Approaching Patent Valuations, Common Methods and Qualifications of Analysts

Guest blog by Manoj P Dandekar, Ph.D., ASA, FRICS

Dr. Manoj P. Dandekar is the Managing Director of Enterprise Economic Evaluation.  He has over 30 years of experience in the identification, valuation and remaining life analysis of intangible assets and intellectual property as well as the appraisal of business enterprises and partial business interests. (Details at: www.3isgroup.com)

3 Approaches to Patent Valuations and Commonly Used Methods

IP (intellectual property), in the form of patents and proprietary technology, is what makes your company unique, and uniqueness is what leading companies strive for. What are the best methods for valuation of your IP?

When we consider the fundamental similarities and differences of the several methods to value patents, they all logically group into the three general categories of valuation analyses. The three approaches to patent valuation, collectively, encompass a broad spectrum of economic theory and of property investment concepts:

• Market approach
• Cost approach
• Income approach

The nature, quality, and quantity of information available will determine the optimum approach(es). More than one valuation method may be appropriate.

The market approach is based upon the related economic principles of competition and equilibrium.

• These economic principles conclude that, in a free and unrestricted market, supply and demand factors will drive the price of an investment to a point of equilibrium.
• Determines value by comparing the intangible asset to similar assets that have been sold.
• Market data is adjusted for factors such as market comparability.
• Less frequently used (other than royalty rates) because of the lack of public information on transactions of comparable intangible assets.
• May be difficult to find recent transactions; may need to consider more dated information.
• Transactions that occur close to the valuation date can be more meaningful when current economic conditions are volatile.

The cost approach is based upon the economic principle of substitution. This basic economic principle asserts that an investor will pay no more for an investment than the cost to obtain (i.e., either purchase or construct) an investment of equal utility.

• The availability (and the cost) of substitute investments is directly affected by shifts in the supply and demand functions with regard to the universe of substitute investments.
• Quantifies the costs required to replace the future service capability of the asset.
• Considers reproduction cost or replacement cost as an indicator of value.
• The time and costs incurred (e.g., to build a distributor network, establish a patent, create a trademark, etc.).

Different techniques are used to measure costs:

1. Reproduction cost method: Estimations are performed by gathering all costs associated with the purchase or development of a replica of the intellectual property under valuation.
2. Replacement cost method: Estimations are performed on the basis of the costs that would be spent to obtain an equivalent IP asset with similar use or function.

For both methods, the costs as of the valuation date and not the historical expenditure when they actually occurred are taken into consideration. The following costs should be considered:

• Direct costs, such as materials, labor and management
• Indirect cost, such as external legal and development expense
• Developer’s profit on the direct and indirect costs
• Entrepreneurial incentive (opportunity cost or lost income during the replacement period

Since the costs are considered as of the valuation date, the evidence of the patent value is as if it is current as of that date. Accordingly, certain factors should be considered to reflect:

• Physical depreciation (not a significant factor)
• Functional/technological obsolescence

o the patent remaining useful life
o excess capital cost
o excess operating cost

• Economic/external obsolescence

o the patent’s inability to earn a return on investment

The income approach is based upon the economic principle of anticipation (sometimes also called the principle of expectation).

• This expectation of prospective economic income is converted to a present worth — i.e., the present value of the expected economic income to be earned from the ownership of the patent or patent portfolio.
• Determines value by converting anticipated economic benefits into a present single amount.
• Assumes that the income or cost savings derived from an asset will, to a large extent, drive its value.
• Relies on a cash flow forecast.
• Based on a discount rate that reasonably reflects the risk of the forecast.

What are Commonly Used Methods in the Valuation of Patents?

Relief-from-royalty (RfR) method: In this method of the market approach, the value of the asset is considered as the value of the royalty payments from which the company does not have to pay since it owns the patent. Hence, the appropriate royalty rate is determined, and the future royalty income stream is estimated. An appropriate discount rate taking into consideration the risks (as mentioned above) is estimated and applied to calculate the present value of this royalty income stream to provide evidence of value of the patent.

Excess Earnings Method (EEM): In this method of the income approach, the economic income or excess earnings are projected after deducting a capital charge on other assets that are used or used up from the profits generated by the patent application. A present value of these future excess earnings is computed by applying an appropriate discount factor. The main source of information to estimate the profits from the patent is generally the business plan of the company that exploits or intends to exploit it.

Option-based techniques to value patents have been presented by some analysts given the advances in technology, computing power, data availability, etc. Unlike other methods, the option methodology considers the options and opportunities related to the investment. It relies on option pricing models (e.g. Black-Scholes) for stock options to achieve a valuation of a patent especially in its early stages. The option pricing method is not commonly used.

Appraisers and economists typically attempt to analyze intangible assets using all three of the basic valuation approaches—in order to obtain a multi-dimensional perspective on the subject intangible asset. Quantity and quality of data dictates which approach and method prevails. The final value estimate conclusion is typically based upon a synthesis of the value indications derived from various approaches and methods.

Choosing a Qualified Valuation Analyst or Appraiser

Valuation, especially patent valuation, is a mixture of science and art. The science is in the financial analyses and formulas that a valuation analyst uses to quantify value from the various sources of data. The art is in how the valuation analyst applies these formulas to generate a meaningful and defensible value.

A valuation analyst should have some background necessary for the understanding and appreciation the technology and legal rights associated with patents including elements of finance, accounting, law, economics, management and other disciplines

A qualified valuation analyst or appraiser:

• Has earned an appraisal designation from a recognized professional appraiser organization with minimum education and experience requirements.
• Regularly performs appraisals for compensation.
• Adheres to a set of professional standards and/or code of ethics as is required for a credible valuation.

Summary: The Patent Valuation Process

The generally accepted valuation approaches and methods presented here are applicable for patent and patent portfolio valuations. The selection of specific valuation approaches and methods are based on:

• Its particular characteristics
• The bundle of legal rights subject to analysis
• The quantity and quality of available data
• Performance of sufficient due diligence related to that data
• The purpose and objective for the patent valuation such as:

o sale or licensing transaction
o financing
o strategic planning
o taxation
o financial accounting
o bankruptcy
o litigation / infringement
o some other purpose

With R&D efforts, new applications, newer markets, technology and patent valuation should be revisited every three to five years to help management evaluate its strategic business policies.

The experience and professional judgment of the valuation specialist is crucial for the task.