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A Case Study on the Importance of Patented IP

By: Edward J. Usalis, AccuVal Associates, Inc.

In today's knowledge-based economy, corporations are continuing to invest more money in intangible assets. Sometimes - depending on the company or industry - those investments can surpass investments for machinery, equipment and buildings. Innovation is critical for staying competitive in the marketplace, and corporate balance sheets have shifted to allow more focus on intangible assets and intellectual property. Furthermore, as corporate awareness of intellectual property has increased substantially, the number of patent applications and granted patents has boomed.

Patents are major corporate assets. Specifically, the value of a patent or patent portfolio might be needed for a number of business transactions, including:

• Evaluating a potential merger or acquisition.
• Identifying and prioritizing assets that drive value.
• Making decisions about the development and commercialization of intellectual property.
• Evaluating commercial prospects for research and development projects.
• Supporting a valuation for loan collateral.

Valuing a patent

It's critical for businesses to understand the value of their patent portfolios, whether the patents were internally developed or acquired. The value of these portfolios is increasingly important in transactions such as securing a loan, mergers and acquisitions, dissolution of a business, bankruptcy and infringement analysis. As with most valuations, a patent's value can be determined through the cost, income and market approaches.

Cost Approach

What's critical for the cost approach to patent valuation? An indication of the value-based replacement cost - or the amount (at a present value) that would be necessary to replace the protection right and any future benefits that would be derived from the invention supported by the patent. A prospective buyer of the patent would not be willing to pay more for the patent than what he or she would have to pay for an equivalent protection right.

Income Approach

In broad terms, this approach bases value on future expected cash flow. The income approach sets a patent's value based on the present value of the incremental cash flows or future cost savings.

Market Approach

This methodology asks what a willing buyer would pay for a similar item. In other words, the value of the patent equals the value of similar patents (or patented products) that have been sold before. Assessors should pay careful attention to industry characteristics, existing market share or potential market share, and growth prospects when finding comparable transactions.

Limitations of valuation approaches

All of these approaches have limitations. First, the cost approach doesn't consider a patent's ability to generate profits. Second, though the income approach attempts to account for a patent's profit potential, it relies on projections that can be very subjective. Finally, the market approach is limited by the difficulty of finding truly comparable transactions. Despite these limitations, patent valuations are designed to make reliable assumptions about risk and an asset's potential on the market.

A case study in valuing patented IP

A client recently asked AccuVal to prepare a valuation for about 60 patents for an emerging technology. This pre-revenue technology company needed the valuation to build a patent portfolio, which would serve as collateral for financing. For this valuation, fair market value was utilized as the standard of value. How was fair market value defined? The price of cash equivalents at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm's length in an open and unrestricted market, when neither is under compulsion to buy or sell and both have reasonable knowledge of the relevant facts.

Information used

AccuVal based the patent portfolio's valuation on the following:

• Copies of the client's issued patents.
• The client's go-to-market strategy for commercializing the patent technology.
• Forecasts from the client, showing projected global sales for products based on the patent portfolio. These spanned a 12-year period from the valuation date through the end of the legal life of the patents.
• Various industry resources discussing the market potential for the patented technology.
• Discussions with the client's management team about the history and prospects for commercializing the patent portfolio, and a review of the client's financial projections.

Selected valuation approach

After carefully considering the three methods, AccuVal assessed the client's patent portfolio by the income approach. The cost and market approaches seemed limited, for varying reasons. For the cost approach, there was too little information about the funds that would be needed to replace the portfolio. The market approach also was discounted because the portfolio was so unique and revolutionary that no comparable transactions existed.

Applying the income approach

Through the income approach, AccuVal employed the relief from royalty method. Simply put, that method considers the present value of incremental income a company would lose, if it didn't own the intellectual property and needed to license it from a third party, plus rental charges that would accumulate from using the technology. In applying this method to the client's patent portfolio, the three key inputs were the royalty rate, sales forecast and discount rate.

AccuVal examined market data about licensing transactions within the client's industry to establish the royalty rate. This particular technology had never been licensed, but a number of past transactions involved similar transformative, patented technologies were found. That set the client's patent portfolio and its commercialization into context. By analyzing those transactions and the market potential for the new technology, AccuVal set a hypothetical royalty rate: a percentage of revenue that would be lost if the client had to license the patented technology.

Although the client provided AccuVal with multi-year financial projections for commercializing the patent portfolio, those numbers were aggressive. Each major assumption about the size of the addressable market and adoption rates of the technology were questioned and underwent a thorough overview. Due to company and industry research, AccuVal adjusted the projections to reflect a slower adoption of the technology in the market.

Finally, because the patent portfolio hadn't been commercialized or generated revenue or profits, a high discount rate was applied to the royalty savings. AccuVal, as a starting point, consulted academic studies about the rates of return needed for early-stage venture capital investors. This venture capital level discount rate was warranted, as the patent portfolio was just about to be commercialized and had not generated revenue yet.

Through the relief from royalty method, AccuVal used market-derived royalty rates, combined with a risk-appropriate discount rate to reach a credible, defensible value for the client's patent portfolio.

Conclusion

Patents and other intellectual property are increasingly important in the market, no matter the industry. Companies should understand the methods and risks involved when valuing these assets and keep their portfolio values up-to-date. No matter the approach to valuation, patents and other intangible assets should be considered as critical as the physical assets that keep a business running from day to day.

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About AccuVal
AccuVal provides a broad range of valuation, advisory and asset management solutions that contribute to growth or help ensure survival. We appraise the business enterprise and shareholder equity; bonds; intangibles and intellectual property; machinery and equipment; inventory; real estate and accounts receivables in over 100 industries worldwide. Learn more at www.accuval.net.