Techniques for valuing Intellectual Property (IP)
Intellectual Property Rights (“IPR”) are worth only what a buyer or licensee will be willing to pay for them. There is no fixed set of rules that can be applied to every valuation. The particular valuation technique selected will very much depend on the unique qualities relating to each IPR and the circumstances surrounding each commercial agreement, such as product market share, barriers to market entry, legal protection, IP’s profitability, economic useful life (as opposed to legal life), growth forecasts as well as industrial and economic factors.
In the UK there are several recognized methods of valuing Intellectual Property Rights. No one method is 100% perfect for a particular situation and equally, no one method is suitable for every case that arises. This is why it is common for one method to be used and then a second method to be evaluated as a way of cross checking the results. This is sometimes referred to as a Valuation Sense Check. Always remember that in valuing IPR, the process can be subjective and there is no obvious right or wrong answer.
The majority of sellers and licensors usually require an upfront payment in addition to a royalty payment. The larger the upfront payment is, usually the smaller will be the royalty rate. On the other hand, buyers or licensees will attempt to resist any upfront payment on the grounds that they will be required to pay out a large sum before they can receive any income from an IPR and in addition, the upfront payment may bear no relation to the amount of income that the IPR will generate in its economic useful life. Buyers or licensees will usually want to share development risks with the IPR. It is for this reason that some buyers and licensees may want to negotiate a higher royalty rate in order to avoid the need for an upfront payment. However, if the IPR is not successfully exploited, there may be no income on which a royalty can be paid to the seller or licensor. It is for this reason that in the majority of cases an upfront payment is required and it will therefore be down to negotiation between the two parties over the amount of any upfront sum and the future royalty to be paid for the IPR.
The three more commonly used methods of valuing IPR are:-
a) The Cost Approach Method
This will involve reviewing all of the costs incurred in developing and creating the intellectual property together with an evaluation of what the costs could be for recreating the intellectual property or in the development of a similar product. The costs incurred in developing intellectual property could include any or all of the following:
- Labour hours
- Materials, equipment and services
- Research and Development expenditure
- The possible development of a prototype
- Trials and testing
- Any regulatory approval and certification
- Registering the IPR
The method will also involve looking at what it could cost to recreate the IPR or to develop a similar product or service. The principle of the cost approach method to valuing IPRs is that a potential purchaser/investor will not pay any more for the asset than the costs that would be incurred in obtaining or constructing a substitute asset of equal quality and utility. The cost approach method can therefore be based on either the historic cost of the asset creation or the estimated replacement cost to create a similar asset with commercial utility, less an adjustment for any obsolescence that may have occurred.
The seller’s intention here would be to persuade the interested/potential buyer that he/she can avoid these costs by purchasing the IPR from him/her. The seller will also need to persuade the potential buyer that if he/she purchases the IPR then the following costs would be avoided:
- Spending at least as much to develop a similar intellectual property
- The risk that the buyer may not be successful in developing a similar intellectual property
- The risk that a similar intellectual property may not be protected
The Cost Approach Method usually finds favour with the seller because it appears fair to them that they should receive all of the costs that they have out-laid on the intellectual property.
This method is also much easier than the other valuation methods. However it is only really appropriate in the valuation of easily replicable assets.
From the buyers point of view this method is not satisfactory. This is because the historic costs incurred in the creation of the IPRs may well have no bearing on the future income that could be generated from it or even the costs the buyer may incur in bringing the asset to the market place. It could also be that the cost method could undervalue the IPR from the seller’s point of view, for instance if the development costs were lower than expected. On the other hand if the development costs were higher than expected or there have been inefficiencies in the development of the IP asset, it could result in an over valuation.
b) The Market Approach Method (sometimes referred to as the Sales Comparison Approach Method)
This method of valuation is based on the economic principle of competition. It is based on the reasoning that in a free and unrestricted market place, supply and demand factors will drive the price of an IP asset. It provides an indication of the value by comparing the price at which similar intellectual property has been exchanged between buyers and sellers in the recent past. However, in practice it can be difficult to use this method effectively because very often it can be difficult to obtain, what is often the case, confidential information about other similar transactions. No two deals are really the same. Businesses trading in niche markets will very often find difficulty in locating any comparative information for their IP assets. However, this method is considered to be objective and fair to both the seller and the buyer, despite being in the large an impractical way of establishing the valuation of an IPR.
c) Income Approach Method
This approach involves the estimating of the fair value of IP by discounting the future economic benefits (income) of ownership at an appropriate discount rate. It is based on the reasoning that the amount an investor will be willing to pay for an IP asset is the cash flow that is expected to be generated from it during its economic useful life, discounted by the cost of capital. The thinking behind this method is that IPRs are only worth what they will generate in future income streams so will involve looking at the future income which the IPRs could generate and the costs of generating that income over the economic useful life of the IP asset. Then the result will be discounted to allow for any risk and the cost of money. This will generate the net present value – often referred to as the NPV. So long as the NPV result is positive, a buyer using this method of valuation is more likely to proceed with the purchase of the IP asset.
However, there are a number of problems associated with this valuation method. It can often be difficult to estimate the economic useful life of an IP asset as is indeed estimating the future income generated from it over several years. Generally, it is a rule that it is not realistic to forecast income beyond five years. Many factors need also to be taken into account including the size of the potential market for the IPR, the competition, the economic climate and registering and defending the IPR. Establishing a fair and reasonable discount rate can also be problematic.
The income based valuation method is closely linked to those methods for determining royalty rates.
There are actually a number of variations to the Income Based Valuation Approach that can be considered. The Income Approach Method is generally the most appropriate way for valuing the likes of patents and trademarks.
There are other valuation approaches such as the Direct Approach which is based on the current value of shares of intellectual property in an Intellectual Property Share market or by using the Pay-Off Approach method on top of those methods already referred to as a way of enhancing the valuation and analysis of intellectual property. These last two methods are not commonly used.
A seller or licensor is more likely to be successful in their negotiations with a buyer or licensee if they have a good idea of what might be a fair and reasonable price to charge and how they can justify the amount they want to charge.
Royalty Rate Determinations
Royalty payments are a form of profit sharing. The parties to a licence are able to choose whatever basis of royalty calculation that fits in with their own particular commercial considerations. However, the most common method adopted is that of royalty payments being expressed as a percentage of revenue or gross profits. Whatever basis is adopted, consideration needs to be given to the detail in the agreement. Two important issues influence a particular royalty rate. Firstly, the level of income generated by the IP and secondly how this income is shared between the IP owner and the licensee. It must be noted that the particular characteristics of IPRs and the subtleties of licence agreements can complicate matters. There are a number of approaches in the determination of royalty rates and information relating to these methods can be obtained upon request.
Decisions regarding the value of IPRs and royalty rates have far reaching commercial consequences. Both sellers and buyers should therefore thoroughly examine potential IP future earnings prior to any transaction being undertaken and give very careful consideration of the value impact of the terms of any agreement. It is advised that professional advice should be sought in order to avoid the potential for disputes or litigious issues.
Sellers and buyers, licensors and licensees will usually negotiate with one another and reach some sort of compromise on the price to be paid for IPRs and/or ongoing royalty payments. A reasonable compromise will be reached more easily if the seller or licensor understands prior to negotiations commencing, his/her own position as well as the position of the buyer or licensee.
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This article was kindly provided by one of Stirling’s independent Valuers who is an FCCA.