Valuation of IP – 3 Basic Approaches Define Emerging Field

 

Despite the significant importance of intellectual property, valuation of intellectual property, and valuation of intangible assets, generally, is still an emerging field.  Several organizations (governmental and professional) have only in the last decade sought to develop standards for valuation of intellectual property and other intangible assets.  In fact, the American Society of Appraisers (ASA) valuation standard adopted in August 2008 has been cited as the only public valuation standard that takes into account the unique aspects of different forms of intellectual property (patents, copyrights, trade secrets, and trademarks) in providing valuation standards.

 “Value” is generally defined as the “present value of future benefits to be derived by the owner of property.”  As such, “valuation needs to quantify the future benefits and then [use such future benefits to] calculate [a] present value.”

There are three major methods for valuation of intellectual property – - the cost approach, the income approach, and the market (or transactional) approach.  Each is discussed in detail below.

The Cost Based Approach
The cost based approach is based upon on the principle of substitution, i.e., value of an asset is estimated on the basis of cost to construct a similar asset at current prices.  The cost based approach seeks to answer the question – - based on economic factors such as supply and demand, functional and technological obsolescence, what it would cost to build the IP today?  The assumption underlying this approach is that the cost to purchase or develop new property is commensurate with economic value of the service that the property can provide during life.

A common technique under the cost approach involves calculation of the “replacement cost” of the IP.  The replacement cost of an IP asset is the cost to develop similar functionality to the subject IP outside the scope of the legal protection. A common usage of the replacement cost method is the cost to “design around” a patent or set of patents. This method is based on the principle of substitution – an investor would not pay more for an asset than the cost to obtain similar benefits from another asset. This method is particularly useful when the legal protection is weak or the technology is relatively well-known, and the IP does not produce income currently.

Limitations: 
1.   This method the value of IP is not the real value, as it does not does not directly consider the amount of the economic benefits that cannot be achieved nor the time period over which they might continue.
2.   It is difficult to determine all historical development costs
3.   This approach consider cost equivalent to value which cannot be true.
4.   This approach doesn’t consider risk involved in future.

In view of these limitations, the cost approach is primarily used when (1) it is not feasible to project earnings for the intellectual property, (2) the IP is not the type of asset that can be readily transferred to a third party separate from the organization in which it currently resides, or (3) the IP is developed for “in-house’ use and not for resale.

The Income Approach
In the income approach assets are valued based on what they will earn in the future.  This requires estimates of (1) future cash flows (both inflows and outflows) in terms of both amount and timing; (2) economic life; and (3) risk-adjusted discount rate that reflects the required return.  The income approach has been described as the “bedrock” of IP valuation.

Projected cash flows are the future income attributable to the intangible asset.  The economic life refers to the length of time that the IP will be able to command the price or cost premium. The economic life is generally bounded by the legal life of the asset but is often much shorter. For instance, it is common in the electronics field for the technology to become obsolete in as little as 3 years, often well before the patent expires. The discount rate refers to the expected cost of financing the asset in question. For IP assets, the discount rates are generally quite a bit higher than the cost of capital of a company and should be thought of as more similar to venture capital types of investments, with a corresponding discount rate from anywhere from 20% – 50% per year.

Limitations:  It is very difficult to estimate income attributable to intangibles, its economic life, appropriate discount rate/ cost of capital and discount rate.

Market Based Approach
Under this approach the value of intellectual property can determine by considering the market prices paid for similar properties as a part of third party transactions.

The approach estimates the value of an intangible asset based on market prices of comparable intangible assets that have been bought / sold or licensed between independent parties. In other words, it provides indications of value by studying transactions of property similar to the property for which a value conclusion is sought.

The transactional approach is appealing because it is a direct measure of the value of the intangible asset. As such, it is often considered to be the most reliable of methods when it can be performed credibly.  As a general rule transaction data can never be ignored in a valuation exercise – it either must be incorporated or affirmatively rejected as part of the analysis.

The key to performing a successful transactional approach is to ensure comparability between the outside evidence and the subject asset.

Typically, there are two steps to a transactional method valuation – screening and adjustments. Screening refers to the selection process of identifying candidate third party transactions with sufficient information on pricing, scope and terms and conditions to be deemed comparable to the intangible asset in question. Adjustments refer to an explicit quantifiable change in the valuation due a specific rationale. Adjustments are typically grounded in a baseline transaction (or transactions) that are sufficiently close to the subject intangible asset, and for which sufficient information is available to analyze the technical, legal, business and financial terms.

Bottom line – for the market based approach to be effective there must be relevant information about the market available.  This is very often not the case in respect of intellectual property transactions.

Limitations:  For intellectual property it is often difficult to implement the market based approach because information about third party transaction involving similar property is scarce. The following are the requirements for valuation of intellectual property.

Summary
The topic of IP valuation can (and does) fill books.  The selection of which approach to use and how it should be specifically applied depends on numerous factors including the kind of IP at issue, the context in which the valuation is made (e.g., valuation in patent litigation is much different than valuation of IP in the context of M&A work).  This short article is merely intended to introduce the basic approaches that are currently used to deal with the difficult question – - what is the IP worth?

Sources:

Cromley, “International Standards for the Valuation of Intellectual Property”, Presented at “IP in Innovative Economy – Industrial Property as Financial Asset”, Symposium Under Honorary Patronage of the Minister of Economy of the Republic of Poland (Krakow) (September 4-5, 2008) copy available at http://www.uprp.pl/rozne/krakow_2008/prezentacje/04.pdf 

Elliott, “What is the value of Intellectual Property?”, May 21, 2008, available at http://blogs.cisco.com/gov/comments/what_is_the_value_of_intellectual_property/ 

Flignor and Orozco, “Intangible Asset & Intellectual Property Valuation: A Multidisciplinary Approach”, IPThought.com (June 2006) (copy available at http://www.wipo.int/sme/en/documents/ip_valuation.htm) 

“Intellectual Capital and Intellectual Property” – available at http://www.klminc.com/intellect_cap/icap_iprop.html 

McElroy, “The Valuation of Intellectual Property”, available at http://www.engsc.ac.uk/downloads/events_dl/eng-ent-thro-iprs/04%20Trefor%20McElroy.pdf  

Moberly, IP Protection – Intangible Assets and Their Increasing Importance to Company Value, http://ezinearticles.com/?IP-Protection—Intangible-Assets-and-Their-Increasing-Importance-to-Company-Value&id=1860048  

Northcutt, “The Value of IP”, available at http://www.sans.edu/resources/leadershiplab/ip_value.php (April 7, 2007) 

PriceWaterhouseCoopers, “Valuation of Intellectual Property Assets” copy available at http://www.sristi.org/material/11.1valuation%20%20of%20intellectual%20property%20assets.pdf  

“Valuation of Intellectual Property: Approaches” available at http://www.intelproplaw.com/Articles/files/Valuation%20of%20Intellectual%20Property.doc.  

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