2010-03-12

IP Valuation

The world in which we live is characterized by expanding capabilities but limited opportunities. The term market has become synonymous with competition which has resulted in shorter product cycles. Therefore, companies are becoming increasingly dependent on their intellectual properties (IP). The strategic decisions are becoming increasingly dependent on understanding the economics affecting the value of these properties.

The value of an IP is the value that the market places on licensing an IP or from sale or exchange of other intangible assets. The intangible assets of a company include goodwill, trademark, technological knowhow, trade secrets etc.
                          The economic value of an asset is determined by market transactions between two unrelated entities dealing at arm’s length. Unfortunately intangible assets (including IP) seldom benefits from open market operations, either due to novelty or secrecy factors. Given the market conditions there is an urgent need to assess the economic value of such IP as early as possible in the product development cycle.

IP valuation is required in areas like:

• Purchase and sale of assets
• Licensing
• Corporate finance
• Litigation
• Transfer Pricing
• Financial reporting

Benefits of value assessment
Assessment of the value of IP provides certain benefits as well. Targeted valuation of IP helps companies to:

• Choose between market opportunities.
• More effectively protect and leverage the IP portfolio and important technology necessary to capture innovation and future growth.
• Develop a strategy for IP development and protection that is closely aligned with the company’s overall strategic goals.
• Identify un-tapped value and revenue opportunities.
• Compare and select projects for the best allocation of the development budget.
• Better utilization of the IP portfolio through various commercial avenues such as licensing, donation, joint ventures, divestiture, transfer to suppliers, set-up of subsidiaries, spin-offs, etc.
• Justify a return on investment for technology and patents.
• Reflect overall company value more accurately on financial statements.

It is important to understand the methodologies involved valuation of IP:

In the Cost approach, the cost to create or recreate the asset is considered. Thereafter, we compare the costs of developing the asset to the expenditure other companies might have to incur if they start from scratch. The cost approach is based on several economic principles such as the principle of Substitution (a prudent buyer will always equate cost of an IP to the cost of developing an asset of equal utility), the principle of Externality (the market is not always able to internalize the externalities which then does not reflect its true value), the principles of Functional, Technological and Economical obsolescence (the value of the asset may be reduced by its inability to perform a function for which it was designed, or due to the presence of close substitutes or by external considerations such as economic cycles), and finally the principle of Shifts in supply and demand (which depends upon the market conditions).

The Market approach, which deals with the sales of comparable intellectual property, where a “somewhat” similar deal could be used for the purposes of comparison. In the absence of a buyer-seller or a licensor-licensee relationship, the valuation process using the market approach seeks to reproduce the context in which a transaction would normally take place in an open market. A survey of the information available on transactions made by publicly traded companies in a field or industry similar to the valued IP is generally performed. Because transactions on comparable IP can be structured in different ways, the research and development of comparables and metrics, particularly for royalty rates, remains complex and time-consuming.

The Income approach, which is based on the future economic benefits produced by the intellectual property; where we take into account the current value of future economic benefits. The various income valuation methods may be grouped into two analytical categories: Direct Capitalization and Discounted Future Economic Benefits. In a direct capitalization analysis, the appropriate measure of economic income for one period is defined and divided by an appropriate investment rate of return (called the capitalization rate), which may be derived from the expected useful market life for the IP. In discounted future economic benefits analysis, the appropriate measure of economic income is projected for several time periods in the future. This projection of prospective economic income is converted into a present value by the use of a present value discount rate. This discount rate is consistent with the rate of return expected by the investor for the time period.

All the three methods generally provide a reliable value estimate. But, it is generally advisable to compare the result obtained by two methods for the purpose of challenging the results. The value provided by each method should be different. No methodology can be equally pertinent however to the particular IP situation under analysis.

A valuer should base his opinion on the value provided by what appears as the more reliable methodology, to the extent of discounting the value by a factor reflecting the qualitative and quantitative contribution of the second best value.

IP valuation faces certain limitations:

• It is based on estimates & assumptions, and a subjective bias.
• It is still a work in progress and hence would need some more time before companies can base economic strategies on it.

However, one should not see valuation as science, but an external judgment based on heterogeneous information pertaining to the IP, product and business project. Sound data and the scientific methodologies offer a scope for improvement. Because of the increasing importance of IP in a company’s valuation, turning ideas into profit is and will continue to be the biggest challenge and the greatest reward of companies in the information age. Sensible decisions making an efficient allocation of resources are therefore essential in achieving the objectives.