost method, where all the costs associated with the purchase or the development of an exact replica of the IP asset that is being considered for valuation; replacement cost method, where all the costs associated with developing an equivalent IP asset being considered for valuation. Both the methods under this approach operate under the principle that there is a direct relation between the costs expended towards the research and development of the IP asset and its economic value.

The valuation figure generated using the cost approach would typically be the lowest among all the approaches. This is because the company might have been frugal in its investment towards R&D for an invention, which potentially has a very high value. Because of this the costs to be considered for valuation of the IP asset would be very limited and hence a low value of the IP asset. Many landmark inventions have revolutionized the market, whose cost of R&D would be very minimal. A classic example that is often quoted under this approach, to highlight the demerits of adopting the cost approach for valuing the IP asset is the case of 3M’s Post-It Notes, where the cost incurred to develop it was very minimal, but it created an entirely new product category, which has generated enormous value to the company.

2. MARKET APPROACH

This is one of the easiest approaches to value IP assets. Under this approach one scouts for a transaction of an IP asset similar to the one being valued and then understand the valuation of that IP asset in such transaction. If a patent for a vaccine were being valued, then another patent for a vaccine that underwent a similar transaction would have to be searched. Such value has to be adjusted to the current patent after which the value for the patent can be determined. This is one of the most reliable measures of IP valuation, because instead of the assumptions made by the evaluator and the IP owner, this approach considers what market determines as the value of the IP asset.

This is also very difficult to ascertain because of two reasons: the first one is finding out an IP asset that is similar to the one being valued, as the existence of similar or a replica IP asset would be very rare; the second is finding information relating to the transaction relating to such similar IP assets, as most transactions relating to IP assets would be confidential in nature and the exact value and the terms of such transaction would be difficult to ascertain. Because of these two reasons, ascertaining the value of an IP asset under this approach becomes difficult.

3. INCOME APPROACH

This approach is based on the financial principle that the intrinsic value of an asset is based on the expected income flows from such asset. In this approach, the expected future cash flows / income from the IP asset is calculated (with reasonable assumptions), which are then adjusted with appropriate expenses that would be incurred for earning such cash flows / incomes. The final cash flows would be discounted using appropriate discount factor adjusting it to the present time. A sum of all such discounted cash flows would represent the present value of the IP asset.

Two methods are usually followed to calculate the value of the IP asset: the first method is to discount future cash flows / earnings that accrue from the IP asset, where the IP asset is being licensed in the expectation of earning future revenue from the IP asset; the second method is to discount the savings from royalty expenditure (also known as royalty relief method). This method is applicable in cases where a company already has an existing license of an IP asset and is exploring an option to buy or license a new IP asset. Any saving from the new IP asset could be used to calculate the discounted cash flow and in turn the value of the IP asset.

This approach is typically followed in situations involving financial professionals, like trying to raise angel / venture financing, private equity investments, or direct buying of IP assets, or in transactions involving mergers, acquisitions, takeovers, and joint ventures. This is based on a lot of parameters that are considered robust by the finance professionals, but calculating the value of the IP asset would be extremely complicated for persons without a background in financial valuation. This approach also involves making a lot of assumptions, which might not become true or might turn out to be different, like the COVID-19 situation is panning out currently all over the world.

4. REAL-OPTIONS APPROACH

This approach, also called contingent claim valuation approach, is used to determine the value of those IP assets whose cash flows are contingent on the occurrence or non-occurrence of an event. This approach is based on two models: the first is based on the model developed by Black and Scholes in 1972 (which is popularly known as the Black-Scholes Option pricing model) which accounts for continuous time-series payouts; and the second is based on the Binomial option pricing model, which is used for discrete time-series payouts.

In this approach, the payouts materialize only under certain contingencies and not in other events. Typically, this approach is followed for valuing patents relating to medicine that is under clinical trials. If the patent owner wishes to dispose the patent or wishes to license it to others in return for a royalty payment, then the buyer of such patent rights would have to arrive at its valuation based on the probability of the drug successfully completing the clinical trials. The value of such patent would be the expected value of the payouts based on the ascertained / agreed upon probability of the event. This approach could also be adopted when the IP owner is trying to license or dispose of the IP asset, which is involved in litigation with others. In such circumstances, the value of the IP asset is dependent on the outcome of the litigation, which is a contingent event.

One of the main problems with this approach is the complexity involved in calculating the value of the IP asset. Another challenge in this approach is ascertaining the probability to the various contingent events with certainty and ascribing the revenue streams that could materialize in such events. Only people with a strong mathematical and financial background would be comfortable using this approach.

5. QUALITATIVE APPROACH

Under this approach, the person evaluating the IP asset for a particular transaction would be using various qualitative inputs like the legal (contractual terms, the legal validity of the IP right, etc.), the technology level covered under the IP right, the market for the product developed by the IP asset, the company organization and its location, the business structuring, the transaction structuring, etc. These factors would be collected using a questionnaire, where the respondents would rate the various questions asked by the evaluating person. Based on the responses, an overall assessment of the IP asset would be made as to the relative importance of the IP asset as compared to others, based on which the value of the IP asset would be determined.

Though this approach is relatively easy, framing the questions becomes difficult and interpreting them into appropriate indicators and ranking would also be difficult. The most important challenge in this is eliciting the responses from the participants whose response matters in evaluating the IP asset.

CLOSING REMARKS

While the above discussed approaches can be suitably adopted by a person conducting the valuation of an IP asset, it needs to be remembered that each of these valuation approaches produce different value for the IP asset. The buyer or the licensee of the IP asset would be trying to pay as less as possible to the IP asset, typically closer to or below the fair market value. The seller or the licensor on the other hand would be trying to as high price as possible for it, typically to recover the investment made towards creating and developing the IP asset. Both the buyer and the seller have to carry out the exercise of ascertaining the value of the IP asset under all these approaches, just to give them a framework or a contour within which the actual value of the IP asset could reside. And the fair value of the IP asset, as mutually agreed upon between the buyer and the seller, would be finalized at the end of the negotiations. The valuation numbers calculated using these approaches would help both the seller/ licensor and the buyer/licensee to align their business strategic goals and objectives with the transaction relating to the IP asset.

About Author

Dr. Nithyananda K.V.

Dr. Nithyananda is currently working as a Faculty Member at the Indian Institute of Management Tiruchirappalli, Tamil Nadu, India, where he teaches electives like Strategic Management of Intellectual Property Rights, Business Models for Managing Intellectual Property Rights, and Legal Aspects of Marketing apart from the core course of Legal Aspects of Business. He earned his PhD in the area of intellectual property and its management from the National Law School of India University, Bangalore. He is also trained at the Harvard Business School on effective management teaching using business cases and business simulation. He has designed a simulation-based course “Strategic Management of Intellectual Property Rights”, which he has been teaching at various institutions and universities at France, Malaysia, Singapore, and Sri Lanka for the last 7-8 years. He has also trained working executives and management professionals on Managing Intellectual Property Assets, which is an area he is very passionate about.