EDITORIAL NOTE: This article is co-authored by Weston Anson and Joshua Cawthorn
Techniques for valuing intellectual property continue to develop, especially as access to information becomes easier and more efficient. The practice of valuing intellectual property has only been around for the past few decades, during which time the practice itself has grown and refined.
Valuation is necessary in a number of context-specific situations, including:
- In a sale, merger, joint venture or similar commercial transaction;
- In a divorce (be it personal or business related);
- Estate planning
- When licensing IP; and
Valuation analysts and IP professionals agree there are three standard methodologies to value IP:
- Cost Approach: The historical cost to develop an asset is sometimes used to determine its value. However, the cost to develop an intellectual asset is rarely representative of its ultimate value. This approach is less useful for intellectual properties used with products that have reached the market and generated revenues. Generally, the cost approach is better suited to analysis of intellectual properties and products that have not yet been developed commercially, or that could be re-created quickly, as it reflects the cost a company could avoid by purchasing, rather than duplicating, a similar development effort.
- Income Approach: The income approach calculates the present value of future income streams specifically attributable to the intellectual property asset. This method utilizes forecasted financial results based on factors such as historical financial results, industry trends, and the competitive environment.
- Market Approach: The market approach values intellectual properties by comparing the subject asset to publicly available transactions involving similar assets with similar uses. This provides a reasonable indication of value if an active market exists that can provide examples of recent arm’s-length transactions, with adequate information regarding terms and conditions.
- Relief from Royalty Approach: In the relief from royalty approach, a hypothetical situation is created to estimate what a business would pay to license its own intellectual property assets in an arm’s-length transaction. The value is then calculated as the present value of the avoided hypothetical royalty charges.
The decision of which approach to use is generally based on four factors: (i) how unique is the asset; (ii) how much data is available and verifiable; (iii) what is the context, purpose or objective of the analysis; and (iv) the judgment of the analyst which (one would hope) is based on extensive earlier experience.
In addition to the traditional methods used to value intellectual property, several alternative methods are available. Some are modifications of the orthodox approaches with which most are familiar, but many other choices exist to value these complex assets. Below is a brief summary of these; a detailed explanation of each methodology could fill websites. Instead, this serves as a brief introduction to alternative intellectual property valuation approaches.
As part of a still developing discipline, there are at least 25 alternative valuation techniques to be employed. I would encourage an interested reader to continue doing research on the methods shown here, if the details provided below are insufficient. This article is intended to serve as a cover of alternative IP valuation methods and not meant to provide a detailed explanation or how-to manual for valuing intangible assets. Some things in life offer the luxury of “one size fits all,” however, the orthodox valuation measures that most of us are familiar with — namely the income, market, and cost approach — are often modified even slightly to meet the needs of both the IP that is being measured, the data available, as well as the context of the valuation. The methods being explained below are frequently associated with a certain IP asset. An example of this is the Venture Capital Method, which is a technique that derives a value for a patent from the cash flows that arise over the asset’s life. Although it is similar to the income approach that utilizes a discount cash flow analysis (DCF), it possesses two differentiating factors: a fixed, non-market based discount rate is used and there is no explicit adjustment for the probability of success. We have broken them up into two groups: generally accepted and specialized/proprietary.
Group A – Generally Accepted
Brand Contribution Methodology: The Brand Contribution Methodology is another market-based methodology for valuing IP. The contribution made by the brand may be separated from the profit contributed from other elements of the business in multiple ways: 1) comparing costs charged by a manufacturer and distributor of the unbranded equivalent (also known as the “utility product”); 2) if one eliminates the value added by other assets, the appropriate return on capital employed with respect to the product may be deducted (this includes assets such as physical distribution systems, fixed assets, etc.); 3) the rate of return (or “profitability”) of the business can be compared with the rate of return of a comparable unbranded business (which is known as the “premium profits” method); and 4) comparing the premium price earned by the brand over the retail price of its comparable generic equivalent (known as the “retail premium” method).
Replacement Cost: When using the Cost Approach to value an intellectual asset, two separate methods under the cost approach shall be considered: the Replacement Cost method and the Reproduction Cost method. The Replacement Cost method aggregates the amount of money necessary to develop a replacement of the IP that provides the same functionality or utility, in the same stage of development as the IP being valued, as of the valuation date. It is important to note that the Replacement Cost measures the amount of money in today’s dollars, rather than the amount of money that was spent historically to develop the IP so inflation is accounted for. The logic behind this method is to calculate the amount, in today’s dollars, to provide an equivalent substitute. Finally, calculating the cost of an IP using the Replacement Cost method excludes the costs associated with any failed or ineffectual models.
Reproduction Cost: The Replication Cost method is very similar to the Replacement Cost method, but differs slightly in that it measures the aggregate costs necessary to develop an exact duplicate of the IP being valued, in the same stage of development as the IP being valued, as of the valuation date. Just like with the Replacement Cost, this calculation is done in today’s dollars to appropriately factor in for inflation. And unlike the Replacement Cost method, the Reproduction Cost method includes costs with associated prototypes.
Technology Factor Method: As the number of digital intangible assets rise, using The Technology Factor Method becomes all the more common because it is applicable only to technology. By measuring a technology’s contribution to a business’ total revenue, an asset’s value can be determined. Specifically, the Technology Factor Method is another method that is similar to the DCF method with respect to the calculation of an IP’s risk-free net present value. Once the NPV has been calculated, it can then be multiplied with an associated risk factor (what we will refer to as the “technology factor”). The Technology Factor value incorporates the intellectual property’s strengths and weaknesses associated with the related legal, market and economic risks.
Venture Capital Method: Analyzing the value of future cash flows over an asset’s life is a common technique used to value intellectual property, which is precisely how the Venture Capital method works. Although similar to the common DCF method, it is different in that a fixed, non-market based discount rate is used (generally, a rate of between 40 to 60 percent used). Additionally, no specific adjustment is made to account for the probability of success (e.g., a patent’s success). Unfortunately, the Venture Capital method’s weakness is such that it does not account well for specific risk factors associated with patents. Moreover, it assumes cash flows are static and the independent risk factors (new patent issuance, patent challenges or declared in valid, patent infringement suits, trade secrets, foreign governments’ failure to comply with Patent Cooperation Treaties, etc.) are marshaled. It is the simplicity of this method that harms its accuracy/credibility.
The Concept of Relative Incremental Value: This methodology works when one is trying to represent some percentage of value of an individual asset that is associated with a larger trademark or patent portfolio. For example, if an underlying trademark or brand has a value of $100 million, and the domain name associated with it is generating 10% of revenues (e.g.), then one can allocate a relative value of 10% of the total or, $10 million dollars for the domain name.
Decremental Cost Savings Valuation: This is the method that quantifies a decrease in the level of costs being experienced by the IP owner / operator. If, in fact, the IP owner can quantify lower levels of capital or operating costs connected directly with the ownership of the IP; then those lower costs can be a direct measurement of the value of the specific IP.
Enterprise Value Enhancement: The valuation analyst establishes the value of the IP owner’s overall business enterprise value as a result of owning the IP – and then compares that to the business enterprise value if the owner did not, in fact, have or control the IP or was not able to use it in its business enterprise. The value of the IP then would be the difference between the total business enterprise value and the business enterprise as calculated without the IP.
Imputed Income Analysis: A subset of traditional income approach methods, this imputed income analysis can be used quite effectively in valuing a domain name or sub brand attached to a trademark; or in valuing flanker patents for a core patent portfolio. In the case of a domain name, value is established by looking at the activity generated by the domain name and associated website assets, relative to the overall value of the core trademark and brand bundle. Therefore, one is able to estimate through imputation the relative value of a domain name to its parent trademark.
Income Capitalization or Direct Capitalization Methodology: This is a method sometimes used to estimate the value for intellectual property that has no predetermined statutory expiration (like trademarks) and for which net income (royalties or profit) is not expected to vary greatly over time (due to contractually-defined license fees, for example). This involves taking an estimate of expected annual royalty stream (or profit) and multiplying this amount by a factor known as the capitalization rate.
Income Differential Analysis: This particular variation simply means that a company manufacturing and selling a product with a particularly strong trademark or unique technology will receive more income than a competitive company producing the same product but without the addition of the specific IP, such as the trademark or patent.
Liquidation Value: Found most often in bankruptcy situations, as the name implies liquidation value for any piece of IP is the lowest price that the asset is virtually guaranteed to be sold in a distressed situation. Used almost solely in bankruptcy, other distressed situations or time critical contexts, litigation value scenarios arise most often in a Chapter 7 bankruptcy.
Premium Pricing Analysis: Of all the variations to the income approach, this is perhaps the most easily understood – because the value of an asset is established by looking at the difference in the price that it can command in the market, typically at wholesale, compared to the average product in the market. The difference between these two prices is the price premium. This, then, is projected out on an annual basis and a net present value established.
Profit Split Methodology: A form of the income approach, it can be tricky to apply accurately: because the profit split method attributes a share or portion of a company’s profitability to a particular intangible asset. This method requires that the valuation analyst have the ability to understand the IP to such an extent that he or she can isolate and expressly separate the intangible asset’s profit generation potential from all the other business assets – and then allocate that portion of profit split to the company’s operations and capitalize that value over a number of years.
Group B – Specialized/Proprietary
Auction Method: There are several market-based methods of valuing IP using recent comparable or similar IP transaction between independent parties (“arm’s-length transactions”). One of these methods is called the “Auction Method.” If a hypothetically perfect auction market existed, several potential buyers that each had all available information regarding the IP would compete with each other to bid on the IP. Through this auction process, a market-based price of the IP would be determined through bidding.
DTA (Decision Tree Analysis) Based Methods: While many people are familiar with the DCF methods of valuing intellectual property, it comes with inherent weaknesses because it relies on selecting discount rates appropriate to the risk associated with the various stages in a property’s life. Not only does it require calculating the possible cash flows which might occur, DCF methods do not account for the various possibilities open to project managers (for example, the levels of risk if a patent lapses or is abandoned at differing stages along the process). Unfortunately, there is no “exact science” to be applied for these and experience is necessary to influence these decisions.
Assumptions can be built into the DCF model in an attempt to account for the possible outcomes as the result of management decisions. Using what is known as Decision Tree Analysis, a limited number of such managerial decision possibilities can be accounted for. It is important to note, however, that the Decision Tree Analysis should be based on an underlying DCF analysis of each branch. The recommended way to perform such analysis is to begin with the final decisions and work backwards in time, which will result in a present value.
The Decision Tree Analysis Method offers a big advantage over the DCF analysis: it factors the value of flexibility associated with a project. However, assumptions still need to be made regarding the discount rate (as does the DCF method). It is important to use a discount rate appropriate with the level of risk involved at each stage of a managerial decision associated with the development of a brand or IP.
The Brand Value Equation Methodology (BVEQ™): In this methodology, a core value for the trademark is calculated, and then each of the individual other assets attached to the core asset have their values calculated. Therefore, the sum of the core brand value plus the incremental assets becomes a total brand value. Expressed in an equation it as follows:
BVEQ = CBV + IVE1 + IVE2… IVEn
The Competitive Advantage Technique: This technique is best used when the subject company has a complex portfolio of intellectual property and works on the supposition that the IP is giving its owner an advantage over its competitors because of proprietary patents, technology, trademarks, software or other intangibles.
Monte Carlo Analysis of Value: This is a method to evaluate how possible future outcomes can affect the decision of whether or not to use a new piece of IP based on possible value – remember that this methodology is most useful in valuing early stage, non-commercialized technology; and, in particular, where there are many unknowns and numerous scenarios about the future development of the technology.
Options Pricing Technique (The Black-Scholes): Patent licensing shares at least one attribute with all other relevant business decisions: it involves risk. Where decisions involving financial risk are concerned, sound management principles suggest considering ways and vehicles to hedge that risk. One of the central vehicles to hedge risk in modern finance is an “Option.” A patent can be seen as the right to invest in or to license (or enforce through litigation) an underlying technology or product line, during the term of the patent. Therefore, an un-commercialized patent can be valued from this “options” perspective using, for example, methods such as those derived from the famous “Black-Scholes” model.
Snapshots of Value Approach: This is similar in nature to the business enterprise value approach in that the snapshots value is based on establishing two different values for a company: one, based on the assumption that the company has full access to the ownership of the intellectual property and intangibles, and the second snapshot of value based on the fact that the company does not have these assets. Measuring the difference between the two snapshots establishes the value of the IP or intangible asset portfolio.
Subtraction Method of Value or Benchmark Method of Value: Establishing the value of a company against another company by comparing them on a so-called benchmark basis is the premise of this method of value. In one instance, the benchmark value will be a company that owns a particular trademark or patent and the second value for a comparable company that does not have that same asset.
The ValCalc Methodology: A proprietary approach employed by our firm, it is a variation on the return on assets employed approach (see above). ValCalc establishes the economic return that each intangible asset class should be earning. Calculations of adequate return are applied also to all classes of tangible assets within a company. Then the return for each intangible asset is calculated as a result.
Valmatrix Analysis Technique: This proprietary system was developed by our firm more than two decades ago and employs a matrix of the twenty most important predictors of value for a trademark, patent or piece of software. The predictors for each of these types of IP are, of course, unique. They are used in a common manner, however: To score a given IP asset against its peers on a numerical scale. Value is therefore established relative to similar trademarks or patents.
An important side note for the interested reader: whenever possible, we recommend the use of multiple valuation techniques when performing a valuation analysis. This is especially true with intangible assets because active markets may not exist and assumptions need to be relied on in making valuation conclusions. Moreover, uncertainty may develop if one depends on a single methodology to value an IP asset (especially a particularly complex family of technologies or brand assets). History has taught us that, as with any new practice, the evolution of methodologies will be ever-lasting.
Valuing and analyzing intellectual property is still at a premature stage, the field itself hardly more than a few decades old. As the process continues to evolve and experts refine a multitude of methodologies, the art of valuing IP will continue to witness developments, innovation, revision, and diligent progression of techniques to value intellectual property and intangible assets. In all probability, the techniques listed above will either be outdated or refined further to become industry standards.
Take, for example, the notorious Georgia-Pacific factors. For a long time, these standards were implemented as a reliable damages quantification method in patent litigation. However, in a 2012 interview between SRR Journal and Chief Judge Rader (considered to be one of the leading authorities in IP litigation), has said they “were never meant to be a test or a formula for resolving damages issues” and determined them to be “merely a list of things to consider.” Conclusions such as this made by authorities such as Chief Judge Rader alter the landscape of valuation calculation, ruling a once-standard technique to be just a “relic” and “a flawed methodology.”
While we cannot make any definite suppositions about which techniques will escalate to the forefront of IP valuation, it is safe to assume that some of these methods will become obsolete while others will move the ranks to mainstream.